Occupational fraud: How it happens

This article is part two of a three-part series, called Fighting Fraud (the first article appeared in the April 2 issue of The Central New York Business Journal.) In this series, we will define occupational fraud, review statistics of the incidence of fraud, identify red flags, and discuss types of fraud, and the steps employers can take to help protect themselves against fraud happening to them. 

In our first article, we discussed the statistics of fraud, why people commit fraud, and red flags that need to be watched. In this second column, we continue the discussion with examples of occupational fraud and how these frauds are perpetrated. Occupational fraud falls into two broad categories — transactional and financial-statement fraud. 

Transactional fraud

Transactional fraud is the misuse or theft of an organization’s tangible assets. Simply put, it’s stealing either money or assets or misusing assets of the company. Transactional frauds represented about 90 percent of the cases studied, with a median loss of approximately $135,000 in the Association of Certified Fraud Examiners (ACFE) 2010 Report to the Nation. Cash is the most easily accessible of an organization’s assets, and about 85 percent of the cases studied by the ACFE involved the theft of cash. Cash can be stolen either before or after the transaction is entered into the accounting system. 

Stealing cash from an organization before the cash is recorded in the system is referred to as “skimming.” Skimming is difficult to detect because it leaves no paper trail. A common skimming scheme is an employee ringing a “no sale” or other non-cash transaction in the cash register. The customer pays for the goods and the employee pockets the cash instead of recording the sale in the register. 

Have you ever noticed a sign reading: “If you do not receive an accurate receipt, your purchase is free” posted near a register and wondered why the store cares if you get a receipt or not? Policies such as providing customers with a receipt deter employees from skimming cash from the register. If a register receipt is generated, the cash transaction is entered into the register and it becomes more difficult to remove the cash and adjust the records afterward.

Another common cash-register fraud is when the cashier doesn’t ring up all of the items purchased by the customer. A friend of the cashier will go through the register line and not all the items purchased will be rung into the register. In these schemes, the cashier will often make the appearance of scanning the items but may cover the bar code so that the item is not actually entered into the register. 

Skimming schemes are most common where there is a point-of-sale involving cash, such as in retail establishments. However, skimming schemes can also occur in any organization where goods are sold. A determined fraudster with access to an organization’s inventory may even go as far as conducting sales during non-business hours or making sales at an off-site location. 

In skimming schemes involving the sale of a product, the organization’s inventory records will be overstated. When physical counts of the inventory are taken, the inventory records will be higher than the actual inventory on hand, or there will be “shrinkage” in the inventory balance. This occurs because inventory items were “sold” to customers but the sale and reduction of inventory was not recorded on the books and records. Depending on how often the company takes physical inventory counts or how closely shrinkage is monitored, skimming schemes can often go on for extended periods of time without being detected. 

Skimming schemes do not always involve sale of items to customers. Another common form of skimming can occur when payments are received on customer-account balances. “Lapping” of payments received can be perpetrated in any company that has customer accounts receivable. This includes service businesses such as medical offices and cleaning companies. The employee who receives payments on accounts, pockets the payment from the first customer and then uses the payment from the second client to apply against the first, and the payment from the third to apply against the second, and so on. Lapping schemes can continue indefinitely, because all of the accounts remain current. Therefore the customer is not alerted that his/her payment has been intercepted. 

Employees can also steal after cash has been entered into the accounting system. A common fraud technique in retail operations involves processing false returns. A friend of the cashier pretends to return goods that were never purchased, the return is rung through the register, and a refund given. While skimming and point-of-sale fraud schemes are some of the most commonly perpetrated by fraudsters, additional fraudulent disbursement schemes that have also proven successful include the following: 

- Forging or altering an organization’s checks.

- Creating fictitious vendors within an organization’s billing system for which payments are made directly to the fraudster.

- Submitting fraudulent or duplicate expense reimbursements. Travel expenses paid with cash, such as taxi-cab fares for which the receipts are often blank and filled in by the employee, are particularly vulnerable to overstatement. 

- Creation of fictitious employees within the payroll system for which paychecks are intercepted and cashed by the fraudster.

- Falsifying hours worked, particularly if overtime payments are involved.

- Misuse or theft of an organization’s inventory. Companies that sell highly marketable items are particularly vulnerable to theft of inventory. 

Transactional fraud can occur at any point where an employee handles cash, inventory, or payments. Unfortunately, the methods the fraudster can employ to steal from his/her employer are numerous and often difficult to detect. 

Financial-statement fraud

Financial-statement fraud is the deliberate misrepresentation of the financial condition of an organization by intentionally misstating or omitting amounts or disclosures in the financial statement in order to deceive the users of the financial statements. These frauds are commonly referred to as “cooking the books,” because the financial statements show the financial picture the fraudster wants you to see, not the actual financial status of the company. Given the complexity of these schemes, financial-statement fraud accounted for fewer than 5 percent of the cases included in the ACFE’s study; however, such schemes resulted in a median loss of $4 million. 

Financial-statement and transactional frauds often go hand-in-hand because the fraudster will often adjust the accounting records to cover up the theft. These frauds can have far-reaching impact outside the business, particularly in companies with multiple investors. Widely known fraud schemes like those involving Bernie Madoff, Enron, and WorldCom involved financial-statement fraud. 

A significant level of authority, as well as technical financial and accounting knowledge is required to perpetrate successful financial-statement fraud schemes, thus these are typically committed by high-level management. This also makes these frauds more difficult to detect. Some indications that an organization may be susceptible to financial-statement fraud include: 

- An individual or small group of individuals possessing a disproportionate level of authority.

- Unusually rapid growth or profitability, as compared to other organizations within the same industry.

- Significant unusual or complex transactions. 

Pressure to meet budget projections and inadequate accounting controls are the primary causes of financial-statement fraud. Most financial-statement frauds are committed to show a better financial picture of the company. Often there are significant pressures from shareholders to meet earnings targets. Many companies are under tight financial covenants associated with bank debt and could be in risk of default. Most key financial executives have significant bonuses that are tied to the performance of the business, which can result in added pressure to adjust results. 

In addition, in industries with significant commission-based payments, there is incentive for the sales staff to inflate sales to increase their personal commissions. Financial-statement frauds typically result in an increase in overall net earnings, either by artificially increasing revenue or decreasing expenses. Some of the common techniques to overstate net income include:

- Recording fictitious revenues, such as fake customer accounts or sales, or recording fictitious sales close to the end of the accounting period and then reversing the sales in the accounting system at the beginning of the next accounting period. This scheme is commonly used to meet sales’ targets for commission payments. 

- Failing to write off uncollectible accounts-receivable balances.

- Recording revenues before underlying terms or sales conditions have been met.

- Recording expenses in the wrong accounting period or capitalizing expenses on the balance sheet in order to decrease expenses reported. 

- Shifting revenues and expenses to the incorrect fiscal period in order to manipulate earnings.

In addition, an organization may omit required financial-statement footnote disclosures in order to improve the fiscal appearance of the organization in the eyes of financial-statement users, which often include shareholders, government agencies, and lending institutions. Such omissions may include disclosures of related party transactions, subsequent events, and contingent liabilities. 

Corruption

Corruption schemes were involved in about one-third of the cases studied by the ACFE. Corruption is dishonest or fraudulent conduct by those in power. Corruption schemes often benefit those perpetrating the fraud and have a negative impact on the organization as a whole. The most common types of corruption schemes involve bribery and are referred to as kickbacks and bid-rigging. 

In kickback schemes, an employee receives some sort of incentive or “kickback” from a vendor in exchange for giving the
vendor the organization’s business. These types of schemes are often common in governmental settings where large projects are awarded based on competitive-bid scenarios. Kickback schemes always involve an employee with the authority to approve payments to vendors. The invoices paid by the organization are often inflated or can be entirely fraudulent in exchange for the kickback. 

Kickbacks to the individual can be monetary or non-monetary in nature. Kickback schemes often happen during large construction projects. One common scenario is the employee approving the payments is also doing some renovations at their home and works out a deal with the contractor that they will order materials for their own project through the organization and have the items delivered to their home. 

In some larger kickback schemes, vendors have been known to send the employee at the organization on lavish vacations. The payment received from the vendor benefits only the employee involved in the kickback scheme, and the organization incurs unnecessary additional expenses because the invoices are either inflated or materials are never received by the organization. Organizations where one employee has the authority to approve large projects are particularly vulnerable to kickback schemes. 

Similar to kickback schemes, bid-rigging schemes can be common with large construction projects and particularly in governmental settings where competitive open bidding is required. In a bid-rigging scheme, the employee responsible for the bid process will “rig” the process so that the preferred vendor wins the bid. Often, bid-rigging and kickback schemes can go hand in hand, because the employee rigging the scheme may also receive a kick-back from the vendor. Many times, the employee has an undisclosed personal or economic interest in a transaction that adversely affects the organization. 

For example, the vendor is a relative or friend. There are several methods utilized in bid-rigging schemes. Some common methods are: 

- Providing certain suppliers advance notice of the competitive bid process.

- Printing public notices of the bid in obscure publications so that other vendors are not aware of the open-bid process.

- Improperly disqualifying the bids of other vendors.

- Opening bids from other vendors early and then informing the preferred vendor of the other bids.

- Submitting high bids from “dummy” or fake contractors to make the bid of the preferred vendor look better.

Bid-rigging schemes can be difficult to detect because, like kick-back schemes, they usually involve individuals with a high level of authority in an organization. Although these types of schemes are often more prevalent in the governmental sector, all organizations are vulnerable. Understanding who has authority within the organization to approve payments and vendors is the first step in fighting and preventing these types of fraud schemes. 

So far, we have discussed the definitions of fraud, the incentives, and red flags of fraudsters and examples of types of fraud that commonly occur. Fraud happens every day, but there are controls that companies can employ to help protect themselves and their assets. Stay tuned for our next article, which will discuss how companies can reduce their fraud risks.        

Linda Gabor, CPA, CFE is the partner in charge of audit services at Green & Seifter CPAs. Contact her at lgabor@greenseiftercpas.com. Christopher Alger CPA, CFE is a supervisor at Green & Seifter CPAs. Contact him at calger@greenseiftercpas.com