FUNDAMENTALS OF FRAUD

by: Craig L. Greene, CFE, CPA

 

DEFINITION OF FRAUD

Fraud is defined as illegal acts that are characterized by deceit, concealment or violation of trust. These acts are not dependent upon the application of threat of violence or of physical force. Individuals and organizations to obtain money; property or services; to avoid payment of loss of services; or to secure personal or business advantage perpetrate frauds.

Internal Fraud

Internal frauds are the illegal acts of employees against the company. This is different from external frauds, which are perpetrated by customers against the entity.

FRAUD STATISTICS

In the United States, annual losses from white-collar crime and fraud are estimated to be $200 billion or more. This represents almost $1,000 for each man, woman and child. 

  1. Most businesses lose from ½ to 2% of sales from fraud and employee dishonesty.
  2. Dishonesty by insiders, directors, officers and employees contributed to over half of the bank failures in recent years.
  3. Top management from 45 of the 100 largest military suppliers has been under criminal investigation for fraud.
  4. One-third of business failures is attributed to internal fraud.
  5. Only 30% of retail losses are from shoplifters; employees steal 70%.
  6. In the savings and loan scandal, it would take robbers 4,000 years to match what officers and directors have stolen. 

Financial crimes pay more than other crimes. Average losses for such crimes are as follows:

 PROFILE OF FRAUD OFFENDERS

Fraud offenders differ little from the "average" person. According to studies, most offenders commit fraud because the following three elements occur simultaneously:

  1. Unsharable Financial Pressure
  2. Perceived Opportunity
  3. Rationalization

Unsharable Financial Pressure

Unsharable financial pressure is usually caused by an immediate need that is difficult to share with others. Examples of these pressures might include:

  1. Living beyond one’s means
  2. High personal debts or poor credit
  3. Financial losses
  4. Gambling, drugs, affairs
  5. Undue peer of family pressure to succeed

Other pressures, which are not necessarily financial in nature, might include:

  1. A challenge to beat the system
  2. Job dissatisfaction
  3. Emotional instability

Perceived Opportunity

Opportunity to commit and conceal fraud can be real or perceived. Potential perpetrators who think they will be detected rarely commit fraud.

Rationalization

Fraud offenders rationalize their behavior as something other than fraud or theft. Common rationalizations might include:

  1. "I’m only borrowing this money; I’ll pay it back."
  2. "I’m not really hurting anyone."
  3. "Everyone is a little dishonest."
  4. "It’s for a good purpose."
  5. "I’m just trying to beat the system."
  6. Greed
  7. "It’s not that serious."
  8. "Everyone does it."

 

LEGAL ELEMENTS OF FRAUD

Definition

Black’s Law Dictionary defines fraud as: "...All multifarious means which human ingenuity can devise, and which are resorted to by one individual to get advantage over another by false suggestions or suppression of the truth, and includes all surprise, trick, cunning, or dissembling, and any unfair way by which another is cheated."

Elements of Fraud

  1. A material false statement
  2. Knowledge that the statement was false
  3. Reliance by the victim
  4. Damages as a result

Elements of Corruption

Bribery

    1. Giving or receiving (or offering or soliciting)
    2. Any "thing of value"
    3. To influence
    4. An official act

Illegal Gratuity

    1. Giving or receiving (or offering or soliciting)
    2. Any "thing of value"
    3. For or because of
    4. An official act

An illegal gratuity is a lesser-included offense of bribery. It is an extra "thank you," or "reward" payment to an official for performing normal duties. Therefore, an illegal gratuity does not require proof of an intent to influence.

Commercial Bribery

    1. Giving or receiving (or offering or soliciting)
    2. Any "thing of value"
    3. To influence
    4. A business decision
    5. Without the employer’s knowledge and consent

Things of value may include:

    1. Gifts
    2. Entertainment 
    3. Travel
    4. Sexual favors
    5. Use of credit cards
    6. Phantom sales
    7. "Loans"
    8. Cash
    9. Payments by check 

Conflict of Interest

    1. an agent taking an interest in a transaction
    2. which is actually or potentially adverse to the interest of the principal

A conflict of interest, which causes actual or potential economic loss to the principal, may be prosecuted criminally or civilly as a fraud. A disloyal agent is liable for any losses caused as a result of the conflict and must pay over any profits that he or she earned, even if no loss to the principal resulted.

 

CRIMINAL VERSUS CIVIL FRAUD

Intent

Wrongful intent, or "guilty knowledge," must normally be proved in civil and criminal fraud cases. There are numerous ways of proving intent, such as:

  1. Alteration of documents
  2. Concealment of evidence
  3. Destruction of evidence
  4. "False exculpatories" (Lies)
  5. Personal gain
  6. Obstruction of justice
  7. Pattern of conduct-Reputation
  8. Testimony of co-conspirator
  9. Admissions
  10. Confessions

Burden of Proof

In criminal cases, the burden of proof is beyond a reasonable doubt, that is, juries must rule unanimously on guilt.

In civil litigation, the standard of proof is much lower and may be decided by merely a "preponderance" of evidence. The verdict also does not necessarily have to be unanimous.

CLASSIFICATION OF FRAUDS

The methodology, the type of concealment, or the elements can classify frauds. Methodology includes at what point of occurrence the fraud takes place, the victim, and the type of organization involved.

Points of Occurrence

Assets can be misappropriated at three separate and distinct points in an enterprise:

Before Reaching the Entity

Examples of this type would be theft of receipts at the point of sale, as well as theft of inventory before it is booked.

Within the Entity

All illustration would include theft of petty cash after it has been recorded on the books.

After Leaving The Entity

Examples would include the conversation of phony vendor payments and ghost employees.

 

Type of Victim

The type of victim can classify frauds. There are four major victim categories:

Shareholders

Shareholders are most often victims of management frauds, whereby managers attempt to falsely inflate profits or assets. 

Investors

Investors are victims of scams perpetrated by fraud artists. Examples of schemes might include Ponzi schemes or advanced fee swindles.

Enterprises

Both commercial and governmental organizations are victims of two types of fraud:

    1. Internal

Theft or misappropriation by officers and employees. Examples include embezzlement and kickbacks.

    1. External

Customers (and in the case of governmental agencies, taxpayers) attempting to defraud the entity. Examples include checks artists, phony insurance claims, and fraud in government benefit programs.

Customers

Business enterprises frequently victimize their customers through false advertising, product substitution, and related schemes.

Type of Concealment

Business or internal frauds can be classified by the way they are concealed. 

On-book Frauds

Principally, an On-book fraud is one that occurs within the business. Illicit payments or activities are recorded, generally in some disguised manner, in the regular books and records of the company. An audit trail (however obscure) normally exists which might aid in the detection of an On-book fraud. Examples might include payments to a phony vendor generated by fictitious charges to travel, entertainment, or other miscellaneous accounts.

On-book frauds are normally detected at the point of payment. For example, if a payment is made to a fictitious vendor, examining the addresses of all vendors might discover the fraud. The address for a fictitious vendor may match up with either a post office box or an employee’s address. If either of these events occur, the auditor should consider the possibility of an On-book fraud.

Off-book Frauds

Off-book frauds normally occur outside the accounting mainstream, and no audit trail is likely to exist. Generally, for an Off-book fraud to occur, the company usually has unrecorded vendor rebates or significant cash sales. Examples of Off-book frauds include bribery and kickbacks.

Off-book frauds are typically proved at the point of receipt; that is, the initial "red flag" will appear with regard to the receipt of illicit funds. For example, if an employee has suddenly purchased a new car and a new home, but the employee’s salary has not changed, then one might concluded that the employee has received wealth from an outside source. If there is no logical explanation for the increased wealth, and irregularities are suspected, further investigation may be recommended to determine the source of the possible outside income.

Generally, Off-book frauds are larger in amounts than On-book frauds.

 

ELEMENTS OF FRAUD

Unlike some crimes, fraud normally involves three steps. (Auditing efforts should concentrate on the step easiest to prove or detect.)

Act

The fraud act is normally the theft. In a simple example, the theft of petty cash would constitute the act.

Concealment

Once the act has been accomplished, efforts must be made by the perpetrator to conceal it. In the case of the theft of cash, falsifying the balance in the cash account would constitute concealment.

Conversion

Once assets are misappropriated, and that fact is concealed, the perpetrator must convert these assets to his or her own benefit. In the case of the theft of petty cash, conversion would occur when the perpetrator deposited the funds in an account, or made a purchase with the ill-gotten gains.             

 

DETECTING FRAUD

There are numerous proactive methods to detecting fraud other than fraud auditing. Once fraud is suspected, it should be documented and investigated. These investigations include interviews, surveillance (observation), investigative audits, record searches, and net worth analyses. Proactive methods include:

Complaints and Tips

Complaints by customers, employees and others frequently lead to suspects in fraud cases. Entities should encourage communication that leads to possible investigation.

Behavior Changes

Fraud perpetrators often undergo personality changes as a result of the continuous pressure of committing fraud. Having management and employees observe changes in behavior can lead to suspects.

Lifestyle Changes

Fraud perpetrators rarely hoard the proceeds of their acts. Instead, they frequently spend conspicuously on lavish luxury items such as automobiles, homes, clothing and jewelry.

Internal Control Weakness

Weaknesses in internal control are a major contributing factor to the opportunity to commit fraud. Weaknesses that lead to fraud are usually fundamental in nature; such as, the failure to properly segregate the functions of record keeping, authorization and custody over assets.