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David Dearman, Partner, PKF (UK) LLP

Fraud is something that afflicts other businesses - that is, until it happens to yours. But exactly how likely is it, how do you spot it - and, most importantly, how do you stop it?

It is never pleasant to imagine that someone you have employed is defrauding your business. It is even more alarming to learn that the typical fraudster is a long-serving director or senior manager, often in the finance department. In other words, you as owner-manager are likely to be uncomfortably close to the culprit. Defending yourself involves recognising the possibility of fraud, understanding the forms it can take, and spotting the warning signs.

What is fraud?

 “Fraud can be committed in an infinite number of ways. One characteristic of a fraudster is his or her ability to exploit weaknesses in systems; another characteristic is to lie most convincingly. So convincingly that sometimes I believe they truly believe it themselves...There may be frauds in the financial markets, for example by share ramping or insider trading; they may be frauds against investors - the so called high yield investments promising huge rates of return by trading in prime bank guarantees and other fictional financial instruments. They may be the high volume but relatively small amounts..; frauds on businesses, long firm frauds, simple thefts from employers, the list is endless. Whatever the means by which the fraud is committed, at the end of the day somebody will have lost and somebody dishonest has gained.”

Robert Wardle, Director of the Serious Fraud Office at the 2004 Adam Smith Institute Fraud Seminar

Fraud is an enormously complex area - there is, interestingly, no precise legal definition of it, and no single criminal offence called “fraud”. It can only be broadly defined by its two key characteristics: deception or concealment, coupled with deprival or loss for the victim. This covers literally a multitude of sins, coming in five broad categories:

• Senior management fraud,
• Other employees abusing their position,
• Suppliers taking advantage (possibly with employee collusion),
• Customers purchasing goods on credit (“long firm” fraud),
• Other external threats (e.g. identity fraud and cybercrime).

Fraud tends to be most damaging when committed by senior management, as these individuals may have more access to records and finances, and come under less scrutiny. It can be anything from false expense claims to the theft of intellectual property, with other possibilities including the creation of false invoices, falsifying of accounts or taking kickbacks from suppliers. Another temptation for senior management is to falsify performance figures, in order to trigger large bonus payments or meet listing requirements.

Fraud is not confined to senior employees, however. Those on lower rungs may have almost as much opportunity (and perhaps greater motivation). Fraud committed by employees includes cheque/signature forgery, payments to fictitious suppliers, removing money from customer accounts, and misappropriating cash - to give but a few examples. The provision of back-handers to suppliers is a danger here also.

Unscrupulous customers can be just as slippery; it is a good idea to run a credit check before accepting any payments. Otherwise, you may have to deal with credit cards that are stolen, forged or simply absent, or a customer who builds up a large “tab” which he has no intention of ever settling.

Identity fraud and cybercrime are perhaps the most insidious of all. This is not just about using stolen credit cards on the internet; it is about the theft of information, perhaps even your own identity, or disruption by hackers. But remember, cybercrime is not a new kind of fraud. It is merely that new technology has provided different ways to perpetrate the age-old offences of dishonesty, deception and theft.

Assessing your fraud risk

Fraud is an unusual risk, because it is deliberate and therefore more difficult to assess. There are six main areas to consider: cultural, structural, relationships (internal and external), the business/economy, the control environment, and people.

This last area is particularly fertile. Ros Wright, Chairman of the Fraud Advisory Panel, writes in the overview to the 2004 annual review: “Long term fraud reduction also depends on informing, training and motivating the widest possible range of employees.”

Fraud is, after all, only committed by people, not by processes or faceless organisations. There is a broad formula to explain what drives a person to fraud: personal and organisational pressures + opportunities + belief that the fraud will go undetected. In other words, people commit fraud because it seems like a good idea at the time.

Drivers that can push an employee towards fraud include:

• pressure from above to achieve targets,
• incompetence (i.e. the need to conceal it)’
• dissatisfaction with the company (e.g. salary, personal grievances)
• boredom,
• awareness that others are doing it.

One in eight cases is caused by the perpetrator having financial difficulties. However, simple greed is by far the most common factor - and a difficult one to manage.

There are various warning signs that can betray even a cunning fraudster, however. These include:

• mismatches between lifestyle and status,
• staff who work excessive hours and/or seldom take holidays,
• cosy relationships with suppliers or contractors,
• high staff turnover,
• rising costs with no explanation,
• customer complaints of unrecognised transactions.

None of the above necessarily point to fraud, of course, but several in combination would certainly warrant a closer inspection.

Your business’s control environment is an important line of defence against fraud; conversely, it can be an Achilles heel. A strong internal audit function and a robust system of controls increases your chance of spotting the warning signs early. But poor commitment to financial and operating controls can raise the level of risk. Bad record keeping is another danger area. Fraud risk is further heightened where there is an emphasis on achieving business objectives at any cost, or a willingness to take on overly ambitious transactions.

Dealing with fraud

According to a recent PKF survey, 59 per cent of SMEs do not have a fraud response plan. No matter how good your prevention controls, the determined fraudster will circumvent them. A response plan is therefore essential if you wish to minimise the impact of such an event.

If you detect or suspect fraud, try to keep calm. Your response must be dispassionate and you should confide in as few people as possible. When it comes to damage limitation, remember that your company’s reputation may be at stake and that you need to protect it.

Evidence of the fraud needs to be secured, and you must be careful to avoid accusing the wrong person - or indeed the right person with the wrong offence. If you are unable to prove your accusation, you could be faced with legal action yourself. Take proper legal and forensic advice. Prompt gathering of evidence is key; evidence can be contaminated or lost if not properly secured at the outset of an investigation. It is vital that computers (i.e. those you suspect have been used to perpetrate the fraud) are left untouched, whether they are currently switched on or switched off. Any interference from you could destroy evidence and jeopardise any potential legal action, thus also reducing your chances of recovering assets. When the evidence is secured, approach the suspected party with care. They may not be working alone - and you do not want the accomplices destroying the evidence.

There is usually very little time to act - the first few hours after discovery are crucial. In other words, make sure you have that response plan in place with clearly defined responsibilities.

Take action, sleep soundly

Prevention is better than cure, and a planned response is preferable to emergency band-aids. Whatever the desired outcome, a calm and considered approach following the discovery of fraud is required to minimise the impact. Most directors consider that given a robust system of internal control within their organisation “it could not happen here”, but in many cases it already has. The question is how long has it taken to find out and what damage has been done.

For a free copy of PKF guide to fraud prevention, please contact frances.dukeson@uk.pkf.com.

Biography

David Dearman is Forensic Accounting Partner at PKF (UK) LLP. Mr Dearman has specialised in forensic services since 1995 and has substantial experience in investigating fraud, both for civil actions and for City regulatory bodies. His investigations experience includes working with the Serious Fraud Office, the Department of Trade and Industry and the National Crime Squad. He has also undertaken a number of large commercial and professional indemnity cases including contractual disputes, contentious business interruption claims and pre-lending and pre-acquisition due diligence investigations of both public and private companies.

 

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