Fraud Prevention

Signs of inventory fraud

Is your inventory being stolen by dishonest employees or customers? Inventory is a prime target for fraud schemes, second only to cash. And it doesn’t always involve the physical theft of items. Here are some early warning signs that your inventory has been targeted.

Know your risk profile

Some companies are more at risk for inventory fraud than others. Obviously, service companies with minimal inventory on hand bear little risk of inventory embezzlement; instead, it’s more common among retailers, manufacturers and contractors. In general, higher-value inventory items, such as electronics or jewelry, tend to be more attractive to thieves.

Sometimes, however, the inventory account is just a convenient place to hide financial misstatement ploys, such as skimming or bogus sales. Thousands of journal entries are typically made to the inventory account, and it’s closed out to cost of sales each year. So, thieves with access to the accounting systems may bury their scams in the inventory account. Then, victim-organizations may write off discrepancies between the computerized perpetual inventory records and physical inventory counts as external pilferage, obsolescence or errors — when, in fact, it’s due to intentional manipulation of the accounting systems.

Monitor inventory metrics

If your year-end inventory counts aren’t adding up, don’t just write off the discrepancy as a cost of doing business; investigate why. You can shed light on the situation by computing various inventory ratios, including:

  • Days in inventory (average inventory divided by annual cost of sales times 365 days),
  • Gross margin (sales minus cost of sales) as a percentage of sales,
  • Inventory as a percentage of total assets,
  • Returns as a percentage of annual sales, and
  • Shipping costs as a percentage of sales.

These metrics should be consistent over time and comparable to industry benchmarks. Sudden changes require immediate action.

Catch fraud early

The median duration — from inception to detection of a fraud scam — is 18 months, according to the 2016 Report to the Nations on Occupational Fraud and Abuse by the Association of Certified Fraud Examiners. Many victims are unaware that inventory balances are inaccurate until they’ve accrued substantial losses. Diligent managers know the signs of inventory fraud and can identify anomalies early. Contact us for help investigating a suspected inventory scam.

© 2016

Related-party transactions: Think like an auditor

Issues between related parties played a prominent role in the scandals that surfaced more than a decade ago at Enron, Tyco International and Refco. Similar problems have arisen in more recent financial reporting fraud cases, prompting the Public Company Accounting Oversight Board (PCAOB) to unanimously approve a tougher audit standard on related-party transactions and financial relationships. To prevent your company from issuing financial statements with undisclosed or misleading information about these relationships, think like an auditor.

It’s all relative

Under PCAOB Auditing Standard No. 18 (AS 18), Related Parties, Amendments to Certain PCAOB Auditing Standards Regarding Significant Unusual Transactions, and Other Amendments to PCAOB Auditing Standards, related parties include the company’s directors, executives and their family members.

Ultimately, companies are responsible for the preparation of their financial statements, including the identification of these related parties. However, auditors are on the lookout for undisclosed related parties and unusual transactions.

Where to look

Certain types of questionable transactions also might signal that a company is engaged in related-party transactions. Examples include contracts for below-market goods or services, bill-and-hold arrangements, uncollateralized loans and subsequent repurchase of goods sold.

Where can you find evidence of undisclosed related parties? Auditors are trained to consider these types of source materials:

  • Proxy statements,
  • Disclosures contained on the company’s website,
  • Confirmation responses, correspondence and invoices from the company’s attorneys,
  • Tax filings,
  • Life insurance policies purchased by the company,
  • Contracts or other agreements, and
  • Corporate organization charts.

Auditors also scrutinize compensation arrangements and other financial relationships with executives that may create incentives to engage in fraud to meet financial targets.

Leave no stone unturned

AS 18 requires public company auditors to obtain a more in-depth understanding of every related-party financial relationship and transaction, including its nature, terms and business purpose (or lack thereof). Moreover, it requires auditors to communicate with the audit committee throughout the audit process about related-party transactions — not just at the end of the engagement.

Related parties present risks to all kinds of entities, not just public companies. Smaller companies and start-ups also tend to engage in numerous related-party transactions, such as rental and compensation arrangements. These arrangements increase the risks of fraud and legal violations, warranting increased attention for companies of all sizes.

© 2016

Fraud Awareness and the Small Business 2016

By Frank Stover, CPA/CFF/CGMA, CFE

Audit Manager at Atchley & Associates, LLP

The Association of Certified Fraud Examiners has released the biennial Report To The Nations on Occupational Fraud and Abuse, a 2016 Global Fraud Study.

For small business the fraud that owners will most often see committed against them or their company is “occupational fraud”.  The Association of Certified Fraud Examiners defines occupational fraud “as the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s resources or assets.”  Occupational fraud can manifest itself in many ways.  Nor is it limited by gender.

Based upon the statistics and information contained in the “Report to the Nations on Occupational Fraud and Abuse”, 2016 Global Fraud Study, approximately two thirds of the reported cases targeted privately and publicly held companies.  Private companies suffered median losses of $180,000. The median losses suffered by small organizations (those with less than 100 employees) was the same as those of the largest organizations, but the impact upon smaller organizations would be much greater.  The total losses caused by the cases studied exceeded $6.3 billion. It is estimated that fraud costs organizations 5% of revenues each year, applying this percentage to the Gross World Product of $74.16 trillion results in a potential total fraud loss worldwide of $3.7 trillion.  Constant vigilance to prevent fraudulent activity is something that small business owners must practice every day.

Generally, occupational fraud categorized as financial statement fraud, misappropriation of assets, or corruption.  Asset misappropriation was the most common form of fraud reported in more than 83% of the cases studied.  Financial statement fraud will typically involve falsification of an organization’s financial statements or some form of regulatory or financial report. Examples include overstating assets and revenues, or understating liabilities or expenses to achieve personal gain.  Misappropriation of assets is the theft or misuse of an organization’s assets, such as skimming revenues, stealing inventory or committing payroll fraud.  Corruption involves fraudsters wrongfully use their influence in a business transaction to procure some benefit for themselves or another person(s), contradicting their duty to their employer or the rights of another, for instance by accepting kickbacks or engaging in conflicts of interest.

94.5% of the cases studied involved the perpetrator making efforts to conceal their fraud by creating or altering physical documentation.

For Small businesses cash, inventory, payroll and misuse of organization assets are the most common areas of fraud occurrence.  Cash is the most often pilfered from small business but because of its nature and importance to small businesses it is usually discovered within one month.  Inventory fraud is usually not discovered until later because small organizations will be more focused on operation measures (for example, revenues run rates, billing cycle  and accounts receivable information) in the short term and inventory will not be counted or reconciled against purchases and jobs in progress until quarter or year end.  Payroll fraud is usually committed by persons who have some form of operational control and authorization such that they can add phantom employees to the payroll or in collusion with others falsified time records submitted to the payroll department, this type of fraud is most usually discovered when there is turnover in personnel, a “falling out” between conspirators, or some form of periodic management review and reconciliation of historical project costs against approved budgets.  Misuse of organization assets many times occurs when a service company employee uses their employer’s assets on the weekend and holidays to run another business on the side, discovery of this type of fraud will usually occur when a disgruntled customer of the employee’s side business complains regarding defective work or makes a warranty claim, control of physical access to company operating assets during no business hours and mileage logs reconciliations are several ways to prevent or detect such abuse.

The most common detection methods in the cases studied were tips (39.1%).  Organizations that had reporting hotlines were much more likely to detect fraud through tips.

There are fraud policies and controls which can assist small businesses in deterring bad behavior.  Some of these include having a clearly written and communicated fraud policy which describes how and who handles fraud matters and investigations within the organization, what actions the organization considers to constitute fraud, reporting procedures (anonymous tip lines, a designated official, etc.), and what consequences the organization will take for such activity and the dedication to follow through with those stated consequences.

Atchley & Associates, LLP is a group of dedicated professionals, which include Certified Fraud Examiners, who can review, assess and make recommendations regarding small business systems of internal controls to decrease the likelihood of fraud being committed.

Month End Accounts and Reconciliations

Quick tips for a more efficient and effective close.

 

By Jeremy Myers, CPA

Audit Supervisor at Atchley & Associates, LLP

 

Businesses, much like your personal finances, balance their books on a monthly basis, or they should. The month end close process of reconciling bank accounts or even credit cards accounts are typically the last item that gets reconciled and closed each month.  This process insures that you have recorded all of the bank transactions such as bank fees or ACH payments/deposits that your business did not already have a paper form of payment.  Also in the sense of reconciling your business’ credit card bill to insure all the charges are proper, have support (receipts kept and attached to the statement), and that no unknown or possible fraudulent charges have made your statement with the end result of showing the complete liability for items that you have not yet paid for. For any control based procedure there is a need to insure the procedure is being performed timely and accurately.

Now that most statements are available online complete the next day after the statement close, the timeliness of the reconciliation can be taken out of the equation.  You just need to set up a schedule and by X day of the month, each month, every month, the account gets reconciled and any entries for transactions that have happened get put into the accounting system.

The other main attribute for effective procedures is accuracy and this attribute is just as much about transcribing the numbers from the statement in to the accounting system as it is as making sure you are reconciling the account to the proper date.  Most bank accounts, unless asked for otherwise, are set up based on the day of the week you opened the account.  For personal use, this might not be a bad thing, however, for businesses, most do not have mid-month closing dates.  Our biggest recommendation is make sure that your statements: bank, investments, credit card, etc… are on a month end basis.  That way you know you are reconciling your statement to each month end, and most importantly, year-end (as each of the months close into the end of the year).  This can be accomplished by simply calling your banker, investment advisor, credit card dealer, etc… and asking them to change your statement to a month end basis; this should cover the months that end in 28, 29, 30, or 31 days.

By performing your reconciliations timely and at the appropriate end date (typically month and year end) you can insure all of the transactions occurring during the month are appropriately recorded in your businesses’ records and for those pesky accruals, you can accrue an entire credit card statement instead of trying to add up the certain transaction that occurred prior to the end of the month.

Fraud Awareness and the Small Business

by Frank Stover, CPA/CFF/CGMA CFE

Audit Manager at Atchley & Associates, LLP

Fraud – a word we hear that many times is different than what our preconceptions may be. Someone may be a fraud or someone may commit a fraud or at times something physical may be a fraud.

For small business the fraud that owners will most often see committed against them or their company is “occupational fraud.” The Association of Certified Fraud Examiners defines occupational fraud “as the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s resources or assets.” Occupational fraud can manifest itself in many ways. Nor is it limited by gender.

Based upon the statistics and information contained in the “Report to the Nations on Occupational Fraud and Abuse”, 2012 Global Fraud Study, published every two years by the Association of Certified Public Examiners, fraudulent activity cost United States organizations 5% of their annual revenues (based upon 2012 US GNP of $16.13 trillion this would be $806.5 billion in fraud losses).

Generally, occupational fraud categorized as financial statement fraud, misappropriation of assets, or corruption. Financial statement fraud will typically involve falsification of an organization’s financial statements or some form of regulatory or financial report. Examples include overstating assets and revenues, or understating liabilities or expenses to achieve personal gain. Misappropriation of assets is the theft or misuse of an organization’s assets, such as skimming revenues, stealing inventory or committing payroll fraud. Corruption involves fraudsters wrongfully use their influence in a business transaction to procure some benefit for themselves or another person(s), contradicting their duty to their employer or the rights of another, for instance by accepting kickbacks or engaging in conflicts of interest.

For Small businesses cash, inventory, payroll and misuse of organization assets are the most common areas of fraud occurrence. Cash is the most often pilfered from small business but because of its nature and importance to small businesses it is usually discovered within one month. Inventory fraud is usually not discovered until later because small organizations will be more focused on operation measures (for example, revenues run rates, billing cycle and accounts receivable information) in the short term and inventory will not be counted or reconciled against purchases and jobs in progress until quarter or year end. Payroll fraud is usually committed by persons who have some form of operational control and authorization such that they can add phantom employees to the payroll or in collusion with others falsified time records submitted to the payroll department, this type of fraud is most usually discovered when there is turnover in personnel, a “falling out” between conspirators, or some form of periodic management review and reconciliation of historical project costs against approved budgets. Misuse of organization assets many times occurs when a service company employee uses their employer’s assets on the weekend and holidays to run another business on the side, discovery of this type of fraud will usually occur when a disgruntled customer of the employee’s side business complains regarding defective work or makes a warranty claim, control of physical access to company operating assets during no business hours and mileage logs reconciliations are several ways to prevent or detect such abuse.

Generally, fraud will happen because someone has a perceived (i) financial problem that cannot be shared or discussed with another (such as an inability to pay debts, a personal financial failure, perceived mistreatment by their employer), an (ii) opportunity (the person believes that their problem can be solved in secret) to fix their problem without being caught, and (iii) a rationalization that allows them to view the situation as non-criminal and justified as part of a situation that they cannot control.

There are fraud policies and controls which can assist small businesses in deterring bad behavior. Some of these include having a clearly written and communicated fraud policy which described how and who handles fraud matters and investigations within the organization, what actions the organization considers to constitute fraud, reporting procedures (anonymous tip lines, a designated official, etc.), and what consequences the organization will take for such activity and the dedication to follow through with those stated consequences.

Atchley & Associates, LLP is a group of dedicated professionals, which include Certified Fraud Examiners, who can review, assess and make recommendations regarding small business systems of internal controls to decrease the likelihood of fraud being committed.

Fraud in the Cash Disbursements Accounting Cycle

By Tyler Mosley, CPA, CFE

Audit Supervisor at Atchley & Associates, LLP

In the Association of Certified Fraud Examiners (ACFE) 2014 edition of “Report to the Nations on Occupation Fraud and Abuse,”1 85% of fraud cases involve misappropriation of assets. In addition, 29% of all fraud cases occurred in companies with fewer than 100 employees and for those fraud cases the median loss was $154,000.

In our March 2014 blog, Robert Marchbanks, CPA/CGMA, discussed preventing fraud in nonprofit organizations and provided a good checklist of steps an organization can take to prevent and detect fraud. I am going to expand upon one of these items as it is the item I come across the most frequently when performing financial statement audits of nonprofit and for-profit organizations. Many smaller organizations do not have enough room in their budget to hire multiple staff members to perform accounting and financial reporting duties. Specifically we see that some smaller companies do not have adequate segregation of duties related to the check disbursement process. We stress with our clients that having proper segregation of duties is important to mitigate the risk of an employee committing fraud and detecting fraud that timely.

For the most effective segregation of duties, employees involved in purchasing functions (initiating requisitions and approving purchases) should not have disbursement related responsibilities. These employees should not be able to approve invoices for payment, record invoices, receive goods, or have access to the vendor master files. We frequently see in small organizations that the same staff member creates check runs, approves invoices, signs checks, and performs bank reconciliations. In the event that segregation of these functions is infeasible, we suggest that a member of management who is not responsible for any of the aforementioned duties be the sole signor on all checks. They should also periodically review all check disbursement activity to ensure that only authorized transactions have been processed.

A little extra time spent monitoring the check disbursement process could save the company significant amounts of money down the road.

1http://www.acfe.com/rttn/docs/2014-report-to-nations.pdf

Preventing Fraud in Nonprofit Organizations

By Robert Marchbanks, CPA/CGMA

Audit Manager at Atchley & Associates, LLP

Most nonprofit organizations operate with limited staff and in a manner that assumes all employees are trustworthy. While the majority of employees are honest and believe in the organization’s mission, there are employees that may face financial hardship from a spouse losing a job, incurring medical bills, or sending a child to college. Other employees believe they are entitled to higher pay and will “justify” embezzling from the organization.

Donald Cressey’s hypothesis on why people commit fraud is referred to as the fraud triangle: Motivation, Rationalization, and Opportunity.

  • Motivation or pressure may include financial problems, addictions like gambling, shopping or drugs, pressure to show good performance or results, or just the thrill of being able to get away with something.
  • Rationalization is when individuals think they are justified because they are underpaid, or it’s for their family, or they need it now but they’ll pay it back before anyone notices.
  • Opportunity is created when there are weaknesses in controls. Individuals think they won’t get caught because nobody is looking, or reviewing, or performing reconciliations and reviews.

While an organization may not be able to prevent motivation or rationalization, there are certain steps the organization can take to minimize the opportunity and the risk of an employee committing fraud. These include:

  1. Set the tone at the top – Management should set the tone at the top for ethical behavior in the organization.
  2. Segregation of duties – No single person should be responsible for receiving, depositing, recording, and reconciling receipt of funds. No single person should be responsible for approving payments, disbursing funds, recording the disbursement transaction, and reconciling the bank statement.
  3. Reconcile accounts in a timely manner – Bank accounts should be reconciled timely by an individual not responsible for recording cash receipts and disbursements.
  4. Documentation and Authorization – You should have invoices to support cash disbursements and the expenditures should be approved by someone outside of accounting. The approval should be in the form of a signed purchase order or signed approval on the invoice. Maintain proper accounting records for all transactions.
  5. Written whistleblower and conflict of interest policies – The whistleblower policy should provide a phone number for the employee to call to report the fraud and remain anonymous. The conflict of interest policy should prevent private inurement.
  6. Look for employees living beyond their means – Be aware of the type of car the employee drives, the vacation destinations they travel to, and the jewelry that they wear.
  7. Carry insurance for employee theft – Even with the fraud policies and procedures in place, you should carry insurance to cover employee theft. This will minimize the risk of the financial hardship of the nonprofit organization.
  8. Keep check stock in a secure location accessed only by authorized personnel.

While the above list is not all-inclusive, hopefully it will encourage you to review your current policies and procedures at your nonprofit organization and implement procedures to deter and detect employee fraud. Please let us know if we can help in reviewing your risk assessment of your policies and procedures.