Fraud Detection – Why, How and When
November 18, 2016
By Hubert Klein, CPA/ABV, CVA, CFE, CFF and Michael DaCosta
The Association of Certified Fraud Examiners (“ACFE”) has released the results of their biannual Occupational Fraud Survey and expectedly, as shown in the past several surveys, occupational fraud continues to plague business both domestically and internationally. In our review of the recent survey, we’ve found that different fraud schemes can have a significant impact on a business’s financial operation, cash flow and public reputation.
Most fraudsters don’t begin their illegal undertakings with the intent of ever getting caught. Generally, they are fully aware of the consequences of their actions and the risks they are putting on their careers, reputations and, in some instances, freedom. Nonetheless, given their circumstances, the perceived rewards of financial gain and status outweigh the risks of getting caught.
Studies show that there is a paradigm known as the fraud triangle. The paradigm consists of three key elements that are generally present for a fraudster to commit their wrongful act – opportunity, pressure and rationalization. Generally in occupation fraud schemes, the perpetrator has the pressure and opportunity to commit the fraud, all they are waiting for is a motive to trigger them to act. Motives can be based on many factors – need for additional income, a financial hardship, seeking status, an addiction (drugs or gambling) or some other form of rationalization and validation that they are doing the wrong thing for the right reasons.
From a detection standpoint the ‘why’ and ‘when’ is generally less important than the ‘how.’ It is clear that uncovering fraud can be a very difficult process given the fact that, initially, the perpetrator is the only one aware of the fraud occurring and usually has no intentions of turning himself in. So from the outside looking in, it is not only difficult to uncover that there is fraud occurring, but also how it is occurring and who is responsible for it. While organizations can be vigilant in trying to prevent or detect fraud in its earlier stages, perpetrators are usually aggressively manipulating information and using various techniques to cover their trail.
So the question becomes “How is occupational fraud uncovered and how can it be prevented? And the answer isn’t exactly what most people would expect or like to hear.
Contrary to what most people might think, the majority of occupational fraud schemes are not detected as a result of the work performed by internal or external auditors. Instead, they are usually uncovered through tips. Most commonly, these tips come from other employees within the organization but it is not uncommon for people outside of the organization such as customers, vendors, shareholders and even the organization’s own competitors to leave a helpful tip. The graph below constructed by the ACFE depicts this and lists some of the other common ways that occupational fraud is initially detected
One major issue for anyone reporting a suspected instance of occupational fraud is whom to report the fraud too once it is suspected and/or uncovered. The answer is – it depends. Most people tend to communicate information to their direct supervisor because they’re usually the first resource they seek when they have an issue. However, depending on the department in which the fraud is uncovered, the organizational level of the employee committing the fraud and several other variables involved in the fraudulent activity, it may be inappropriate to just relay the information to your direct supervisor.
According to studies by the ACFE, the majority of whistleblowers (58%) elect to use internet-based reporting such as emails or web-based/online forms while the remaining reports come from the submission of physical forms or direct reports to a direct supervisor. Those reporting mediums are great for those of us who don’t mind serving on the front line against injustice and having their name identified as the source of the report. However, there are people who would rather do their good deeds behind the scenes and remain unidentified. There are numerous reasons as to why an employee would elect to remain anonymous. Sometimes it’s because their tip may involve a direct superior or another person who may have the ability to negatively impact them or their career and they fear retaliation. Because of this, they would rather report wrongdoing anonymously and let the organization investigate the allegation.
As a result, companies have begun to take notice of this and have begun to implement procedures for those who would like to report suspected instances of occupational fraud through tip hotlines. These hotlines can be either internal (within the organization) or external (a private company or fraud fighting organization). Many companies have developed policies and procedures for where and how to report tips for suspected fraud activity. The study also indicates, 14% of total reporting tips came from anonymous sources through such hotlines. These hotlines and resources are generally made available to employees and outside parties and have proven to be advantageous for those companies who have successfully implemented them into their fraud prevention and detection control activities.
The graph below visually depicts the effectiveness that having an anonymous hotline available provides and how it can alleviate the pressures and money spent on uncovering occupational fraud through other methods.
The ACFE survey also shows that the method in which the fraud is uncovered can vastly impact the effect the fraud has on the company. For instance, if a surveillance camera caught an employee stealing from the register, the issue would be resolved fairly quickly, with substantial evidence of wrongdoing and minimal losses to the company. However, if it were to get to the point where it has gone undetected for over a year and we begin to look towards outside services such as external auditors, law enforcement, tips or sheer luck to detect the ongoing fraud, losses could reach detrimental heights.
Like in any other aspect of business, there are risks and occupational fraud is no different. So, from an organizational standpoint, the question becomes how much risk is your organization willing to take and what can they do to minimize that risk?
The key consideration is that the longer an occupational fraud continues without being uncovered, the greater the risk and size of a financial loss. Knowing how occupational frauds are detected and reported is important, as it helps when designing and strengthening an organization’s fraud fighting controls. It is also useful when designing, reviewing, and updating organizational policies and procedures as they relate to the detection of occupational fraud within an organization. Organizations that are proactive can reduce their risk of occupational fraud and resulting financial loss. In addition, they may be able to deter and, in a perfect world, detect fraud schemes quicker than organization that are reactive and slow to adapt their controls, policies and procedures to the ever changing business world.
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