It is estimated that over $3.5 TRILLION is lost to fraud every year. That’s more than the combined GDP of the smallest 135 countries in the world. That’s the GDP of Germany.
In any given year, the average business loses about 5% of their revenue to fraud, and small businesses are hit the hardest - sustaining higher median losses than larger organizations. The lack of proper fraud prevention measures (controls) make them easier targets for fraudsters.
After last week’s post, you may be thinking to yourself, “OK, I know fraud is an issue, but what am I supposed to do about it?” The first step is to arm yourself with knowledge. Similar to other crimes, there are certain conditions which make a person more likely to commit fraud. A criminologist named Donald Cressey developed a framework called the “Fraud Triangle” for understanding this phenomenon. According to his theory, the three components of the triangle are pressure, opportunity and rationalization.
An example of this would be an employee who needs money to support their lifestyle (pressure), has been passed over for a promotion they think they deserved (rationalization) and has access to a company credit card no one else oversees (opportunity). In fact, this example is pulled from my personal experience working with a company whose previous finance director did exactly this.
There are many different types of fraud, but the example above is based on a specific subset called “occupational fraud.” This is the type we’ll explore today, and the main kind Scrutinize is designed to detect.
Occupational fraud is defined as “the use of one's occupation for personal enrichment through the deliberate misuse or misapplication of the organization's resources or assets.” The three categories of occupational fraud are asset misappropriation, corruption and financial statement fraud. Each can be perpetrated individually, but they are often used in conjunction with each other.
Misappropriation in this context means using any of the company’s assets for any other purpose than the direct benefit of the company. This includes theft, but also includes misusing company assets for personal gain.
Theft falls into the following categories:
Theft of cash on hand - taking cash from a secure place such as a company lockbox.
Theft of cash receipts - taking cash the company receives from doing business. This can be accomplished by stealing from a register or intercepting payments to the company.
Fraudulent disbursements - causing the company to issue payment to the fraudster by creating fictitious vendors, submitting false expense reports, creating forged checks, creating fake employees or other false disbursements.
Theft of inventory and other assets - taking any non-cash asset of the company for personal use, such as: office supplies, vehicles, computer equipment, etc.
Sometimes, people “borrow” things from the company they don’t intend to keep or use company assets in ways that personally benefit them. For example, using a company vehicle for ride-sharing on the weekend or using a company computer for personal reasons. These don’t sound very nefarious, but are in fact fraud.
All of these schemes come in many forms and can get complex quickly. Asset misappropriation is by far the most prevalent of all types of occupational fraud.
Corruption is broadly defined as wrongful acts undertaken to achieve unfair advantages.
Four categories of corruption are:
Conflicts of interest - directing company business in such a way as to create illicit gain for yourself or other parties with whom you have a relationship. For example, using your purchasing authority to procure supplies from a company owned by your brother. Disclosing such conflicts negates the issue.
Bribery - giving, taking, asking for or offering anything of value with the intent to impact a business decision.
Illegal gratuities - anything of value that is transferred from one party to another as a result of a favorable business decision by the receiving party on behalf of the giver.
Economic extortion - receiving anything of value by way of threatening or committing an act of force or an act intended to instill fear in the giving party.
Corruption is hard to uncover. The exact nature of an improper relationship or payments to an individual are not always readily apparent to the company and often the illicit gain does not create an auditable trail. That said, there are patterns of behavior associated with the different types of corruption. It is common for corruption to be perpetrated in tandem with other fraud schemes such as asset misappropriation or financial statement fraud. In those cases, the corruption is usually found as a result of an insider tip or noticeable pattern in the company’s records.
Enron. WorldCom. Lehman Brothers. This guy.
What do these things have in common? If you guessed “financial statement fraud”, you win.
Financial statement fraud schemes can be incredibly complicated, often intentionally so, but the intention is easy to understand - manipulate the accounting records to deceive the end user of the financial statements into believing the company is performing better or worse than it is in reality.
Intentional overstatements of revenue/assets - entries or misstatements created to materially affect the financial statements in a positive manner. This is usually done to defraud investors, management or lending institutions.
Intentional understatements of revenue/assets - entries or misstatements created to materially affect the financial statements in a negative manner. This is usually done to defraud government bodies such as the IRS.
We don’t have to look too far afield for examples of this kind of fraud. Recently, Texas billionaire Robert Smith, CEO and Chairman of Vista Equity Partners, settled with the government for $140 million related to a tax evasion scheme he perpetrated by understating his personal assets and income. Millions of dollars were stored in offshore accounts, which he controlled but failed to report. The initial investor in Vista Equity Partners, referenced in the link above, is also being charged with $2 billion of tax fraud in the largest ever criminal case brought in the United States.
This kind of fraud is usually found through a careful scrutiny of the ratios between certain financial statement accounts over time.
In future articles, we will do a deeper dive into the mechanics of each of these types of fraud, as well as red flags and preventative measures you can take to protect your company against them.
For answers to questions you have about this or related topics, schedule your free consultation today.
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