Fraud: the occupational hazards

In recent years, people the world over have watched as companies such as
Enron, Parmalat, and Hollinger International have fallen prey to the financial
misdeeds of crooked executives.

The stories of these organisations and their tumbles from greatness are
symptomatic of what some believe to be a continuing trend of dishonesty in
business. Accountants are often faced with the choice of being part of this
global problem or part of the solution.

Like many of you, I began a career in public accounting. I spent the next ten
years in the trenches as a U.S. FBI agent specialising in fraud investigations.
Then I founded the Association of Certified Fraud Examiners, headquartered in
Austin, Texas and I have been chairman for 20 years.

We now have about 50,000 members in 125 nations. During the last two decades,
I have personally trained tens of thousands of accountants and auditors in the
UK and the US and have conducted extensive worldwide research on white-collar
crime.

My experiences have taught me one thing above all others ­ fraud is a war.
And like other wars, we can’t win unless we have the ability to recognise the
enemy.

Occupational fraud defined

There is no such thing as an ‘accidental’ fraud. In general, four elements
must exist in any fraud case: a material false statement, knowledge of the
falsity of the statement (intent), reliance on the false statement by the
victim, and damages as a result.

Although there are many types of fraud, they all have the above elements as
their common basis. As accounting professionals, we are most often concerned
with one type, which is frequently called ‘internal fraud’. A more precise term
is ‘occupational fraud’, which was defined in the ACFE’s first Report to the
Nation on Occupational Fraud and Abuse as: ‘The use of one’s occupation for
personal enrichment through the deliberate misuse or misapplication of the
employing organisation’s resources or assets.’

As you can see by the breadth of this definition, occupational fraud can—and
does—occur from the mailroom to the boardroom and everywhere in between. But
that doesn’t mean that there is an unlimited number of ways to commit it. In the
early 1995, I began a research project that examined 2,608 cases of actual fraud
provided by Certified Fraud Examiners, many of which occurred in the UK. I
reached the conclusion that regardless of international borders there are three
principle categories of occupational fraud that can be broken down into 13
different schemes and numerous sub-schemes.

This
research developed the Uniform Occupational Fraud Classification System, more
commonly known as the ‘Fraud Tree’.

Some of the major findings from the most recent report are:

• Certified fraud examiners estimate that the average organisation loses about
  7% of its revenues to all forms of occupational fraud (since not all fraud is
  uncovered, reported, or prosecuted, finding the true losses cannot be
  calculated).
• Occupational fraud schemes tend to be extremely costly. The median loss for
  the 959 cases analysed in the study was $175,000 (£114,365), and more than
  one-quarter of the frauds caused losses greater than $1m (£654,624).
• Small organisations, because they typically lack adequate anti-fraud
  controls, are by far the most vulnerable to fraud. Organisations employing fewer
  than 100 individuals were the most frequent victims of the frauds in our study
  and suffered disproportionately large losses.
• More frauds are uncovered through tips and complaints than audits, internal
  controls, or any other means.
• Audits—either internal or external—are not very effective in detecting
  fraud, but do help in mitigating losses resulting from occupational fraud
  schemes. Surprise audits in particular had a measurable impact on an
  organisation’s exposure to fraud.
• The amount lost to fraud is in direct proportion to the perpetrator’s
  position in the organisation; the higher the position, the greater the loss.
• The vast majority of those who commit fraud do not have a criminal record.

Types of occupational fraud

Based on our research of the methods used to defraud organisations, we have
identified three broad categories of occupational fraud: asset misappropriation,
corruption, and financial statement fraud. Each of these can be further broken
down into several sub-schemes (see ‘sub-schemes categories’ below).

Asset misappropriations involve the theft or misuse of an organisation’s
assets. Common examples include skimming revenues, stealing inventory, and
forging cheques. Asset misappropriations are by far the most common of the three
categories of occupational fraud, having occurred in 89% of the cases in the
2008 Report. However, these frauds also had the smallest median loss of the
three categories, at $150,000.

Corruption occurs when fraudsters wrongfully use their influence in a
business transaction in order to procure some benefit for themselves or another
person. Common examples include accepting kickbacks and engaging in conflicts of
interest. Corruptions cases fall in the middle of the three categories of
occupational fraud in terms of both frequency and cost; in the 2008 report,
corruption was a part of just over one-quarter of the cases we reviewed and
caused a median loss of $375,000.

Fraudulent statements generally involve falsification of an organisation’s
financial statements. Common examples include overstating revenues and
understating liabilities or expenses. Of the three categories of occupational
fraud, financial statement schemes are the least common—occurring in only 10% of
cases in our 2008 report—and most costly, causing a median loss of $2m.

Now you have an overview of occupational fraud: the main categories, the
relative frequencies and median losses, and how frauds are typically uncovered.
Although there is much more that we can—and must—learn about fraud prevention
and detection to effectively combat it, hopefully I have laid the groundwork for
you to become an active deterrent to the lies and deceit that plague the
business world today.

Sub-scheme categories

Asset Misappropriations

Two scheme types target incoming cash:

• Skimming schemes are directed at incoming funds, where the perpetrator
  swipes the payment before it is recorded on the company’s books as received
• Cash larceny schemes are the cruder ‘take the money and run’ types of frauds
  that involve the theft of cash that already appears on the books.

Fraudulent disbursements involve thefts of outgoing payments and include:

• Payroll schemes, in which the employee falsifies payroll records in order to
  generate a fraudulent payment.
• Expense reimbursement schemes, such as overstating reimbursable business
  expenses or improperly requesting reimbursement for personal expenses.
• Billing schemes, which typically involve the submission of fraudulent
  invoices and the manipulation of the accounts payable function.
• Cheques tampering schemes, in which the fraudster alters or forges some part
  of a company cheque for his or her own benefit.
• Register disbursement schemes, in which a fictitious refund or void
  transaction is processed, allowing the thief to steal money from the cash
  register.

Theft of non-cash assets involves the larceny or misuse of physical assets,
including inventory, computer equipment, office supplies, and company vehicles;
non-cash financial assets, such as stocks, bonds, or other investments; and pr
oprietary information.

Corruption Schemes

Corruption schemes can be broken down into four categories:

• Bribery involves offering or paying (or, conversely, soliciting or
  receiving) something of value to another party to influence a decision.
• Illegal gratuities consist of payments offered or given as a reward for a
  favourable decision.
• Economic extortion is the flip side of bribery, where one party demands
  payment from another under threat of financial harm, such as loss of business.
• Conflicts of interest occur when an employee has an undisclosed interest in
  a transaction that adversely affects his or her employing organisation.

Financial Statement Fraud Schemes:

Most financial statement manipulations take the form of one or more of the
following classifications:

• Fictitious revenues, which involve the recording of fake sales of goods or
  services.
• Timing differences, such as booking future revenues in the current period or
  delaying the recognition of current expenses until future periods to boost
  current earnings.
• Improper asset valuations, including fraudulently inflating the physical
  inventory count and intentionally miscalculating the amount of goodwill acquired
  in a business combination.
• Concealed liabilities and expenses, for example, capitalising expenses that
  should be charged against income or simply failing to record certain
  liabilities.
• Improper disclosures, such as omitting disclosures pertaining to contingent
  liabilities, related-party transactions, or changes in accounting methods used.
  

Joseph T Wells, CFE, CPA is founder and chairman of the
50,000 member Association of Certified Fraud Examiners in Austin, Texas, USA.
Andi McNeal, the ACFE’s assistant director of research, assisted in its
preparation .

To view a chart explaining uniform occupational fraud classifications, click
here