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How to Spot a Fraudster | Operational Red Flags

The Man with One Red Shoe is one of my favorite movies from the 1980s. It’s a remake, but I prefer it to the original because, really, how can you not love a movie that brings Tom Hanks, Carrie Fisher and Jim Belushi together? The plot revolves around a case of mistaken identity. Tom Hanks’s character, a concert violinist, is wrongly identified by the CIA as a person of interest. The tip-off? His unusual attire of one red shoe.

Identifying a Fraudster

Unfortunately, identifying a fraudster is never as simple as looking at their footwear. To detect fraud, management and human resources need to watch for specific types of behavior. Meanwhile, internal auditors should monitor operations and compliance with financial policies and procedures. Employees intent on committing fraud provide their own motivation. Employers need to maintain organizational controls that eliminate the ways and means to commit fraud.

The Fraudster’s Red Flags

During their research into fraud and embezzlement, criminologists Edwin Sutherland and Donald R. Cressey developed a model they called the Fraud Triangle. Introduced in 1978, this diagram remains fundamental to understanding fraud. The three sides of the triangle are opportunity, pressure and rationalization – fraud results when all three sides come together for an employee.

The Association of Certified Fraud Examiners (ACFE) notes that employees often exhibit one or more of these behavioral issues while committing occupational fraud:

  • Living beyond one’s means

  • Financial difficulties

  • Unusually close association with a vendor or customer

  • Control issues/unwillingness to share duties

  • Divorce or family problems

  • “Wheeler-dealer” persona

Fraudsters come from every part of the company, at the employee, managerial and executive/owner levels. They tend to be company veterans, with the ACFE reporting that over 75 percent of all internal fraud occurs in these business units:

  • Operations

  • Accounting

  • Executive/upper management

  • Sales

  • Customer service

  • Administrative support

  • Finance

  • Purchasing

While these types of behavior don’t necessarily indicate fraud, they may be consistent with departmental reports that indicate the cause for concern. Red flags merit closer inspection, which is particularly true when audit and accounting professionals detect unusual activity in business operations.

Operational Red Flags

The Corporate Financial Institute, a leader in financial education and training offers a useful summary of activities that warrant investigation, which include:

Inventory shrinkage — Excessive inventory shrinkage may indicate fraud. Internal accountants and auditors can detect shrinkage by comparing the number of products in stock with the numbers sold. They can also compare these numbers to projections and historical sales. Watch for customer reports of under-packing and investigate to determine if the problem comes from the sales or packaging department.

Missing documents — Recurring reports of missing documents may be a sign of ongoing fraud. Watch for missing motor vehicle registrations, lists of transactions, checkbooks and inventory reports. Their loss may be a cover for the loss of corporate assets or funds.

Multiple payments — Mistakes happen, so accounting departments can accidentally process duplicate payments to vendors. Genuine errors will be rectified and reported promptly. Failure to do so may indicate a problem, which makes monitoring and verification essential for all payments.

Invoice volume spikes — Growing businesses can process large volumes of invoices, creating space for potential fraud. Check for unrecorded payments and payments understated by volume or amount, and confirm delivery. Tracking timely order fulfillment is also good customer service.

Frequent complaints — It’s unwise to dismiss critical feedback about personnel, particularly when it’s frequent or about senior executives. An investigation can determine the validity of the complaint and suggest possible courses of action.

Excessive entry adjustments — These may be a cover for misappropriating funds. Watch for customer adjustments that have a significant effect on your financial results. Unexplained and excessive adjustments can indicate fraud. Legitimate adjustments will include corresponding notes that provide an explanation.

Experienced fraud examiners and auditors find that fraud typically occurs in the following operations:

  • Vendor management/accounts payable

  • Cash handling

  • Crisis payments or pre-payments

  • Travel and subsistence payments

  • Contract management

  • Administrative access to restricted systems

  • Access to sensitive data

  • Grant programs

Ideally, your employees should detect fraud during their normal business activity. This requires strong controls and oversight of compliance. Internal auditors should reinforce this with an understanding of the way fraud works and how fraudsters try to conceal it.

Recognize the Risk and Prepare Accordingly

Every business, no matter its size or approach to financial controls, is at risk for fraud. Acknowledge that it exists and then help your employees build awareness and understanding. Train them to recognize unusual activity or behavior, and support their willingness to raise concerns. Make sure you have specific anti-fraud policies and procedures in place, and then conduct oversight to maintain compliance.

You should also define and assess your internal controls. Look at the incidence of management or control overrides and your level of employee supervision. Fraud is expensive and merits a proportionate investment in preventive measures. The ACFE noted in their 2020 Report to Nations on Occupational Fraud and Abuse that fraud costs U.S. businesses an estimated five percent of their annual revenues. This percentage covers both misuse of assets and fraudulent reporting, and has remained steady over recent history.

Financial loss may only be part of the damage. Fraudsters can harm corporate relationships with customers, business partners and employees. These actions may also place their employers in breach of banking covenants, leading to regulatory costs, fines and sanctions. In light of these consequences, employers should stay vigilant and take all potential fraud seriously.

Strategic Resources for the Fight Against Fraud

If you suspect that fraud has occurred at your company, contact Windham Brannon’s Forensic and Litigation Services team to discuss an investigation. Our team has extensive experience in working with businesses and their legal counsel to investigate fraudulent acts. We can quantify damages and provide the supporting evidence to pursue criminal charges and/or seek restitution.

We also work with clients to implement stronger controls designed to mitigate the risk of fraud. For more information, talk to your Windham Brannon advisor or contact Natalie Lewis.