Conditions are ripe during the COVID-19 crisis for dishonest employees to commit fraud. Here’s some important information that companies should know to protect against incurring fraud losses during these unprecedented times.

Types of fraud schemes

Occupational fraud can be broken down into three primary categories. The first and most common category is asset misappropriation. Nearly 86% of cases involve the misappropriation of assets, according to the Report to the Nations: 2020 Global Study on Occupational Fraud and Abuse, issued by the Association of Certified Fraud Examiners (ACFE). However, these schemes also caused the smallest median loss of the three categories, at $100,000 per scheme. Assets that are especially vulnerable to theft and misuse include cash, receivables, inventory and equipment.

The second category — corruption schemes — falls in the middle in both measures, at 43% of cases with a median loss of $200,000. Corruption may include bribery, conflicts of interest and extortion. These schemes tend to be less common in the United States, Canada and Western Europe than in other places around the globe.

Lastly, financial statement frauds are the costliest type of occupational fraud, with a median loss of $954,000, but are the least common, occurring in just 10% of cases. (It’s important to note that some frauds may fall into more than one category, so the total adds up to more than 100%.)

The ACFE defines financial statement fraud as “a scheme in which an employee intentionally causes a misstatement or omission of material information in the organization’s financial reports.” Methods for committing such fraud aren’t just limited to the overstatement or understatement of assets or revenues.

For example, liabilities or expenses might be recorded improperly to make the company appear more liquid or profitable in the current accounting period. Or a dishonest employee could manipulate accounting cutoffs by recording revenues early and expenses late, which violates the accounting concept of matching expenses with the associated revenues in the same period. Financial statement fraud also can easily occur when the accounting rules call for the use of subjective estimates.

Fraud triangle

Is your company at risk for occupational fraud? The following three conditions, commonly referred to as the “fraud triangle,” must be present for fraud to happen:

1. Pressure. The perpetrator experiences some type of pressure that motivates the fraud. It may come from within the organization — for example, pressure to meet aggressive earnings or revenue growth targets. Alternatively, the pressure could be personal, such as the need to pay off debt from credit cards or medical bills.
2. Rationalization. The perpetrator must be able to mentally justify the fraudulent conduct. Common excuses for wrongdoing include: “I’ll pay back the money before anyone misses it,” or “My employer can afford the financial loss.” By rationalizing, perpetrators overcome ethical barriers that ordinarily guide their conduct.
3. Opportunity. Fraudsters exploit perceived opportunities that they believe will allow them to go undetected. Poor internal controls, weak management oversight and ineffective or nonexistent audits all create opportunities for fraud.

It’s important to remember that the presence of these three conditions doesn’t prove that fraud has been committed — or that an individual will commit fraud. Rather, the fraud triangle is designed to help organizations identify risk and understand the importance of eliminating the perceived opportunity to commit fraud.

Fraud prevention

During the COVID-19 crisis, it’s important to evaluate how economic conditions have altered workers’ motivations, opportunities and abilities to rationalize fraudulent behavior. If financial indicators or even hearsay cause you to suspect someone might be stealing assets or cooking the books, investigate further. One proactive measure to consider, especially when suspected wrongdoing involves a C-level executive, is a surprise audit.

Compared to a traditional financial statement audit, a surprise audit more closely examines the company’s internal controls that are intended to prevent and detect fraud. Here, auditors aim to identify any weaknesses that could make assets vulnerable and to determine whether any employees have already exploited those weaknesses.

Fraud perpetrators likely have paid close attention to how previous financial statement audits were performed — including the order in which the auditor proceeded. In a surprise audit, the auditor might follow a different process or schedule. For example, instead of beginning audit procedures with cash, the auditor might first scrutinize receivables or vendor invoices.

Surprise audits focus particularly on high-risk areas such as inventory, receivables and sales, and auditors typically use technology to conduct sampling and data analysis. Auditors show up unexpectedly — usually when the owners suspect foul play or randomly as part of the company’s antifraud policies. The element of surprise is critical because most fraud perpetrators are constantly on guard. Announcing an upcoming audit gives wrongdoers time to cover their tracks by shredding (or creating false) documents, altering records or financial statements, or hiding evidence.

The primary advantages of surprise audits are fewer financial losses and reduced duration of schemes. The median loss for organizations that conducted surprise audits was $100,000, compared with a median loss of $150,000 for those organizations that didn’t — a 33% difference, according to the 2020 Report to the Nations. And the median duration in those organizations was 18 months, compared with only 11 months for organizations that performed surprise audits. An auditor’s finding of suspicious activity in a surprise audit will likely require additional forensic investigation.

Such audits can have a strong deterrent effect as well. While surprise audits, by definition, aren’t announced ahead of time, companies should state in their fraud policy that random tests will be conducted to ensure internal controls aren’t being circumvented.

Targeting fraud motives

In addition to using surprise audits to eliminate the perceived opportunity to commit fraud, your company also could try to reduce internal pressure on employees to report unrealistic financial results, especially during these challenging times. A forensic accountant can review your company’s bonus plans, familial dynamics and financial condition to help identify (and alleviate) high-pressure situations. Doing so can create a healthier work environment and reduce fraud risks.

 

Sidebar: 2020: A perfect storm

Today’s economic conditions can bolster the motive, rationalization and opportunity that are needed for honest employees to resort to dishonest behaviors. For example, employees with unemployed spouses or other interruptions to their income during the pandemic may rationalize the need to steal property and resell it so that they can pay their own bills, such as mortgages. Unethical managers may conceal deteriorating performance with creative journal entries to avoid loan defaults. Or they may attempt to inflate sales to preserve their bonuses — or simply their jobs.

The COVID-19 era has also brought opportunities to defraud. Layoffs typically spread the remaining employees thinner, making it harder to implement strong internal control procedures, such as supervisory review and segregation of duties.

Likewise, owners and top managers may be distracted from fraud prevention and detection efforts as they scramble to recover lost sales or focus on cost containment. And employees working harder without more pay — and with personal financial problems — may be more likely to rationalize a fraudulent act.

If you suspect foul play, contact a forensic accountant to assess your company’s risk profile and dig deeper to determine whether fraud losses have been incurred.

© 2020