Five percent may not sound like a lot in the abstract. But when you’re talking about businesses losing 5 percent of their annual revenues to fraud each year, that number becomes quite significant.
Indeed, in the 10th edition of its “Report to the Nations: 2018 Global Study on Occupational Fraud and Abuse,” the Association of Fraud Examiners (ACFE) estimates that businesses lose an average of 5 percent of annual revenues to occupational fraud, with smaller companies generally suffering greater losses.
Consider how this impacts value: If a company earns $8 million in revenues, 5 percent equals a loss of $400,000—and that’s just the dollar value being stolen from the company every year. Fraud may also cost the company in terms of reputation, plus legal and forensic accounting fees. Also, when it comes to selling the company, a valuation based on the company’s revenues will be diminished. The bottom line is that fraud destroys value.
Three Types of Fraud
The ACFE identifies three types of occupational fraud:
Asset misappropriation: The most common type of occupational fraud, asset misappropriation is also the least costly, with a median loss of $114,000. Asset misappropriation schemes range from theft of cash and skimming to billing schemes and fictitious expenses to inventory misuse and theft.
Corruption: These schemes incur a median loss of $250,000 and include sales and purchasing schemes; bribery, kickbacks, and bid rigging; illegal gratuities; and economic extortion.
Financial statement fraud: This is the least common but most costly form of fraud, with a median loss of $800,000. Financial statement fraud schemes include income overstatements such as fictitious revenues, improper asset valuations and concealed liabilities, as well as income understatements, such as understated revenues and overstated expenses.
Fraudsters often commit more than one type of occupational fraud at a time. The median duration of all types of fraud in the ACFE report was 16 months. Most fraudsters start small and then increase their frauds as they continue to be successful over time. Obviously, the longer the fraud continues, the more severe the losses.
As expected, to cover their tracks, fraudsters often use concealment methods such as altering documents or creating fraudulent documents, creating fraudulent transactions in the accounting system, or destroying physical documents. It can take months—or sometimes years—to discover these clever cover-ups.
Not surprisingly, fraud committed by employees in prominent positions tend to result in bigger losses. For example, owners and executives commit only 19 percent of frauds, but their schemes incur the highest median losses—$850,000.
Owners and executives are also more likely to collude with others. Owners or executive perpetrators also tend to be engaged in non-fraud-related misconduct more often, such as bullying or intimidation. Fraudsters with longer tenure typically hatch more costly schemes.
Next to frauds committed by owners and executives, frauds committed by those in the accounting, information technology, manufacturing/production, and warehousing/inventory departments are typically the most costly. Conversely, frauds committed by those in customer service are the least costly relative to other departments.
Gender, age, and education are also factors. Most fraudsters are male (69 percent), and men cause much larger median losses ($156,000) than women ($89,000). Older fraudsters (age 56+) cause much more damage than younger ones (under 30). Those who are highly educated cause higher median losses than those with a high school degree or less.
Interestingly, most fraudsters have no prior history of criminal fraud convictions. It’s unclear whether this indicates that most fraudsters are first-time criminals or that they simply haven’t been caught or turned over to law enforcement. Sometimes, business owners are embarrassed by the fraud or are hesitant to report it due to the risk of reputation damage, either to the business or, strangely, to the perpetrator.
To Catch a Thief
How do fraudsters get caught? The most common method (40 percent) is by tip, and more than half of these tips come from company employees. About a third of tips come from sources outside the company, including customers, vendors, and competitors. Promoting a whistleblower hotline—especially an anonymous one—is a powerful way to generate and encourage fraud reporting. Fraud losses at companies with hotlines were 50 percent smaller than at those without hotlines.
Internal audit is the second most common means of detection, with management review in third place. More active detection methods involving deliberate searches for misconduct, such as IT controls and surveillance or monitoring, typically result in shorter duration and less costly frauds. Passive detection methods have opposite results: discovering fraud by accident, by confession, or via law enforcement notification means more costly losses and longer duration of the scheme.
Fraud isn’t always easy to detect—and often, owners have no idea fraud is occurring right under their noses. Remember that valuation reports typically include a list of “assumptions and limiting conditions” describing the engagement. Usually the report includes verbiage saying that the valuation is based on financial statements and other information provided by the target company. Until an accounting or valuation professional digs into the numbers, the owner may be completely in the dark.
However, sometimes owners are perpetrators. They may excuse their bad behavior as “doing what everyone else does” or using what they call “aggressive” accounting methods. As a valuation gets under way, scheming owners might suggest that the financial statements aren’t really reflective of the company’s earnings, hinting at profit skimming or at inflated or personal expenses, which are always red flags to valuation analysts.
Or, in the course of a valuation, an analyst may notice that the company’s earnings are unusually low or don’t meet typical industry benchmarks. If a seemingly healthy company is losing money or has negative cash flow, this is cause for further investigation. Fraud isn’t always the reason for these issues, but a forensic accountant should be called in if the numbers aren’t making sense.
Preparing for Sale
Improving internal controls is an effective—and usually relatively easy—way to keep fraud at bay on an ongoing basis. An internal controls study can illuminate various steps owners can implement to deter theft.
And as an owner prepares to sell his or her company, there are several steps to take to ensure an accurate valuation. One key activity is to scrub the company’s finances so that the financial statements are indeed a good representation of the company’s financial position. This involves steps such as removing personal expenses, adjusting owner’s compensation to reflect market salary, getting non-contributing relatives off the payroll, and, obviously, taking action to correct, report, and account for any fraudulent activity.
As the ACFE report makes clear, when it comes to occupational fraud, acting sooner rather than later results in fewer losses and less damage to the company overall.