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