Prevention and Deterrence Measures for Occupational Fraud

Frank Rudewicz
February 26, 2008 — 2,790 views  
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The final component of our discussions on the occupational fraud centers on measures that can be taken to prevent and deter future violations. Terms “fraud prevention” and “fraud deterrence” are often used interchangeably. The Handbook of Fraud Deterrence provides the following definition for fraud deterrence: “Fraud deterrence is the proactive identification and removal of the causal and enabling factors of fraud. Fraud deterrence is based on the premise that fraud is not a random occurrence; fraud occurs where the conditions are right for it to occur. Fraud deterrence attacks the root causes and enablers of fraud; this analysis could reveal potential fraud opportunities in the process, but is performed on the premise that improving organizational procedures to reduce or eliminate the causal factors of fraud is the single best defense against fraud.”[1] To many people, the most obvious solution for preventing occupational fraud is to avoid hiring individuals who may have a propensity to commit fraud. The use of a thorough Employment Background Investigations is one way to minimize the chance of hiring someone who will commit occupational fraud. A typical pre-employment background investigation should include, at a minimum, verification of the applicant’s Social Security number, educational credentials and prior employment, as well as searches for criminal convictions. Oftentimes, it is prudent to go beyond the basic level, particularly with applicants for management positions or jobs where the individuals will have access to confidential or financial information or accounts. These deeper investigations may be conducted after the employee has been hired as a preventative measure to identify fraud risk. These due diligence background investigations include bankruptcy filings, civil litigation, tax liens, judgments, credit history, press reports, corporate affiliations, professional licenses and a myriad of other public records. It may also be helpful to speak with past supervisors of the applicant to gauge the applicants’ honesty and to identify any potential problem areas. Pre-employment background investigations can often identify prior problems involving an applicant; however, even the most thorough background checks may not eliminate the risk for occupational fraud. According to the Association of Certified Fraud Examiners (ACFE), “only 12% of the fraudsters … had a previous conviction for a fraud-related offense. Criminal background checks can help organizations make informed hiring decision, but will not weed out all fraudsters because most frauds are committed by apparently honest employees.”[2] To attack fraud at its root, an organization must create an environment of fraud awareness by setting up Codes of Conduct and/or Ethics and by providing proper Employee Training. These types of measures set the tone of an organization and instill a corporate culture that can effectively influence the daily behaviors of employees. In addition to establishing moral standards through Codes and Training, an organization may also create Fraud Policies that provide clear expectations to employees for an honest business environment. Fraud policies need to clearly state the organization rules in regarding fraud and spell out the consequences and punishment associated with violation of those rules. The organization should make sure the policies are properly communicated to the employees via memoranda, employee handbooks and/or employee training programs. Two critical components of a company’s Fraud Deterrence Program are Fraud Assessment and Strong Internal Controls. These are also part of management’s responsibilities as required by Sarbanes-Oxley Act Section 404. When a company has established and maintained a strong internal control environment by having proper segregation of duties, approval authorities, and a security system to safeguard the cash, inventory and other storage areas, the opportunities for a perpetrator to commit fraud will be reduced. Having an environment of strong internal controls will not, by itself, be effective in preventing and deterring occupational fraud. The internal controls need to be re-assessed, evaluated and updated regularly. Other prevention measures, such as performance of Analytical Reviews, Regular External and Internal Audits and Surprise Audits, can supplement and enhance a company’s effort of creating a fraud-free business environment. An Analytical Review is an important technique that is used to measure the significance of changes in company’s financial performance and can assist in identifying incidents of fraud. Analytical reviews are most effective when a company implements job rotation and mandatory annual vacation policies. Many large scale fraud schemes require a fraudster’s continued intervention in a particular account or access to a location. By preventing continued access to the tools needed to facilitate a fraud, a fraud is more likely to stopped or detected, or even prevented all together. External Audit is one of the most common ways used by companies to deter and detect fraud. The independent auditors are required to perform the audit to provide reasonable assurance that financial statements are free of material fraud.[3] While there are benefits of external audits from the perspective of fraud prevention and detection, there are also some deficiencies. External auditors are only hold responsible to material fraud, so if the fraud is not material it may not be raised by the external auditors. External auditors can only spent a limited time on a particular company due to the budget and/or timing requirements. An alternative, or compliment to an external audit is the Internal Audit. Internal auditors are full time employees of the company, often with unrestricted access to company management, employees and data. Because of their familiarity with the company’s controls systems, they may understand those systems’ strengths and weaknesses better than outsiders. On the other hand, internal auditors may not have the required independence to effectively prevent or detect fraud, particularly when fraud by management is involved. The use of regular internal and external audits sends the message that a company is committed to catching fraud. Awareness of the existence of such audits is likely to create a stop sign in a potential perpetrator’s mind. In addition to scheduled internal and external audits, many people believe that the Surprise Audit is the most effective audit for deterring and detecting a fraud. As the name indicates, this type of audit is unscheduled and unannounced. Lack of anticipation will make sure a perpetrator does not have time to hide and to recover the fraud trail. Under the surprise audit environment, fear of being caught will certainly give a potential perpetrator second thoughts. Very often, an occupation fraud is revealed by a tip from an employee or a third party, such as a vendor or a customer. Information provided by an informant may provide a company with an opportunity to uncover a well hidden scheme. The Sarbanes-Oxley Act requires the following: “each audit committee must establish procedures for the receipt, retention and treatment of complaints regarding accounting, internal accounting controls or auditing matters, including procedures for the confidential, anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters.”[4] Whistleblower hotlines have been used by many public companies as a solution to comply this requirement. These hotlines provide informants with an anonymous means to provide tips of fraud and other misconduct without fear of retribution from management or other employees. Even though the private companies are not bound by Sarbanes-Oxley regulations, the use of a hotline to receive tips is still strongly recommended by many fraud fighting professionals. The ACFE reported in its 2004 Report to the Nation on Occupational Fraud and Abuse that, “The median loss among organizations that had anonymous reporting mechanisms was $56,500. In organizations that did not have established reporting procedures, the median loss was more than twice as high”.[5] Occupational fraud has caused significant irrecoverable social and economical losses to the U.S. The 2004 ACFE Report continues, “Organization suffers tremendous costs as a result of occupational fraud and abuse. Participants in this study, anti-fraud specialists with a median 16 year’s experience in the fraud examination field, estimated that the typical U.S organization loses 6% of its annual revenues to fraud. Applied to the U.S. Gross Domestic Product for 2003, this translates to approximately $660 billion in total losses.”[6] With advances in technologies and the communication of information, more sophisticated fraud techniques and schemes will continue to be created. Fighting occupational fraud will be an ongoing task. The methods listed above are a few of the best practices and most commonly used fraud prevention and deterrence measures. Choosing the appropriate fraud prevention measures to fit your business need is not an easy task. They are often limited by the budget and available human resources. Yet with management’s commitment of setting anti-fraud procedures and culture within an organization, prevention and deterrence of occupational fraud are achievable. Special thanks to Qian Wang, CFE and Jonathan Newcomb, CFE of UHY Advisors Forensic, Litigation and Valuation Services Group [1] Cendrowski, Martin, Petro, The Handbook of Fraud Deterrence [2] “2004 Report to the Nation on Occupational Fraud and Abuse”, Association of Certified Fraud Examiners, Inc. [3] Statement on Auditing Standards (SAS) No. 99, [4] [5] / 6 “2004 Report To The Nation On Occupational Fraud And Abuse”, copy ©2004 by the Association of Certified Fraud Examiners, Inc.

Frank Rudewicz

Marcum LLP

Frank E. Rudewicz serves as Principal and Counsel of Marcum LLP and heads the Forensic, Investigative and Valuation Advisory practice for the New England area. He has more than 26 years experience conducting domestic and international investigations for anti-trust/anti-competitive issues, harassment, fraud, ethics and other employment related conduct.