Do you know where your internal controls are? (Proceedings)

Estimates of fraud in the united states

Consider the following estimates of fraud in the United States

i. Health agencies estimate fraud represents 10 percent of the nation's health care bill at a cost of $75 to $130 billion a year.

ii. The tax gap, which is the difference between what people owe the government and what they pay, exceeds $200 billion a year.

iii. The IRS estimates that electronic tax filing fraud costs the government billions of dollars a year. For example, in one 10-month period, fraudulent electronic returns increased 105 percent.

iv. Thirteen percent of credit card sales resulted in loss due to fraud. For example, fraud losses at MasterCard exceed $300 million a year.

v. Losses related to telephone fraud exceed $10 billion a year.

vi. Some 60 percent of Americans have shoplifted. An estimated 200 million shoplifting incidents a year cost U.S. businesses almost $12 billion or about $150 per family per year.

The pervasiveness of dishonesty

Not only are the losses to fraud very high, but the estimates of the number of people who commit or would commit a dishonest act are also very high. Consider the following:

i. The director of fraud and security for a large consulting company stated that of every 10 workers, three look for a way to steal, three would steal if given an opportunity, and four would usually be honest.

ii. Two out of three college students admit to cheating on exams.

iii. An Institute of Management study found that 87 percent of managers were willing to commit fraud if it would make their organizations look better.

iv. A study of 400 people found that 47 percent of top executives, 41 percent of controllers, and 76 percent of graduate-level business students were willing to commit fraud by understating write-offs that cut into their company's profits.

What is the definition of fraud?

Fraud is defined as an intentional act of deceit for the purpose of gaining an unfair advantage that results in an injury to the rights or interests of another person. This can be accomplished through presentation of false or misleading information, suppressions of the truth, lies, tricks, and cunning. Fraud perpetrators are often referred to as white-collar criminals to distinguish them from criminals who commit violent crimes.

Three steps to fraud

To commit most frauds, a perpetrator must take three different steps: (i) the theft itself; (ii) converting the asset to personal use; and (iii) concealing the fraud.

1. Theft

Theft involves stealing something of value, such as cash, inventory, tools, supplies, equipment, or data. It can also be an intentional reporting of misleading financial information.

2. Conversion

The perpetrator converts the assets into a form that can be used personally. Conversion is usually required for all stolen assets except cash.

a. Stolen checks must be deposited to an account from which the perpetrator can withdraw funds.

b. Information (such as trade secrets or confidential company data) is often sold to someone such as a competitor.

c. Industry experts estimate that computer companies annually lose up to $200 billion in computer chips due to armed robbery and employee theft. In some circles, computer chips are better than gold. Their theft is being referred to as the crime of the electronic age.

Employees who steal computer chips must convert them to cash. A sophisticated black market exists, and the chips often change hands as much as ten times in three days. When some companies run short, they often end up buying their stolen chips back.

The following example illustrates the conversion practices discussed above:

Example

On the advice of its trusted manager, a brand-name carpet manufacturer approved purchase orders replacing looms described by a subsidiary as deteriorated past reconditioning. Instead of being discarded or sold to a dealer, the used looms, which were in perfectly sound condition, found their way to another building in a town close by, along with skilled workers to man them. In a short time, a new low-priced carpet maker was bidding against the original brand.

3. Concealment

The perpetrator must conceal the crime in order to avoid detection and to continue the fraud. Concealing a fraud often takes more time and effort and leaves behind more evidence than the actual theft does. Where there are checks and balances in the system, the perpetrator often must "cook the books" to avoid detection.

a. The theft of cash may require the employee to doctor the bank reconciliation and/or make false accounting entries to avoid detection.

b. Taking cash takes only a few seconds, but altering records to hide the theft can be more challenging and time consuming. One effective way to hide an employee theft is to charge the stolen item off to an expense account. For example, an employee could steal $10,000 and charge it off to miscellaneous expense. Or, a payroll clerk could add a fictitious name to the employee payroll records, intercept the paycheck, and cash it. The company would be missing funds, but the books would be in balance because there was a debit to wages expense and a credit to cash.

In the case of expense accounts, the perpetrator's principal exposure is limited to a year or less, because expense accounts are zeroed out at the end of the year.

If perpetrators chose to hide the theft by affecting another balance sheet account, they would have to continue to hide it. Hence, one of the most popular ways to cover up a fraud is to hide the theft in an income statement account.

One of the most effective ways to prevent the theft/conversion/concealment process is to have an effective system of internal controls. When such a system is in effect, fraud is made much more difficult. The internal control system must either be overridden or two or more perpetrators must collude with each other.

The nature and elements of fraud

A typical fraud has a number of important elements or characteristics.

i. The perpetrator of the fraud must have gained the trust or confidence of the person or company being defrauded. This confidence makes it possible for the perpetrator to commit and conceal the fraud. For this reason, fraud schemes are often referred to as cons (from the word "CONfidence").

ii. In contrast to most other crimes, a perpetrator uses trickery or cunning to commit the fraud rather than force. Instead of using a gun, a knife, or physical force to commit a crime, perpetrators use false or misleading information. The intent is to get someone to give them money or assets. They hide their tracks by falsifying records or other information about the asset.

iii. Most frauds, once begun, are rarely terminated voluntarily by the perpetrator. The greed of the perpetrators is such that they continue to exploit the opportunity to obtain extra funds. The following factors can contribute to reasons why perpetrators may continue a fraudulent scheme:

a. They begin to depend on the "extra" income and cannot afford to stop.

b. When faced with the prospect of having additional money at their disposal, many move to a higher lifestyle that requires even greater amounts of money.

c. Most perpetrators will take as much money as they think their particular scheme or method will allow them to take. The amount taken is usually limited only by the success perpetrators have in concealing their actions or in the accidental or contrived opportunities the perpetrator is able to discover and/or create.

d. Some frauds are self-perpetuating. If perpetrators stop, their actions would be discovered, and they would get caught.

e. Fraud perpetrators rarely save or invest what they embezzle. In all of the cases that one particular fraud expert has investigated or read about, he has only uncovered two perpetrators that saved the money embezzled. One perpetrator converted the money to gold bullion and stashed it in his basement. The other put the money into trust funds for her grandchildren.

f. If the perpetrators are not caught shortly after they begin, they typically become more confident of their scheme. Many get greedy and take larger amounts of money. These larger amounts are more prone to be scrutinized, and a scheme that might have gone undetected for some time is uncovered because the amounts taken rise to unacceptable levels. Such perpetrators usually make a mistake that leads to their apprehension. In time, the sheer magnitude of the amount of the fraud leads to its detection.

Example

At one veterinary hospital, the accountant, a lifelong friend of the owner, embezzled ever-increasing funds from the hospital over a seven-year period. In the last year of the fraud, when the embezzler took over$100,000, the owner, facing bankruptcy, eventually had to fire the accountant and have his wife take over the bookkeeping. When the practice began doing better, the wife began looking into the reasons for the recovery. She uncovered the fraud.

g. The most significant contributing factor in most frauds is the failure to enforce existing internal controls.

Weaknesses in controls

Some of the most commonly overlooked weaknesses that make embezzlement easier for the dishonest employee are as follows:

1. Checks received in the mail go directly to the person who records, posts them and prepares the deposits, with no independent record being made of the receipts.

2. Bank statements go directly to the person who reconciles them.

3. Checks and cash are allowed to accumulate before being deposited.

4. Cash sales are loosely handled and sales slips are not accounted for by renumbering.

5. There is no separate cashier to reconcile daily cash receipts with sales slips.

6. Cash register amounts are not compared with bank deposits.

7. Monthly statements are mailed by the very same person who works on accounts receivable without being checked by a superior and compared to the accounts receivable schedule.

8. Customers report discrepancies on their statements, but no one in authority attempts to reconcile them.

9. Accounts receivable are never confirmed with the customer.

10. Uncollectible accounts are simply written off without being first turned over to an attorney or collection agency for collection.

11. No one bothers to count and review petty cash because the fund is only a few hundred dollars.

12. Petty cash slips are made out in pencil and are not canceled after use.

13. No one cancels invoices, vouchers, supporting documents and checks to make sure they are not resubmitted for payment.

14. Invoices are often paid without the initials of the person who is supposed to authorize their payment.

15. The person authorizing payment of invoices does a perfunctory examination of the supporting documents: receiving reports, purchase requisitions, freight bills, etc.

16. Physical inventories are not compared to book inventory figures and differences are not satisfactorily explained.

17. Anyone with packages can walk out of the plant or other facility without question.

18. Payroll checks are distributed by the same person who prepares the payroll or maintains the time records.

19. The person signing payroll checks does not scrutinize the payroll, has little idea of its approximate total or who the employees are.

Some businesses may not have sufficient personnel to provide the desired segregation of functions, but if the proper procedures are carefully followed, they can reduce the possibility of losses due to employee dishonesty.

Some common methods of embezzlement

Misappropriation of cash receipts

a. Cash Sales

Covered by:

1. Not recording sales; destruction or omission of sales slips.

2. Tampering with cash register tapes; understating footings of cash sales reports.

3. Charging customers more than the duplicate slip shows.

4. Controversial charges collected, but reported as uncollectible.

b. Collections on accounts and notes receivable

1. Lapping (both of bank balances and – with currency collections – petty cash)

2. Kiting, or inter-bank check transfers.

3. Write-off of accounts as uncollectible.

4. Improper credits for allowances or discounts.

5. Entry in customers accounts only, concealed by:

a. Over-footing of cash receipts and tampering with adding machine tapes.

b. Tampering with bank statements, passbooks and customers' statements.

c. Insertion of fictitious ledger sheets at time of an audit.

6. Reporting fake robberies of cash.

c. Receipts of miscellaneous income and credits

Covered by:

1. Not recording (including proceeds of illegitimate note executed to company bank).

2. Recording as an exchange item.

Misappropriation of disbursements

a. Cash on hand

Covered by:

1. Cashing vouchers a second time.

2. Payment of the same expense out of petty cash and also by check.

3. Use of fictitious vouchers.

4. Raising amounts on legitimate vouchers.

5. Cashing worthless "exchange" checks.

6. Unauthorized borrowing by employees.

7. Unclaimed wages and dividends pocketed or check endorsements forged and cashed through the petty cash fund.

8. Transfer of cash from one fund to another at time of an audit.

b. Cash with banks

Cover by:

1. Fictitious creditors' invoices (checks cashed through petty cash, secret or falsely named bank accounts, or forged endorsements).

2. Increasing amounts on creditor's invoices; refund of excess pocketed or split with the creditor.

3. Paying creditor's invoices twice and appropriation of the second check.

4. Failing to record purchase returns, allowances, and discounts, and appropriating check or cash payments therefor.

5. Payment of fictitious refunds or allowances.

6. Increasing telephone and electric bills, etc., by employee's personal bills from the same utility.

7. Making off with the check properly drawn to the creditor.

8. Padding payroll rates, time, production or number of employees.

9. Fictitious advances to employees, and neglecting to deduct them from subsequent payrolls.

10. Duplicating payment for the same payroll or invoice by two checks signed by each of two authorized officers or partners.

11. Appropriating checks made out to "cash" or the bank, supposedly for creditor's account, payment of note or expense.

12. Buying improper disbursements in personal accounts of partners and officers.

13. Altering the name of a payee or increasing the amount of a check after signature.

14. Forging checks and destroying them on return by the bank, concealed by forced footings in the cash journal, or by raising amounts of legitimate checks.

15. Mingling cashier's funds with company funds and withdrawing company's funds after cashier's are exhausted.

16. Charging illegitimate withdrawals to fictitious customers' accounts.

Merchandise

a. Illegitimate removal of merchandise.

Covered by:

1. Overstatement of lists of physical inventory.

2. Unauthorized requisitions.

3. Entry only in stock records of fictitious purchase returns.

b. Reporting as received, items not received (usually associated with collusion between the creditor and the receiving clerk).

Miscellaneous

a. Undercharging customers through reduction in unit prices, quantities or calculation.

b. Allowing officer or employee free services or merchandise, or at reduced rate, when not entitled.

c. Manipulating financial showing to secure excessive commissions, bonuses or dividends.