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How to Minimize the Risk of Fraud by Customers

Feb 27, 2018

Since the 2009 recession, many statisticians have claimed fraud, especially against financial institutions, is on the rise and some claim that there are more frauds being exposed because there’s less cash to cover up frauds. In any case, almost every statistician would agree that more fraud is coming to light and being exposed.


The first thing to be conscious of in a potentially fraudulent situation is not to panic. Don’t make any accusations until you know all the facts. As Occam’s Razor states, the simplest explanation is usually the better one. And equally important, but not as well known, is Hanlon’s Razor—"never attribute to malice that which is adequately explained by stupidity.” The interpretation in this case is that inefficient accounting and management of a customer can look like fraud, but may be nothing more than incompetence. Accusing a customer, vendor, or employee of fraud when there is no fraud is a quick way to a lawsuit. This is obviously to be avoided at all costs. In a situation where you don’t know all the facts, asking questions without accusations is always better. If the answers unsettle you or if the questions are not answered at all, that’s the time to consider a recommendation to a forensic accountant.


So what observations should you be making and what should you be looking for when evaluating any banking relationship? While there are three broad types of fraud (asset misappropriations, corruption, and financial misstatements), it’s important to remember that there has never been a fraud where the internal controls were properly designed and executed. In addition, according to several recent studies, including the Marquet report on embezzlement, approximately 98% of embezzlements were of cash or cash equivalents.


Based on the above statistic, most companies should spend most if not all of their internal control budget preventing fraud on cash, and bankers should be conscious of weaknesses or problems in customers’ cash management.


The following explores some of the more common red flags for fraud issues. While many times red flags are easily and reasonably explained, when they’re not, a call to an expert in financial forensics, a notice to your officers, or a change in the banking relationship is called for.


Most problem situations can be told from the internal accounting records. This is very often an overlooked and undervalued red flag. Internal accounting records requested should be made readily available in a reasonable period. If they’re not, why not? Are there timing issues on any financial statement produced by an independent accounting firm? Is the accounting firm having issues getting records in a timely manner from their client? Have you talked to the accounting firm? What is their opinion of the accounting department of their client? If you’re not getting good answers to your questions, you may need to make some hard decisions on the customer relationship and what needs to be done to continue it.


Knowing your customer is also invaluable in determining if there are any issues. Do you see any red flags in how their accounting department is run? Proper segregation of duties is important for a properly functioning accounting department. Ensuring the accounting staff can do their job properly and not be overridden is important as well. An overabundance of monthly journal entries is a red flag, as is turnover in the accounting staff or an accounting staff dominated by one individual.


Something that’s not always obvious is reviewing what happens when a member of the accounting staff takes a vacation. As a best practice, many companies require their accounting staff to take mandatory vacations. If done properly, other staff step in for the employee and the employee on vacation has no contact with customers, vendors, etc. This creates an internal control by having other people review the vacationing employee’s work. However, one of the worst situations is when there is a mandatory vacation but nobody steps in and does the job in the employee’s absence. It creates a mistaken feeling of confidence and can potentially open doors for fraud.


While there are dozens of issues that should raise red flags, I’ve highlighted internal reporting, character of an accounting department, and mandatory accounting department vacations to help illustrate the following case study. It also will reinforce how to approach the fraud issues with your customers.


Several years ago, a new client came to us. It was a labor union having cash flow issues. There were new officers in charge, and they were puzzled why revenue was going up but they were having issues meeting monthly bills. We were called in to investigate. They were very concerned about the possibility of fraud but listened to our advice and never used any language to indicate their opinion to the staff.


The accounting department was dominated by one individual, and there was constant turnover underneath this person. Nobody could make journal entries but this individual, and she was the only person to have complete access to all areas of the internal records. She had four weeks of vacation every year and used them every year. However, she was the only person who had the passwords to her computer access so nobody could do her work while she was on vacation. She went as far as locking the door to her office and putting a box outside for mail and questions while she was gone. She insured that nobody could consider her work while she wasn’t there. Because of her personality, the staff loved her and nobody questioned her methods.


When we started our examination, we immediately noticed issues with their payroll tax returns. There were mathematically impossible figures such as negative federal withholding. What we noted next was that the address of the entity on the returns was not their only office address; it was a P.O. box in a town a couple of suburbs over. We elected to lay down a map of all the employees of the entity and compare it to the location of the office and the P.O. box. The P.O. box turned out to be less than a mile from her home in a straight line between the office and her home. We then requested documentation from the IRS for all payments and notices for the entity’s FEIN. We discovered several hundred thousand dollars in penalties paid to the IRS for improperly and non-timely filed and paid payroll tax returns. We elected to look at every payment the union made. What became apparent is that while she was spending so much time cultivating the appreciation of the staff, she was neglecting her job. Almost every bill was paid late and incurred significant penalties and late charges. If anyone had accused her of fraud without a thorough investigation, she had a very good case to sue them because there was no fraud, just massive incompetence.


The issues created by this individual should have been noted much earlier by either management or the union’s financial institution (because of her lack of cash management skills, there were bank fees far higher than normal). Primarily because of her personality, they weren’t noticed, and this oversight cost the union over $1,000,000 in unnecessary penalties and interest. They were able to renegotiate with the financial institution and the banker assigned to that account was reassigned.


There are dozens of red flags that can come up in dealing with your customers. The ones in this article were important in discovering the issues with this entity. It’s vital to never panic, to ask intelligent questions, and to give proper evaluation to the answers, or lack thereof. It’s similar in concept to security these days—if you see something, say something. Whether you keep it in the financial institution for investigation or refer your customer to a qualified firm, it’s to your benefit to treat this in the right manner.


David G. Friedman, CPA, CFE, CFF, CICA
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