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Commercial Angles' Newsletter - June 2001

Fraud Prevention - Part II

Fraud detection

Fraud is a big subject: too big for a single newsletter to cover. Therefore the subject has been split into manageable pieces. Last month's article concerned identifying the common types of fraud. This month's newsletter discusses the detection of fraud and next month's will contain an article on the prevention and deterrence of fraud.

In this month's article it is assumed that fraud is suspected and that no prior fraud detection procedures are in place. The emphasis will therefore be on examining the facts to determine whether or not a fraud has taken or is taking place.

There is no single test that shows in every single case that a fraud has been committed. Some of the more sophisticated frauds, such as short-term share price manipulation are incredibly difficult to unravel. However most frauds are less sophisticated and frequently involve an employee or manager of the defrauded company.

The starting point for most fraud detection is to ask oneself a series of questions:

If someone wanted to make some money by defrauding my employer, how could he or she go about it?

Someone who knows a lot of detail about the way the business works will probably be able to think of several ways in which the suspected fraud could have been committed.
For each possible method of fraud a further series of questions should then be asked.
1. Who might be involved in this fraud?
2. Why would this person risk his job, reputation and future livelihood by committing the fraud?
3. How would the person attempt to cover up the fraud?
4. Where would the loss appear in the company's accounts?
5. Would the fraudster need accomplices either inside or outside the company to carry out the fraud?
6. What would be the tell-tale signs to look for?
7. Who is the best person in the company to look for suspicious signs of fraud?
8. Is the company's policy to prevent future frauds or punish existing frauds?
9. Is the investigation to be kept secret and if so how does this affect the answers to the above questions?

By answering the above questions for each method of perpetrating the suspected fraud, the company will be well on the way to evolving a fraud detection plan with clear objectives. In particular the following questions will have been answered:

What are the most effective means of detecting whether fraud has taken place?
Who should lead the investigation into the suspected fraud?
What should the company do if fraud is confirmed? At what stage, if any, are the police or others within or without the organisation to be informed?

In what conditions does fraud thrive?

Fraud is found to be more frequent in organisations with some or all of the following characteristics:

Domineering management with no effective oversight board or committee.
Climate of fear or an unhealthy corporate culture.
High staff turnover rates in key controlling functions. Long-service staff in stores/purchasing departments.
Chronic understaffing in key control areas.
Frequent changes of legal advisers, auditors or professional advisers.
Excessive reporting leading to insufficient time for analysis of data.
Remuneration based very significantly on financial performance.
Inadequate segregation of duties - e.g. where an individual orders goods, approves the invoices and then authorises the payments.
Low staff morale / lack of career progression / weak management.
Excessive hours worked by key staff with insufficient delegation of duties.
Lack of effective procedures in HR, credit control, inventory control, purchasing or accounts departments. Consistent failure to correct major weaknesses in internal control.
Management frequently override internal controls.
Rumours of fraud not dealt with effectively or at all.
Inadequate internal reporting or management accounting.
Loss of records or inadequate documentation about transactions.
Unusual transactions having a large profit effect.
Frequent transactions with related parties/ no checking that suppliers are appropriate.
Overly secret dealings with certain clients or suppliers.
Mismatch between profitability and cash flow.
Excessive pressure to meet budgets, targets or forecast earnings.
Personnel not required to take their holiday entitlement.
When an employee is on holiday leave the work is left until the employee returns.
Inadequate responses to queries from management, suppliers, auditors or bankers.
An employee's habits change or his/her lifestyle is more affluent than would be expected from his/her employment.
Lack of common-sense controls such as changing passwords frequently, requiring two signatures on cheques or restricting access to sensitive areas.

Common features of fraud

Except in the case of investment fraud or some consumer scams, most cases of fraud will impact the company profit and loss account or balance sheet. Frequently fraud will become apparent when investigation reveals one or more of the following:

Credit notes given to customers for undisclosed or inadequate reasons.
High level of inventory losses accepted without investigation.
Suppliers insist on dealing with only one employee in the department.
Discrepancies in petty cash are not investigated or written off to "sundry" expenses.
Payroll summaries are not checked by department heads or by the HR department.
Excessive habitual overtime worked without relation to workload.
High levels of sickness absence not investigated.
Unduly friendly relations between some employees and their suppliers or service providers.
Faulty goods are not returned to the supplier for credit or credit notes are not chased up.
Excessive and constant level of returns to suppliers.
Company assets are not checked against a fixed asset or stock register.
Inadequate reconciliation of balance sheet accounts.
Insufficient justification for balance sheet reserves.
Unusually high levels of despatches or purchases just prior to the period end.
Employees' expense claims are not checked and authorised by departmental managers.
Management appears to condone petty fraud because "everybody knows about it but never does anything about it".
Invoices from some suppliers seem high in relation to the goods or services rendered.
Amounts are written off the sales ledger without authorisation or investigation.
Management and supervision are remote from those they control.
Some branches are in reality uncontrolled because of geography or because no manager has become involved in the branch.

Effective fraud detection requires management to be sufficiently knowledgeable about the mechanics of the business and constantly aware of the need to be vigilant against fraud.

Next Part

Articles from previous newsletters