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Controlling Fraud and Abuse

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While the legal definition of fraud changes from jurisdiction to jurisdiction fraud can be defined in common terms as an intentional deception made for the purpose of personal gain or to damage another person. Fraud is intentional; it doesn’t happen by accident. Fraud involves deceit. People who commit fraud misrepresent material facts, they lie, in the hope that the intended victim will rely on their false representation to their detriment.

You might be interested in this fraud case (Gunther Herrmann Skarin fraud in Johannesburg):

Fraud is not usually a violent crime, it is not a victimless crime. In fact, every time you make a purchase you are probably paying the price of someone else’s fraud. The 2012 Report to the Nations published by the Association of Certified Fraud Examiners indicates that the typical organization loses 5 percent of its revenue through fraud and that the worldwide cost of fraud is about $3.5 trillion. Companies, to compensate for the cost of fraud increase the prices of their goods and services and we all pay the price.

Sometimes fraud is committed by an organization, think Enron, against the public. Other times fraud is committed against an organization by individuals like employees, customers, and suppliers. This type of fraud is often referred to as “occupational fraud and abuse” and is the subject of this article. The medial loss from this type of fraud, according to the 2012 Report to the Nations, is $140.000; however, more than one fifth of these frauds resulted in losses in excess of $1 million. Fraud losses are not small change. Compare that with the amount taken in the average bank robbery, just $4,330 according to one survey.

So who are the fraudsters? Take a look around you… they look just like you and me. Individuals who commit fraud in general are well-educated, have been with a company for long enough to have been promoted to a position of trust, and usually work in a company’s accounting, operations, sales, customer service or purchasing departments, or hold executive or upper management positions. These are places were an individual has access to cash or other assets, and the ability to steal the assets and hid the theft.

All frauds are not equal and not surprisingly, frauds committed by executives and upper management are bigger, averaging over $500,000 each. Frauds committed by managers are smaller, about $180,000 incident while those committed by other employees are the smallest, averaging only $90,000… but still a lot more than that taken by a bank robber.

You might wonder how frauds are detected. Very few frauds are identified by external auditors, the ones that have a professional responsibility to detect material fraud if it exists. Surveillance and monitoring, and accounting control process like document review and account reconciliations do an equally poor job of detecting fraud. And forget about the police, they only show up after a fraud has been detected. It appears that when it comes to fraud we have to rely on the kindness of strangers. By far the best fraud detection mechanism is an anonymous tip. Sad but true, over 40 percent of all frauds are detected this way.

So you run a business or are a corporate manager. What can you do to reduce fraud risk. Two big things. First, understand the fraud triangle and second, be aware of behavioral risk indicators.

Fraud is more likely to be committed when all three elements of the fraud triangle are present: opportunity, pressure and rationalization. Opportunity is present when someone is in a position to steal an asset (cash or inventory for example) and hid the theft, usually by manipulating business documents or the accounting system. Think about your company or department. Can you think of a creative way to steal cash or another asset from you business and cover up the theft? If so, then chances are good that someone else has already thought of it and may in fact be doing it right now.

Individuals tend to commit fraud when they are under financial pressure. We talk to our friends and colleagues about many things, but not about our personal finances. Financial pressure has many sources: unexpected medical expenses, college tuition for which a family wasn’t financial prepared, addictions (gambling, drugs, etc.). When individuals experience financial stress and can’t share that pressure with others they often start to look for relief, and fraud can be a way out.

Individuals who commit fraud have to look at their faces in the mirror every day and live with their actions. One way to deal with the inner conflict that comes doing something that they know to be wrong is to justify their action, to provide a socially “acceptable” excuse for their actions. For example, and employee may think, “I work really hard and I don’t get paid what I am worth. If they paid me a fair wage I wouldn’t be in this mess so I’m not stealing, I’m just taking what they owe me.” That is rationalization.

Managers and business owners can’t get inside their employees heads to see what they are thinking; how they are rationalizing their behavior. They can, however, be aware of behaviors that result from such rationalization, behaviors like withdrawal, anger, and frustration. They may snap when asked simple questions or withdraw from usually activities like the water cooler chit chat.

Of the three elements in the fraud triangle (opportunity, pressure, and rationalization) opportunity is the easiest to work with. Well designed internal controls are still the best way to reduce or eliminate opportunity.

In addition to being aware of the fraud triangle and using it to evaluate risk, it is also important to be on the lookout for behavioral red flags. The most common red flags include:

  • Living beyond means (think new and expensive adult toys like cars, homes, and expensive vacations),
  • Financial pressure or difficulties,
  • Unusually close association with vendors, and
  • Excessive control issues.

You are probably familiar with MBO (Management by Objectives). Practice some MBWA (Management by Wandering Around) as well. Be observant, pay attention to employees and be aware of behavioral changes. Remember that you may be the only roadblock in the path towards a fraud. Auditors, management and accounting controls, and the police are not likely to stop the fraud before it occurs and probably won’t even detect it after it has been committed. Get in the way of fraud and use the fraud triangle and behavioral red flags to prevent fraud.