Fraud is a growing problem and this increases the risk premium on investments. Companies lose a substantial amount of earnings from revenue due to fraud and this makes identifying it a part of due diligence. There are several ways investors and businesses can identify the potential for fraud, some of which include knowing where fraud is likely to occur, understanding the signs of fraud, and awareness of the symptoms of fraud.
The “Fraud Triangle”
According to the Association of Certified Fraud Examiners, The fraud triangle represents how fraud occurs. It is comprised of three elements: pressure, opportunity and rationalization. The presence of all these is believed to be required for fraud to take place. However, if a higher amount of one exists than for another element, then the risk is equally high. For example, the presence of weak auditing, undistributed accounting responsibilities and inadequate employee screening all create opportunity for fraud. In such case, a lower amount of pressure and rationalization is required to ignite the fraud process.
Types of fraud
Numerous methods of fraud exist. Vendor kickbacks, executive collusion, investor scams and employee theft and customer theft are all examples of fraud. To illustrate further, consider managerial fraud in the form of manipulation of accounting methods and corporate policies to create ill-gotten gains. For instance,suppose a policy requiring managerial allocation of resources from flexible spending accounts is combined with the decision making power to solely authorize the use of funds. Seemingly innocuous transactions could incrementally be used to hide a slow, but steady siphoning of funds away from a business. The possibilities are countless, which makes fraud fighting a challenge.
Internal control systems
In terms of businesses, a strong system of internal controls within an organization helps reduce the opportunity for fraud without complicating procedures and reducing productivity with inefficiency. In other words, simple but effective safeguards prevent fraud before it becomes costly. Such preventative measures include physical security such as locked filing cabinets or limited access records, rotation or mutual verification of work and well organized and recorded records. With a little thought, an effective internal control system can safeguard against countless dollars in lost profit.
Signs of fraud
Depending on the type of fraud, the signs of fraud differ. For example, in the case of boiler room fraud, pressure tactics, coercion and anonymity are all indicative of potentially dubious activity. In terms of organizations, when internal controls are bypassed, signs of fraud usually lie in the wake of fraud. These signs include irregular patterns in bookkeeping, suspicious activity and behavior among employees, managerial overrides that hide or shuffle money, and unusual accounting relationships such as an increase in inventory while storage costs decline. Whether it be real-time signs or an audit trail, knowing what to look for helps stop what is not prevented.
Signs of fraud do not necessarily mean fraud has occurred. Rather, it means something is is either wrong due to error, operational inconsistency or something worse. In order to distinguish between human error, operational failures and acts of fraud, methods of identification and analysis are necessary to detect the symptoms of fraud. For example, according to the fourth edition of Fraud Examination, the use of data review and fraud detection software that incorporates financial analysis and statistical examination algorithms helps confirm fraudulent patterns. Additional examples include generating what is called a “Matosas matrix”, which helps identify fake accounts or fraudulent transactions and “fuzzy matching”, which helps root out known patterns of fraud within large data sets.
When a gray area exists in the rules, an opportunity for fraud lies dormant. Similarly, when lack of oversight or enforcement of policies is carried out, an unmonitored chance for theft waits to be discovered and exploited. Moreover, when the authority to make decisions for personal gain goes hand-in-hand with trust and responsibility, a wrong turn into the abyss of fraud with all its shiny jewels and temptations becomes all the more easy to make. With the right awareness, knowledge and methods, these risks are reduced and avoided at a lower cost than the cost of fraud itself.
About the author: A.W. Berry is a financial writer and the managing editor of Moneycation.com