Detecting Internal Fraud in Your Accounting System

Posted by Dena Singer on April 4, 2017 at 9:06 AM

Employee theft and fraud are alarmingly on the rise, and they are among the most serious threats to the success of businesses today.

The Global Fraud Study released by the Association of Certified Fraud Examiners determined that businesses can lose an average of 5% of their revenue each year to fraud. Here are a few areas to be aware of that could rob your company of thousands of dollars in profits.

Spyglass.png Missing Documents

Documents which are unable to be located can be a red flag for fraud. Although it is expected that some documents will be misplaced, the business owner should look for explanations as to why the documents are missing and what steps were taken to locate the missing items. If this happens frequently, you should make efforts to determine if a problem exists.

Spyglass.png Excessive Voids

Voided invoices and sales receipts could mean that the sale was rung up, the payment pocketed by the employee, and the sales document then voided to cover the theft.

Spyglass.png Excessive Credit Memos

Similar to excessive voids, this technique can be used to cover the theft of cash. A credit memo to a bogus customer is created to “pay off” the sale.

Spyglass.png Lifestyle Changes

Employees with a relatively low wage may suddenly purchase a luxury vehicle, designer clothing, vacation home, a new boat, or they may take expensive vacations or engage in similar activities. Much of the time, these lifestyle changes coincide with a sudden decrease in company profits.

Spyglass.png Stale-dated Items in Reconciliations

When there are old, un-cleared deposits or checks that never get investigated or voided and replaced, this could signal theft. Uncleared deposits could mean that an employee took the funds. Uncleared checks could mean that an employee created checks to a bogus payee to cover up a reduction in sales or to compensate for false bank deposits. Usually, these stolen deposits or bogus checks written are not removed or covered, but the reconciliation report is created to appear that the bank account is in balance. This will result in an increase in the amount of uncleared transactions over time.

Spyglass.png Adjustments to Receivables or Payables

It is possible for customer payments to be misappropriated and a credit memo or an Accounts Receivable adjustment made to cover the shortage. Closely reviewing Accounts Receivable can uncover write-offs when an employee has taken customer payments. In addition, there could be Accounts Payable adjustments made to convert cash to personal use when an employee is using a phony billing scheme. This occurs when fraudulent payment to the employee is made but the business still records it as a legitimate business expense.

Spyglass.png Cost of Goods Sold is Unusually Low

This would result in a higher gross margin and could signal that inventory is being diverted. When an adjustment is made to falsely inflate inventory, the result is a decrease in the Cost of Goods Sold.  It’s important to observe COGS as a % of sales over time to detect major fluctuations.

Spyglass.png Cost of Goods Sold is Unusually High

Excess purchases can be used to cover fraud in a several ways. Payments could be made to fictitious payees to cover theft of funds. In other scenarios, payments could be posted to regular payees but actually made out to a ghost company owned by an employee. Purchases could also be inflated in order to provide vendors with a payoff or kickback.

Spyglass.png Inventory Shortages

When decreases in inventory exceed normal shrinkage, there could be fraudulent activity such as embezzlement or inventory theft. In a manufacturing environment, inventory levels could be lower than usual due to an increase in scrap. This scrap is not usually scrutinized and can be taken by employees for resale.

Spyglass.png Duplicate Payments

Duplicate payments to vendors are sometimes created in error. An employee could notice the duplicate payment and prepare a phony endorsement of the check and convert the funds to their own account.

Spyglass.png Ghost Employees

When there is little or no monitoring of paychecks, there could be extra paychecks made out to fictitious employees and converted to the bookkeeper’s own family or friends.

Spyglass.png Employee Overtime

Employees could alter time sheets either before or after they are approved and be paid for overtime hours not worked.

Spyglass.png Employee Expense Reports

Employees often commit fraud in preparing their expense reports. Receipts should be required to be documented in detail. Expense reimbursements should be closely reviewed, especially where cash transactions appear on the expense report.

Spyglass.png Refunds and Mailing Addresses

Sales employees could make bogus refunds to customers for merchandise. The address for the refund could belong to an employee or to a co-worker or friend. When merchandise is shipped to a PO Box, this could indicate that an employee is shipping to a fictitious purchaser. Also, merchandise ordered on a company credit card for office equipment or other merchandise could be delivered to the employee’s address.

Spyglass.png Unusual Behavior

There are behavioral signals to be aware of where fraud could be committed. The employee may never take a vacation or call in sick so that no one else has an opportunity to review their work or their procedures. They may not ever delegate their work even if they are overloaded. Sometimes there are personal changes in behavior, such as defensiveness, excess drinking, and irritability. Lack of job satisfaction or employees’ personal crises, along with lack of screening in hiring and lack of supervision, can lead to internal theft and fraud.

By implementing internal and external controls, a company can reduce the risk of fraudulent activities. 

Topics: Fraud Prevention

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