How to Spot Fraud

By Hall, John J. | Journal of Accountancy, October 1996 | Go to article overview

How to Spot Fraud


Hall, John J., Journal of Accountancy


Putting a squeeze on theft.

While there is no sure-fire way to eliminate fraud and if there were, the cost probably would be prohibitive with proper attention by management it can be minimized. This article explores the various ways CPAs in industry and in public practice can sharpen their fraud-detection and -prevention skills.

Part of the fraud problem is perception. For example, one controller recently said that "2% shrinkage is normal in our industry; we are pleased that our experience is just under that amount." When asked what caused the shrinkage, she had no idea. She had already decided not to worry about it--even though the loss totaled about $1.5 million a year--because the unstated assumption was that it wasn't possible in her industry to reduce shrinkage below the 2% "normal" range. When it was pointed out that the real issue was acceptable theft levels rather than acceptable shrinkage levels, she changed her thinking. After an investigation, she discovered that the inventory was systematically being stolen from the warehouses.

The fact is few cases of fraud are uncovered by external auditors. The most effective sleuths are the people who handle a business's day-to-day transactions. Sampling, by itself, is not always an effective way to uncover fraud. When auditors rely on sampling, which they almost always do, they see only a few' transactions. As a result, the odds are against the likelihood they will stumble on a fraudulent transaction. But those on staff who review transactions and maintain the relationships with external parties are in the best position to notice when something is fishy As a result, effective managers should issue policy guidelines that, in effect, tell each employee, "You are responsible for being aware of what can go wrong in your area. You also are responsible for detecting wrongdoing when it does occur." Everyone--including auditors-- should be on the alert and at least look for those frauds that only he or she is in a position to detect.

To get better at finding fraud, auditors and employee managers should follow the following four-step approach:

1 FOCUS ON THE POSSIBILITIES

Before getting down to the detailed job of devising controls, do some research on what can go wrong. Most financial and operating professionals have only a passing knowledge of the specific cons used by white-collar thieves. We hear about schemes involving credit cards, fake vendors, inventory theft, kick-backs, bad loans and other cases, but few executives really know the details of the deceptions.

Managers who have been defrauded often say, "But we had controls in place to prevent this from happening!" Hard as it is to accept, most preventive controls can be beaten by a motivated thief. And when thieves are inside the organization, they may be part of the control effort itself.

So, find out how past defrauders pulled off their crooked acts. What was the thief's role m the organization that gave him or her the freedom to commit the act? Ask yourself how management steps such as reengineering, downsizing, outsourcing, computerization and globalization affect the reliability of controls--as well as the attitudes of those who have access to the assets.

Other places to look are industry resources. Many industry organizations maintain data on fraud cases. Since banks, insurers and others all support fraud prevention, they keep useful information on the subject. In addition, contact your industry association's security professionals for guidance.

Keep files of news reports of fraud. These articles often contain enough detail to allow you to understand how the deed was done. But be careful not to get caught up in the drama of the fraud: Put less emphasis on the thieves and their reasons for stealing, focusing instead on the modus operandi.

Certainly take advantage of any formal training on fraud detection that's available. …

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