The workforce crunch isn’t just making hiring harder, it may be leaving your business vulnerable to fraud. When it comes to preventing fraud, the first line of defense is making sure no one person has control over the flow of money at every step in the process. But businesses struggling to fill key positions may find that first line of defense quickly goes down.
And the result is costing businesses big bucks. According to the Association of Certified Fraud Examiners’ Occupational Fraud 2022: A Report to the Nations, asset misappropriation schemes are the most common but least costly form of fraud, representing 86% of cases with a median loss of $100,000. Financial statement fraud schemes are the least common but most costly, representing 9% of cases, with a median loss of $593,000.
Organizations with the fewest employees had the highest median loss ($150,000), while the top five median losses by industry occurred in real estate, wholesale trade, transportation and warehousing, construction, and utilities; ranging from $200,000 to $435,000.
Ross Pry, a certified fraud examiner (CFE) and the vice president of membership for the Association of Certified Fraud Examiners (ACFE), says he has definitely seen growth in the fraud detection industry in his 15 years with ACFE. Sometimes it is driven by new regulations such as the Sarbanes Oxley Act, which was triggered by a number of large fraud events including the failure of Enron and NH-based Tyco. Pry says these high-profile cases lead to pressure from regulators for better oversight.
“The ACFE was founded in 1988 by Dr. Joseph T. Wells, CFE, CPA, (an accountant turned FBI agent), who realized accountants didn’t know how to investigate, and police didn’t know accounting,” says Pry. “We continue to grow and have more than 90,000 members worldwide; 60,000 are CFEs. It has grown to encompass a variety of individuals concerned with protecting the organizations and governments they work for; not just accountants but auditors and internal control, loss prevention and risk management professionals.”
Kevin Kennedy of Maloney & Kennedy, PLLC in Auburn, a CPA, certified fraud examiner and a member of the board of the NH Chapter of CFEs, says forensic accounting often comes into play when fraud is suspected. It is an in-depth analysis of the information in the books and the records, and involves a certain amount of tracing. “It may also include trying to investigate where assets are located, if things were properly authorized, if assets have left a company or something illicit is going on.”
A forensic analysis is different from a standard audit, says Steve Drouin, CPA and certified fraud examiner with Drouin Associates LLC in Manchester. He says a standard audit is to determine if financial statements are in line with generally accepted accounting principles. “That’s very different than a forensic analysis where something triggered it, where abnormalities have given rise to a concern that there might be misappropriation of assets,” he says. “It is diving deeper into transactions, who initiated them, whether they were executed in the normal course of business and whether they were properly approved.”
Ernie Tomkiewicz of Ernest L. Tomkiewicz, CPA in Concord, agrees. “You’re looking for things in a different way; in forensic analysis, you usually have a question that you are trying to answer.”
The Elements of Fraud
In the world of fraud investigations, there is a concept called the fraud triangle, which has three components: pressure (sometimes referred to as incentive or motivation), opportunity and rationalization. “The first one is a pressure or need,” says Tom Bates of Thomas S. Bates, CPA, PC, in Keene. “An individual employee may all of a sudden have a financial crisis, such as high medical bills or an addiction and have the need for more cash. The second point on the triangle is opportunity, and if the employee sees an opportunity where they can embezzle or misappropriate assets then they’ll go for it. Third is rationalization. The fraudster rationalizes that what they did, they were entitled to do so.”
Pry agrees that the fraud triangle remains the standard. “We end up interviewing a lot of fraudsters along the way and see the same situations over and over,” says Pry. “Sometimes it’s a case of people living beyond their means and trying to keep it together, ‘I’ll just take this and give it back later,’ but it never happens. Sometimes they look at bosses or colleagues and feel they are working harder and should be compensated fairly.”
Pry says small business cases are more shocking as fraud can cripple an organization. And the shock can also result from who perpetrated the theft: a trusted employee who is seen as a dedicated and hard worker. “Even when organizations find the perp they don’t always go to court. Unless they have to, they don’t want to admit there was a fraud,” says Pry. This can lead to repeat offenses.
Bates says businesses need to limit opportunity. “Of the three corners to the fraud triangle, management and business owners can only control one: opportunity,” explains Bates. “You can’t control a person’s individual need, you can’t control the rationalization that they’ll make after the fact, but small businesses and the nonprofits can certainly limit the opportunity.”
Bates adds that fraud is happening more often, especially in small businesses. “You can’t pick up a paper today without finding an embezzlement scheme. We recently had one in West Milan that went on for 30 years. In another case, the controller of a company admitted to taking $3 million,” he says.
First Line of Defense
The segregation of duties is one of the primary ways to prevent fraud, says Kennedy. Businesses should put in place a system of checks and balances based on reviews and approvals. “When you just have that one bookkeeper who’s been with you for 25 years, and you rely on them for everything, there certainly is the opportunity for this person to do something inappropriate,” he says.
Kennedy says businesses need to consider how fraud or illegal activity might occur within their systems. Employers need to recognize that employees may feel a personal sense of mistrust when a forensic review is conducted. Employers need to reinforce that it’s not the person they’re questioning by being proactive; it’s the position. “You’re not doing an investigation into Jane the bookkeeper; you’re doing an investigation into the bookkeeping position to make sure that the controls are in place,” he says.
Too Much Trust
Bates says it’s difficult to convince small businesses and small nonprofits to look at their internal controls in an effort to prevent or detect fraud. But they are more susceptible because they don’t have the resources for internal audit functions, they don’t have sophisticated internal controls and often don’t have good checks and balances.
“Typically, the owners really trust their employees to be honest. There is no room for trust when it comes to fraud, misappropriation or embezzlement,” says Bates. “I have been involved in a couple of fraud cases where the owners didn’t invite me back to improve their internal controls. I guess they thought when they found the culprit and discovered the scheme that there weren’t going to be any others.”
Watch for Red Flags
Kennedy says the warning signs are there but often overlooked. The person in charge of the books will resist requests for information or accountability. They’ll complain and argue, he says. “A lot of times people don’t push the issue, don’t want to rock the boat, especially in a nonprofit. Perhaps a new board member is asking all of these questions about the controls over cash, and the treasurer or the person in charge says, ‘Why are you asking me all these questions? Nobody asked me all these questions before?’”
Drouin says a person engaged in fraud is often highly protective, doesn’t let anyone help with the bookkeeping, doesn’t take frequent vacations and locks down their computer when they go to lunch or go home. These could all be warning signs.
Technology—A Double-edged Sword
Many accounting functions and banking transactions have moved completely online, and banks are employing robotic process automation to improve accuracy and efficiency. While automation may mean fewer human eyes on transactions, computers can see patterns over time that will flag a problem.
“The ways to steal money have not changed, the schemes are the same as they were 50 years ago. They just have different tools,” says Tomkiewicz. “There are different tools now that are helpful to fraudsters, but as technology has advanced the ways to steal, the ways to find the fraud have also advanced.”
Forensic Accounting Gets Personal
Forensic accounting also comes into play when there is a transfer of assets in a divorce or a succession of a family business. An investigation may be used to uncover hidden assets and verify the real value of assets in play.
Bates, who retired after a 47-year career, says he will never forget one of the first cases he worked on. “A husband and wife were going through a divorce, and they owned a small motel in ski country. He ran the motel, and he managed the books and records. The attorney that I was working with said, ‘Let’s go on the assumption that he’s not reporting all the income.’
He suggested we look at the invoices for linen service … you’re not going to get a set of sheets cleaned unless they were slept in. Based on those invoices, we counted up the number of days that somebody would have paid for a room, and the revenue was understated by about half. It was so cool; I will never forget it.”
Even when there’s no suggestion of fraud, forensic techniques may be employed to help determine the true value of a business. Bill Howell, CPA, ABV, ASA and owner of Howell Valuation in Exeter, has been specializing in determining the value of businesses for almost 20 years. He says the valuation may be needed in advance of the sale of the business or filing an estate tax return where one of the properties that’s owned is a business interest. It might be for succession planning or an employee stock ownership plan.
“When we approach valuation, it’s a look at the past for determining a proxy for the future because business valuation is always about the future,” says Howell.
“The forensic work is designed to come up with the real profit stream and then base the value on that as opposed to one that might be either depressed or inflated. Sometimes the profits that are reported are really not the real profits,” says Howell. “It might be that there are nonbusiness related expenses—personal expenses—being recorded as business expenses, which has the effect of depressing the profit and lowering the value.”
He says valuations may recast the past to adjust for an anomaly, such as a big expense that was incurred but is a one-time concern or event.
Business climate is also a consideration. Some businesses benefitted from the pandemic and others were hurt and that affects valuation. The evaluator must try to determine the new normal.
Valuations are often triggered by litigation such as a shareholder dispute resulting in an owner getting bought out, or marital dissolution where the business is an asset. “There’s a divorce case and the primary generator of income for husband and wife is a business that is reporting $50,000 of income, but they have a $200,000 lifestyle. So, the question becomes, ‘What’s going on with the difference?’”
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