Occupational Fraud in an Economic Downturn

Fraud on the Rise

In early 2009, a Deloitte 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.”

An economic downturn shines a revealing light on the true story.  “A lot of frauds that were propagated and flourished during the economic boom will blow up when there is an economic meltdown,” says Zeune.  He cites Bernard Madoff-like Ponzi schemes as an example, which fell apart when investors wanted to pull their money out and the fraud could no longer be funded.

Zeune says fraud happens in good times and bad but is more likely to be discovered when the economy begins to go south.

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:

asset misappropriation (such as false invoicing, payroll fraud, or skimming),
corruption (bribes, extortion, conflicts of interest), and 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).

The biggest risk areas?  Management and accounting.  Why?  Because they’re the groups with the access and the power, Zeune says. 

Indeed, the 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.

“Trust is a feeling, not an internal control.”
Gary Zeune, CPA

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.  Lack of management review and override of existing controls were each cited by 17 percent of respondents.

Several factors contribute to weakening internal controls.  Zeune says that the smaller the company, the worse the internal controls.  There tends to be more trust in a smaller company, and it’s easier for people with access and power to get away with misdeeds.  “The owner or two or three managers have done the hiring, and they automatically trust the employees they’ve hired,” Zeune says.  “But trust is a feeling not an internal control.”

In addition, companies that might have had stronger internal controls prior to the economic downturn have now faced layoffs and find themselves in the position of having one person doing the work of three, jeopardizing internal control.

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) than their larger counterparts. These findings accentuate the unique problems in combating fraud—primarily the limited amount of fiscal and human resources available for anti-fraud efforts—frequently faced by small organizations. Check tampering and fraudulent billing were the most common types of small business fraud.

In nearly two-thirds of the fraud schemes analyzed by the ACFE study, the perpetrator acted alone, resulting in a median loss of $115,000.  However, fraud that involved two or more individuals resulted in a median loss of $500,000, over four times higher than the amount lost in schemes committed by a single perpetrator. Collusion often enables employees to circumvent specific controls that would otherwise detect or limit the impact of a fraud.

Is it Elementary?

Many 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.

After interviewing several hundred white collar criminals, Dr. Donald Cressey developed the fraud triangle in the 1950s. In 2003,  the AICPA incorporated the triangle into Statement on Auditing Standards Number 99, Consideration of Fraud in a Financial Statement Audit and required auditors to use the knowledge to plan and perform the audit to detect material misstatements due to 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.  “CPAs should be aware of the fraud triangle, the importance of it, and how it contributes to potential fraud,” he says.

Metro developed its fraud course six years ago.  “Prior to Enron, there was very little focus on fraud, “Laufer observes.  The topic  might have consisted only 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.  As accountants, we just need to have more awareness.”

Laufer notes that in addition to learning about fraud detection, his students learn how to prevent fraud.  “The tone at the top of the organization is very important,” he says.  He also emphasizes internal control systems and teaches his students that prevention is much less costly.

Every CPA has heard about tone at the top, Zeune says. He explains that auditors don’t realize that people behave the way they see those above them behaving. So, when a business owner uses the company as a personal piggy bank, it gives employees permission
to do it as well. When owners run personal expenses through the company, they are knowingly violating their own internal controls. As a result, lower-level employees also will violate controls: the boss did it, so it must be OK.

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 as well, to help students understand the forensic accounting process.  She has worked with Laufer’s students to hold mock trials based on actual cases.  A student serves in Betzer’s role as a mock expert witness.  “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.

Occupational fraudsters are generally first-time offenders. Only seven percent of fraud perpetrators in the ACFE study had prior convictions, and only 12 percent had been previously terminated by an employer for fraud-related conduct.

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,” Zeune emphasizes. This is called the ‘lifestyle’ paragraph in SAS 99. CPAs don’t audit lifestyle, but if they trip across it and see someone’s lifestyle doesn’t make sense, auditors can’t ignore it.

In financial statement fraud cases, which tend to be the most costly, excessive organizational pressure to perform is a particularly strong warning sign.

An Ounce of Prevention
 

Laufer mentions, the tone at the top of the organization is critical to controlling fraud.  CFOs can help keep this risk in check through a combination of clear communication, leading by example, and maintaining a watchful eye across the entire organization. Nearly half of the cases in the ACFE’s study were uncovered by a tip or complaint from an employee, customer, vendor, or other source.

Zeune says the most powerful thing CPAs can to do minimize risk is to stop being so predictable.  “When you come in with the same procedures year after year, you’ve just told people who want to cook the books, embezzle, steal, etc., where not to do it,” he says.  “The moral is not to do more work; just be unpredictable.  Move the cop car around, so to speak.”

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.   “They need to be retaught.”  Hold staff meetings to discuss what the organization’s policies are and what happens if there’s a problem.  And don’t just hold these meetings once.  People forget. Hold them every six months, Betzer counsels. 

In smaller companies, owner involvement is vital.  “Don’t trust the financial accounting responsibility to others,” Betzer cautions.  “Owners need to keep a close eye on things.”

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.”  Of course, a CPA can help 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. s

For more information, contact Sheri Betzer at Sbetzer@bccllp-cpa.com.
Contact Gary Zeune at Gzfraud@bigfoot.com.

Upcoming CPE Classes on Fraud at CSCPA

August 18—Fraud: 15 NEW Cases You Need to Know for 2009 Financial Statements, Instructor: Gary Zeune, CPA
August 19—Auditing: The 50 Biggest Risks NOT in Your 2009 Checklist, Instructor: Gary Zeune, CPA
August 20—Accountants Guide to Fraud and Abuse in Government and Nonprofits, Instructor: Gary Zeune, CPA
For complete details and to register, go to www.cocpa.org, or call (303) 773-2877 or toll free, (800) 523-9082.

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