Fraud: No Company Immune, Risk Can Be Reduced

Fraud: No Company Immune, Risk Can Be Reduced

No one likes to think about fraud – especially internal fraud that could be committed by a trusted employee. As uncomfortable as the subject is, however, fraud is a fact of life in all industries. A recent global fraud study conducted by the Association of Certified Fraud Examiners (ACFE) provided some insight into the ways different companies are affected by this issue.

The ACFE’s 2012 “Report to the Nations on Occupational Fraud and Abuse,” which surveyed fraud patterns from 2010 and 2011, suggests that the construction industry is at risk for larger-than-average fraud losses. While industries such as financial services, manufacturing, and healthcare reported more fraud cases, the average size of loss per case was notably high in the construction industry.

Among all 21 industries surveyed, construction posted the third-highest median loss rate: $300,000 per incident. This rate was more than twice the median loss figure for all industries combined.

The survey also revealed that privately held companies generally are more susceptible to certain types of fraud and that smaller companies account for the majority of fraud cases. More than half the fraud cases in the survey occurred at companies with fewer than 1,000 employees.

Recognizing the Conditions That Enable Fraud

Criminologists tell us that three conditions generally are necessary for fraud to occur. As Donald Cressey explained in his landmark 1953 book “Other People’s Money: A Study in the Social Psychology of Embezzlement,” these conditions are:

1) Motivation (or pressure). The person who commits fraud generally does so in response to a financial motivation.

2) Opportunity. In many industries, work often is performed at remote locations away from company headquarters, and materials that are difficult to track and can be diverted easily. Poorly designed financial controls can be another factor.

3) Rationalization (or attitude). Employees who commit fraud do not view themselves as criminals. Instead, they find a way to rationalize their dishonest behavior.

Fraud Risks

Just as three general conditions enable fraud, the various types of fraud schemes can be grouped into three broad categories:

1) Theft or misappropriation. Companies can be particularly vulnerable to theft of materials, but a related risk involves the misappropriation of equipment for personal use.

2) Corruption. This category includes subcontractor kickbacks and other bid-rigging schemes, payments to shell companies, fraudulent billing, and substitution of specified products with lesser-quality materials.

3) Financial reporting. Although financial reporting fraud often is associated with publicly traded companies, this type of fraud also can occur in smaller, privately held businesses.

Though not as common as theft or corruption cases, financial reporting fraud can be extremely costly. In the 2012 ACFE global fraud survey, only 8 percent of the cited cases involved financial reporting fraud, but the median loss involved in those cases was $1 million – four times the median loss in corruption cases and more than eight times the median loss from misappropriation of assets.

Beyond these general categories, some common risks should be of particular concern to companies:

  • Billing and payment fraud. Billing-related schemes accounted for more than 36 percent of construction industry fraud cases in the ACFE study.
  • Kickbacks. A formal bid review process that requires multiple bids can help reduce vulnerability to kickback schemes.
  • Manual checks. Some day-to-day on-site costs must be paid at a time that does not fall within the normal disbursement process. Limits on the size of manual checks are a must.
  • Payroll fraud. Without proper controls, a project manager or payroll clerk easily can authorize paychecks to a “ghost” employee and deposit the funds into a personal account.
  • Vendor or supplier fraud. Unscrupulous suppliers and subcontractors can falsify information on invoices or payment applications to generate greater costs.
Steps to Reduce the Threat

A proactive anti-fraud program will address all three of the conditions that enable fraud, with particular emphasis on the second element – opportunity. Several important principles should guide the effort:

  • Tone at the top. Company management must visibly demonstrate its commitment to ethical behavior in all aspects of the business.
  • Employee involvement. Alert employees to the most common fraud schemes and the red flags they should watch for.
  • Fraud hotline. Establish a tip line or another way for employees to anonymously report concerns. In 2012, 43 percent of all fraud cases came to light as the result of tips, and more than half of those tips came from suspicious employees.
  • Segregation of duties. The authority for collecting cash, depositing receipts, disbursing funds, and recording and reconciling accounts must be spread among a number of people, with clear requirements for documentation and accountability.
  • Internal controls. In addition to establishing strong internal controls, management must insist that these controls be applied consistently.
  • Management involvement. Company owners and senior managers must be involved personally – in ways that are not always predictable.

Such steps are just the beginning – a starting point. Although it is impossible to eliminate completely the possibility of fraud, a strong, thorough, and consistent anti-fraud program can significantly mitigate the risk. With the median loss in construction industry fraud cases standing at $300,000, no company – whether large and sophisticated or small and close-knit – can afford to be complacent.

Category Features, Rule of Law