But scandals such as Enron confirm that things are not always what they seem. The government responded with the Sarbanes-Oxley Act of 2002, which put in place accountability checks to deter corporate fraud in public firms. But regardless of a company’s size or scope, management must implement sound accounting systems and controls to deter employees from crossing legal boundaries. Before setting up systems to prevent internal fraud, owners must recognize a few key indicators and understand two basic types of fraud.
Consider this scenario: The corporate treasurer places cash on a desk, a workspace all employees can access. Reverting to altruistic assumptions about employees’ ethics, the treasurer concludes that no one would consider swiping a few dollars or several hundred, for that matter.
However, human instinct often gives in to temptation. If the treasurer had placed the cash in a safe instead, the option to “borrow” it would not exist. The safe is an employer’s control, and systems including oversight procedures, physical controls and assessment of potential risk areas are critical to preventing internal fraud. The following pressure points are common to both small and large companies.
- Incentive and pressure. Why might management commit fraud? For example, is it buffering revenue to show growth in order to secure a bank loan?
- Opportunity. Poor oversight and weak controls provide plenty of air space for fraudulent transactions.
- Rationalization. Fraud perpetrators can often justify their behavior.
Fraudulent financial reporting
Financial statement fraud occurs when a company misrepresents its financial position, operations results, disclosures or financial statements.
A number of motives spur this type of fraud. One example is an employer who inflates profits to obtain additional financing. Or a manager might understate profits if a business partner wants to lower the buyout price of another partner.
Symptoms of falsified financial reports include fictitious transactions with related parties, recording improper asset values, fictitious revenue, recording income and expense in the wrong accounting periods, concealing liabilities and not recording expenses.
Misappropriation of assets
This type of financial fraud involves theft of an organization’s assets. Perhaps financial statements are materially misstated. Or an owner notices missing inventory in the plant. This type of fraud includes situations in which the person in charge of keeping books also holds check-writing responsibilities or some other form of access to cash.
Protect your company
Don’t let fraudulent behavior ruin your company or force your business into a legal bind. By setting up internal controls and implementing the following checks and balances (representing just a few examples), you can rest assured that appropriate measures to counteract accounting oversights are in place.
- Improve physical control of assets. Safeguard inventory and hold people responsible for inventory identified on financial records. Install security procedures so inventory doesn’t walk out your back door.
- Control cash. Do you require dual signatures on checks? Are invoices properly authorized? Is the person who writes checks or transfers monies the same person who has recordkeeping responsibilities? If the latter is true, it is time to divide these responsibilities.
- Identify potential risk areas for fraudulent activity. Perform an internal assessment and diagnose areas of your business where weak systems could allow temptation to overpower ethics. Where are the soft spots? Inventory control? Accurate accounting practices? Structure controls or discuss these issues with a financial professional and devise a plan to help deter theft.
- Create a corporate culture of honesty and high ethics. Practice what you preach and ensure that management leads by example. Educate employees on fraud during team training meetings and let employees be your physical checks and balances, in addition to sound accounting systems.
Lawrence A. Simon is a certified public accountant and director of Doeren Mayhew, a regional accounting firm in Troy, Mich. Doeren Mayhew provides a wide range of professional services to middle-market companies. Reach him at email@example.com or (248) 244-3225.