Financial Fraud – Definition, Detection and Prevention

By: Yigal Rechtman, forensic principal, Grassi & Co.

Yigal Rechtman

Yigal Rechtman

In today’s complex economy, fraud schemes are growing more sophisticated, and the costs to both avoid and repair the damage higher. With cloud technology and weak cybersecurity threatening every business worldwide, the white-collar criminal of the future will be more armed and ready to fire than ever before. In 2014, roughly 40 million people in the U.S. were affected by identity theft and cybercrime alone is already costing the U.S. economy as much as $400 billion a year and as much as $1 trillion globally, according to a study released in 2014 by McAfee and the Center for Strategic and International Studies

The cost of financial reporting fraud (“management fraud”) costs about $1 million per incident, while occupational fraud costs roughly $150 to $200,000 per incident. Losses due to fraud cost an average of 5% of gross profit and take around 24 to 36 months to discover—usually via a tip (40%), by accident (20%) or during an audit (10%).

So what is fraud and why do people commit it?

Fraud is the intentional deceit of a material fact causing damage to its victims and benefiting the perpetrators. Fraud is generally classified as: occupational fraud, financial statement fraud and corruption—usually by an official. The more dissatisfied an employee, the more likely he or she will engage in fraud. There is a triangle theory of fraud by famed criminologist Donald Cressey to describe why people commit fraud: a person under pressure, due to a financial problem, will find an opportunity, a way in which to use his position to solve his problem, and then will rationalize, justify, the crime in order to make it acceptable. Most fraudsters are first-time offenders with no criminal past and do not see themselves as criminals; rather, they see themselves as ordinary, honest people who are just in a bad set of circumstances.

How can fraud be detected?

When there is a predication (i.e. a tip) of fraud, fraud examiners typically start with top-level analysis, looking for outliers in the results (excessive voids, missing documents, excessive credit memos, increased reconciling items, adjustments to receivables or payables, duplicate payments and ghost employees are just some examples.) Top-level analysis is the comparison of plausible relationships between balances and noting any unexpected results.

How can fraud be prevented?WP-Scam-Alert-red-black-white-sign

The best defense against financial fraud, especially financial report fraud and occupational fraud, is through the development of strong internal controls.

  • Segregation of duties: having more than one person performing or completing a task is a deterrent as the work of one individual is either independent of, or serves to check on, the work of another.
    • Custody or monitoring of assets
    • Authorization or approval of related transactions affecting those assets
    • Recording or reporting of related transactions
  • Reconciliations: these should be completed by an independent person who doesn’t also share bookkeeping responsibilities or check signing responsibilities.
    • Examine canceled checks—authorized signatures, appropriate endorsements, recognizable vendors, check sequence.
  • Physical security: access logs, video cameras, keyed entries
  • Pressure: perform periodic credit reviews and add a right to audit clause to the contracts. This not only gives the party the right to audit, it also sends the right message.
  • Provide training to your employees regarding the rationalization factor of committing fraud.

The most effective way to prevent fraud is to understand and fix internal controls, however, the bottom line to your bottom line is this: even the best systems of internal control cannot provide absolute safeguards against irregular activities.

For more information on how you can help fight fraud, contact Yigal Rechtman of Grassi & Co. at