Occupational Fraud in an Economic Downturn

In the midst of difficult times, it suddenly seems fraud is taking center stage, affecting businesses and agencies of all types. What’s behind the increase in fraudulent activity? And perhaps more important, how will it be stopped?

Fraud on the Rise

In early 2009, a Deloitte & Touche LLP survey found that two-thirds of 1,280 financial services and technology executives expected to see more instances of accounting fraud.  Fraud tends to increase in an economic downturn because the forces of the economy cause people to react in ways they would have never imagined, observes Gary Zeune, CPA, nationally recognized speaker and writer on fraud and auditing standards and founder of The Pros & The Cons, the only speakers bureau for white collar criminals.  “People don’t realize or understand the things they’ll do when faced with a situation they’ve never been in before.”

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Fraud Defined

The Association of Certified Fraud Examiners (ACFE) defines occupational fraud as: “The use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s resources or assets.” Fraud can be classified into three broad categories:

n asset misappropriation (such as false invoicing, payroll fraud, or skimming),

n corruption (bribes, extortion, conflicts of interest), and

n financial statement fraud which aims to make companies look healthier than they actually are.

Asset misappropriation is the most common fraud but the least costly (averaging $150,000 per incident). Fraudulent statements are the least common form of fraud, but a 2008 ACFE study showed they accounted for a whopping $2 million median loss (as measured by lost market capitalization in most cases).

ACFE’s 2008 Report to the Nation on Occupational Fraud & Abuse shows that occupational frauds were most often committed by the accounting department or upper management. Twenty-nine percent of frauds in the report were committed by persons in the accounting department, while 18 percent were committed by executives or upper management. Frauds committed by executives were particularly costly, resulting in a median loss of $853,000.

The ACFE report shows that the lack of internal controls is the most common factor allowing fraud to occur. Thirty-five percent of respondents cited inadequate internal controls as a primary contributing factor in the frauds they investigated.

Small businesses-defined as those with fewer than 100 employees-are especially vulnerable to occupational fraud.  Small businesses suffer both a greater percentage of frauds and a higher median loss ($200,000). Check tampering and fraudulent billings were the most common types of small business fraud.

Is it Elementary?

Studies suggest fraud is more likely to occur when someone has an incentive (pressure) to commit fraud, weak controls or oversight provide an opportunity for the person to commit fraud, and the person can rationalize the fraudulent behavior (attitude). This three-pronged framework, commonly known as the “fraud triangle,” has long been a useful tool for CPAs seeking to understand and manage fraud risks.  All three factors are usually present when people commit fraud.

Doug Laufer, CPA, CFE, Ph.D., accounting professor at Metropolitan State College of Denver, teaches the school’s accounting fraud course.  He discusses the fraud triangle on the first day of class.  “Pressure increases because people have trouble paying their bills, they rationalize because we’re in a downturn, and maybe internal controls are slipping, which creates opportunity,” Laufer says.  And suddenly, the opportunity for fraud exists where it didn’t before.  

Metro developed its fraud course six years ago.  “Prior to Enron, there was little focus on fraud. The topic might have consisted of a chapter in an audit textbook.  This is where the accounting profession and education could do more,” Laufer says.  “Accountants are positioned to help prevent and detect fraud more than anyone else.”

Laufer notes that in addition to learning about fraud detection, his students learn how to prevent fraud.  

Witness for the Prosecution

Sheri L. Betzer, CPA, CFE, of Betzer, Critchfield & Call, LLP, Denver, has made a career of forensic accounting. For the past 35 years, she has worked to find fraud and testify against those responsible. After deciphering mountains of accounting and financial data for attorneys, Betzer sometimes wonders if she should have been a psychologist instead of a CPA. “The criminal mind fascinates me,” she says of her work.

Betzer takes her real-life experience into the classroom to help students understand the forensic accounting process. She has worked with Laufer’s students to hold mock trials based on actual cases. “Students say it’s the best class of the semester,” Laufer notes.

Fraud perpetrators are frequently those you would least suspect, Betzer says. They are trusted members of a business who have been like family but are ultimately not immune to the pressures of the fraud triangle.

There are red flags employers can, and should, watch for. According to Predictably Irrational: The Hidden Forces that Shape Our Decisions, behavioral testing shows that people cheat if they can get away with it – even smart, Ivy League-educated people with relatively little to gain.  “Desperate people do desperate things,” Zeune says.

The most commonly cited behavioral red flags are perpetrators living beyond their apparent means or experiencing financial difficulties.  Anybody who is under a lot of financial stress-a sick child or parent, losing a house, credit card bills, divorce-anything external to the work environment that puts pressure on someone, if that person has access to assets, it’s a red flag.

An Ounce of Prevention

Betzer suggests reviewing internal controls on a regular basis. Look at which employees handle what pieces of the accounting. She also says that many employees don’t know what fraud is. “They fudge on travel reports and think it’s OK. They don’t realize it’s fraud,” she says.  Hold staff meetings every six months to discuss what the organization’s policies are and what happens if there’s a problem.

When fraud does occur, Betzer is a proponent of taking the necessary steps for prosecution.  “Theft is theft,” she says.  Prosecution can be emotionally difficult, especially if an employee has been like family.  Betzer suggests immediately involving in-house counsel or an attorney before taking any action. “You don’t want to take steps to fire somebody, and open yourself up to a lawsuit.  And if the employee knows you suspect something, it opens the door for them to destroy evidence.”  A CPA can examine the information uncovered without talking to the employee.  Betzer recommends talking to the employee and escorting him or her from the premises.  “If we can get in early enough, we have saved the evidence, we can investigate, and write up a report,” she says.

Betzer says the knee-jerk reaction of most small business owners is to confront the employee and ask what’s going on.  “The owners want answers, and they want an apology,” she says. She suggests calming down first, talking to an attorney and a CPA, and having a strategy in place before taking any action against an employee. Because ultimately, owners probably never hear that apology.

Natalie Rooney is a free-lance writer and serves on the Editorial Board for the Colorado Society of CPAs. She can be reached at 970-328-1895 or nrooney@centurytel.net.