Business Owners Must Understand Risks in Their Organizations
The Fraud Triangle
By Julie Quink, CPA
As a culture, we generally believe that people are honest and are trustworthy. Failures like Enron and WorldCom, whose combined fraud losses totaled $46 billion, have raised an awareness of the costs of fraud and have highlighted the need for management to understand and monitor the business risks within their organizations.
What Is Fraud?
Fraud is an intentional act that results in misrepresenting financial information (lying) or misappropriation of assets (stealing). The misrepresentation of financial information typically encompasses misstating earnings to meet market or company expectations and to meet compensation-plan benchmarks. Misappropriation of assets is the taking of company assets, whether cash and equivalents, inventory or supplies, for personal benefit and use.
Statistics indicate that:
• 10% of employees would never, ever commit fraud;
• 10% of employees are actively exploring ways to commit small-scale fraud against their employer, which could include padded mileage and expense reports, small-scale theft of supplies and other materials; and
• 80% of employees would never commit fraud unless certain factors are present.
The factors that would provide the motivation for 80% of employees to consider committing fraud are termed the Fraud Triangle. These factors include:
• Pressure — a financial need created by gambling addictions, substance and alcohol abuse, family illness, or extramarital affairs;
• Opportunity — the ability to access cash or items easily convertible to cash (inventory); and
• Rationalization — the feeling of entitlement or the feeling that there is no other way to financially meet the pressure unless taken from their employer.
Otherwise honest employees may commit fraud under these circumstances.
Indicators that an employee may be committing fraud include the appearance that the employee is living beyond their lifestyle, suspected or known substance or alcohol abuse, and resistance to relinquishing control of duties to others.
Common Ways Fraud Occurs
Generally, misrepresented financial results are accomplished through fictitious transactions or adjustments recorded in accounting records.
Fraud is an intentional act that results in misrepresenting financial information (lying) or misappropriation of assets (stealing).”
The most common ways that an individual can misappropriate funds are:
• Creating fictitious employees on the payroll system and generating payroll checks that the fraudulent employee cashes — the ghost- employee scheme;
• Creating fictitious vendors and generating checks to the fraudster for goods and services never received by the company — the ghost-vendor scheme; and
• Taking customer checks or cash before being deposited into the bank and modifying the accounting records to conceal the theft.
According to the 2018 Report to the Nations published by the Assoc. of Certified Fraud Examiners, 50% of fraud and corruption cases are detected by a tip. Meanwhile, weaknesses in internal control are responsible for nearly 50% of all frauds, and losses are up to 50% higher when collusion of fraudsters exists.
When considering effective prevention and detection techniques, it is critical to:
• Implement a whistleblower policy that provides a mechanism for confidential communication of suspected impropriety;
• Assess areas of risk and evaluate internal controls over the most susceptible business cycles, including cash receipts, cash disbursements, and payroll; and
• Review financial and operational trends to determine routine and unusual patterns.
Simple techniques to strengthen internal controls over significant business cycles include the receipt of unopened bank statements by owner for independent review of monthly activity, and varying of procedures relative to the review the payroll journals or signing of vendor checks, if another individual is typically responsible for those areas. Inquiry and observation, such as camera systems, in areas that pose a concern may act as a deterrent for the occurrence of fraud due to the mere fact that someone is reviewing activity or inquiring.
When techniques fail to prevent and detect fraud, it is important to gather and review evidence. It is recommended that legal counsel be involved in suspected fraud and investigations at the onset. Legal counsel will likely engage an accountant to assist in the review of evidence and documents.
Business owners and management cannot afford not to be aware of fraud indicators and assess the associated risks within their own organizations. Awareness of who puts your organization at risk, review of trends, and simple monitoring tasks can assist in preventing fraud losses, which can create significant, unplanned costs for an organization.
Julie Quink, CPA is the managing principal of Burkhart, Pizzanelli, P.C., specializing in the accounting and consulting aspects of the practice. She is also a certified fraud examiner.