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Abstract

Although a glimmer of hope might suggest that the economy is inching back upward after the economic downturn of the past six years, classic fraud schemes remain prevalent; because most professionals are focused on servicing their clients, they might not be scrutinizing a company's inflow and outflow of funds. Fraud has always colored the business landscape and probably always will; thus, business owners must understand the red flags of classic bud schemes and know when to turn to professionals who can perform fraud risk assessments and conduct investigations if financial fraud is suspected. Fraudsters' motivation might differ in varied economic climates; typically, such individuals are trying to obtain more money to pay for an enhanced lifestyle or to fund a habit that requires cash support. Stricter due diligence or control procedures can enhance fraud prevention.

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Although a glimmer of hope might suggest that the economy is inching back upward after the economic downturn of the past six years, classic fraud schemes remain prevalent; because most professionals are focused on servicing their clients, they might not be scrutinizing a company's inflow and outflow of funds. Fraud has always colored the business landscape and probably always will; thus, business owners must understand the red flags of classic fraud schemes and know when to turn to professionals who can perform fraud risk assessments and conduct investigations if financial fraud is suspected.

On the Lookout for Fraud

The same red flags indicating potential fraud exist in both vibrant and stagnant economies. Fraudsters' motivations might differ in varied economic climates; typically, such individuals are trying to obtain more money to pay for an enhanced lifestyle or to fund a habit that requires cash support. Regardless of the state of the economy, financial fraud has the same negative impact on business owners: less money in the bank translates into lower bonuses for employees, less capital available for business expansion, and lower profits for the owners.

Which types of fraud should business owners remain on the lookout for? The most common fraud scenario is misappropriation of assets, more commonly referred to as embezzlement, where employees who are experiencing personal financial pressure steal cash or other company assets. Such employees usually know the threshold amounts that require a higher level of approval for funds to be disbursed, and they know which amounts internal and external auditors review to form opinions. Thus, they might believe that they have the tools necessary to commit fraud. Asset misappropriation takes place whenever assets are readily available and controls are relatively loose.

Another increasingly common form of fraud involves stealing an employer's intellectual property or confidential financial information. There is currently a major push by federal law enforcement to crack down on such identity theft. Business owners or medical professionals who maintain clients' or patients' Social Security numbers should take extra precautions to protect this confidential information from internal employees who could sell it to criminal enterprises. The explanation of why employees take advantage of such situations is simple: They are under financial pressure. They have lost hours or benefits and their spouses have lost jobs. They have a strong incentive to try to make up their losses by taking readily available cash and other assets.

Fraud Prevention Steps

In light of these examples, what should business owners do? The first step is to recognize that fraud is common and that it can be orchestrated or perpetrated even by the most trusted employee. The second step is to understand the impact of fraud on the bottom line. Statistics have shown that a business loses approximately 5% of its gross revenue to fraud schemes per year (Report to the Nations on Occupational Fraud and Abuse: 2012 Global Fraud Study, Association of Certified Fraud Examiners [ACFE], http://www.acfe.com/rttn-highlights.aspx).

Assets disappear readily. In more than 20% of 2012 cases, the cost of each fraud exceeded $1 million; in another 68% of cases, it ranged from $1 to $400,000 (ACFE 2012). Many of these losses-particularly in the tier of $400,000 or less-were for very basic crimes. Billing fraud (i.e., creating false vendors, submitting personal invoices for payment) accounted for nearly one quarter of the cases. Check tampering (i.e., taking blank checks or diverting checks to a personal account) and skimming (i.e., accepting payments from a customer and not reporting them) followed close behind, as well as noncash theft (of inventory).

After recognizing the risks and the stakes involved, business owners should perform a fraud risk assessment. The key components of such an assessment are as follows:

* Assess. Review current internal controls and rank the potential vulnerabilities to fraud

* Design. Remove temptation by taking a risk-based approach to minimizing the opportunity for fraud to occur.

* Detect. Identify possible fraud when it happens.

* Evaluate. Revisit the changes made to reassess effectiveness.

* Respond. Take corrective action to strengthen internal controls in order to reduce the opportunity for fraud and investigate any fraudulent activity discovered.

A fraud risk assessment is critical. Although conducting investigations is a job for experienced outside professionals, fraud prevention begins with a business owner who recognizes the enormous impact of fraud on revenue. The business owner should evaluate risk areas across the entire organization and obtain input from process owners, in order to assess opportunities for fraud and weaknesses in internal controls.

Stricter due diligence or control procedures can enhance fraud prevention. Moreover, business owners should place some focus on "tone at the top." Creating a code of conduct that defines acceptable business practices, along with conducting annual (or more frequent) entity-wide training sessions, can go a long way toward establishing a low-tolerance atmosphere and keeping borderline fraudsters from acting on their impulses. These heightened due diligence procedures will likely deter an employee who is trying to decide if stealing company assets is worth it. Setting up a whistleblower telephone hotline is another method of giving employees or vendors the opportunity to call in anonymously and report suspicious activity.

Once a fraud is detected, the assistance of an experienced fraud investigator is essential. A fraud expert can conduct the investigation with oversight from general counsel or outside attorneys, if deemed necessary. Depending upon the type of entity and the industry, the results of the investigation might need to be reported to the appropriate regulator or authority.

The most important lesson is that fraud is still prevalent-it always has been and it always will be. Classic misappropriation of assets is a fraud scheme that remains a risk in both good and bad economic times. Business owners are encouraged to realize that financial fraud might be going on right now in their company, perhaps even by their most trusted employee. By implementing the suggested controls and by displaying a consistent tone at the top, business owners can protect themselves from fraudulent schemes being committed by their employees and outside predators.

Additional Considerations

One common form of fraud is an employee stealing from an employer, but a business owner facing higher taxes due to tax law changes and rate increases can also perpetrate fraud. Such business owners might begin contemplating how to not report all of their income or might create false expenses to reduce their federal and state income tax bills. This temptation involves greater risks and potential jail time. Often, in the authors' personal experience, these instances start small and escalate into major problems after several years in which such schemes go undetected. Business owners are lulled into a sense of comfort when they believe that they remain under the radar-until they receive an 1RS or state audit letter.

The chance of a taxpayer being audited is small; however, the risk of selection for audit for a sole proprietor or closely held (five or fewer shareholders) business is greater. Trusted employees might not be fraudsters, but in cases where business owners are committing fraud, such employees might turn into whistleblowers for a percentage of the taxes collected. Employees who suspect such activities should look into the Whistleblower Protection Enhancement Act of 2013.

Business owners and their advisors should remain aware of the risks of fraud and should remain vigilant by implementing the fraud prevention steps suggested in this discussion. Although fraud might never disappear, business owners and employees can take steps to lessen its frequency. ?

David Gannaway is a principal in Citrin Cooperman's valuation and forensic services group in New York, N.Y. A former special agent with the 1RS's Criminal Investigation Division, he now provides litigation consulting services. He can be reached at dgannaway@citrincooperman.com.