Detecting and Preventing Corporate Fraud 1

Detecting and Preventing Corporate Fraud

Paul Van Sickle

SECR 5030 – Business Assets Protection

April 21, 2023

Corporate accounting frauds are political and business scandals which arise with

the disclosure of misdeeds by trusted executives of large public corporations. Such

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misdeeds typically involve complex methods for misusing or misdirecting funds,

overstating revenues, understating expenses, overstating the value of corporate assets

or underreporting the existence of liabilities, sometimes with the cooperation of officials

in other corporations or affiliates.

The last decade has seen an amazing number of corporate frauds, which have

had a spiraling effect on the incomes and savings of common people. Most of these led

to losses totaling billions of dollars, and have led to a clamor for more stringent rules

against corporate and accounting practices.

One of the biggest and more recent examples of accounting fraud comes from

the now defunct energy company Enron. A multibillion dollar company, Enron was on

the verge of becoming one of the largest energy trading companies in the world.

Conversely, though few suspected it, Enron was also on the verge of one of the biggest

crashes in recent history. In fact many magazines had listed Enron as one of the top,

most innovative companies. Enron had managed to hoodwink everyone, from its

employees, to investors to financial analysts and regulators, including the governments

of various countries. The company had, over a period of time, started to lose more

money as its cash flow dried up. To cover up the losses, the company, with the

connivance of its accountancy firm Arthur Anderson, starting showing profits out of

nowhere and using techniques later described as “… innovative accounting practices.”

It was also seriously involved in various bribery scandals in different countries.

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As news started to get out via whistle blowers, the company was in deep trouble

and it filed for bankruptcy, the largest in American history. Share prices fell from nearly

$90 to less than 30 cents as news spread of its failure. Many of its employees - who

ironically had rated it as the best company to work for, in a previous report - also found

they had lost their entire life savings. Many investors and stakeholders were furious and

the crash caused a ripple in the stock markets in 2001. The company and its

accountancy firm were soon wound up and criminal investigations were initiated.

As brutal as was Enron’s fall, its recurrent cases of fraud had spiraled out of the

control of any CSO at warp-speed. However, there is an anecdote in the world of fraud

investigation, “There are no small frauds, only frauds that have not been around long

enough to become big.” Within the bailiwick of the CSO is the much more common

‘Inventory Fraud’. Though not nearly as earth-shattering as most corporate level cases;

inventory fraud is that infection that if left alone will most certainly blossom into the big,

company-ending news headliners on CNN. Moreover, these cases very often result in

criminal charge filed against the perpetrators, back- lashing the CSO and his/her staff

for their failure to prevent the headlong train wreck.

During the past several years, more than two dozen major retail companies have

been forced to file for bankruptcy due to inventory based fraud. These include such

ostensibly profitable stores as Revco Drug Stores, Crazy Eddie Electronics, Leslie Fay

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Women’s Apparel, and Macy’s Department Stores. How did these companies fall from

raking in high profits and exponential expansion to filing for bankruptcy protection from

creditors? They all were affected by inventory fraud; one of the most common areas of

theft by employees and method of financial statement manipulation by management.

The manner in which these corporations have circumvented auditors and their

investigations varies, but there exist four major methods of inventory fraud: theft of

assets, misappropriation of assets, scrap sales, and embezzlement. These examples

emphasize the need for the Chief Security Officer (CSO) and their appointed

investigator to plan and control inventory audits carefully. They also demonstrate the

need to use supplementary resources to research recent trends in inventory fraud and

how to detect the fraud as well as to research the company being audited. One of these

sources should be the Internet.

The Internet provides the most up to the minute information available on any

topic imaginable as well as offering multiple search engines. The tech-savvy the CSO

can quickly and easily locate the information necessary to their investigation/audit;

saving time and money for both the auditors and the corporation. During the 1980s, a

fraud of enormous magnitude with a cost exceeding $1 billion was perpetrated with

relative simplicity in the 300 store deep-discount drug and merchandise chain of Phar-

Mor (Schroeder, Schiller & Atchison, 1992). The company had to close several stores

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when the fraud first broke. One of the major reasons for the failure was a massive multi-

year inventory fraud that went undetected by auditors.

Many resources can be found simply via an online search engine. For example, if

a search is performed with the word "fraud," thousands of useful (and some deleterious)

web sites are identified. One resource that is found is a page entitled "Twenty Ways to

Detect Fraud" (Darius, 2006). This site lists twenty different symptoms of various

fraudulent activities and what the possible sources of these symptoms may be. It also

lists among its symptoms, the general ledger being out of balance, inventory shortages

in excess of normal shrinkage, increased levels of scrap, and post office boxes that are

used as shipping addresses. These are all activities associated with inventory fraud.

Had the Phar-Mor auditors been aware of these symptoms, then perhaps the fraud

would have been detected sooner and the investors would have saved thousands of

dollars.

One of the most obvious resources for fraud detection and reporting is the

Securities and Exchange Commission Home Page. From this database, auditors have

access to all the required filings of all public corporations. The auditors can perform

industry analysis and ratio analysis of accounts such as inventory, sales, and

purchases. This data can then be compared to Phar-Mor’s accounts to determine if they

are within range of the industry averages. If they are not, then further research should

be performed to determine what is causing the difference.

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Yake & Associates, Inc. (Yake, 2011) is an investigative service for the

accounting profession which specializes in retail businesses. They have developed a

detailed methodology to identify retail companies headed for financial disaster.

Investigators and auditors visiting this section of the home page at will learn that it is

necessary to profile executive performance in past positions, to research senior

management in order to determine if there has been a pattern of condoning or

participating in inventory manipulation, and to determine if the company’s structure is

designed to enhance or avoid accountability. Another section of the Yake & Associates,

Inc., home page is the company newsletter. One previous month’s newsletter detailed

various activities of business abuse, including inventory fraud and excessive shrinkage.

In addition to giving an analysis of these topics, perhaps more importantly, the paper

relates personal experiences with fraud. Fraud auditing can only be ‘taught’ to a certain

extent; after this point is reached, it becomes a self-learned skill.

The auditor may know all the ways that fraud is perpetrated and all the tricks

used to cover up the fraud, but the auditor should become familiar with the ways that

actual companies commit fraud. The more personal experience the auditor has with

fraud, the more developed his instinct will become. One way to supplement this instinct

is through ‘shared training.’ In this way, one auditor’s personal experience becomes the

almost-personal experience of another auditor. (Owojori & Asaolu, 2009)

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Inventory fraud is one of the most damaging types of fraudulent activity that can

go on in a corporation due to the value of the inventory and its far-reaching effects on

the financial statements and investors. It has brought down multi-million dollar

corporations with ease. Committing fraud does not require unusually high intellect.

However, it is usually committed by knowledgeable people ~ people who know how to

circumvent the system by knowing how to capitalize on the weaknesses in the business.

Fraud auditors now can use the Internet to research corporations and fraudulent

activities in order to detect these weaknesses and the frauds that may be linked to

them. In addition to all of the sites listed in this article, below are seventeen other

Internet sites that fraud auditors will find beneficial in their work.

Business owners want to believe they hired honest and ethical people who have

their company’s best interests at heart. However, in some circumstances, this is just not

true. Many times fraud is being perpetrated by the most loyal-seeming and trustworthy

employee. The following are warning signs that is noted, should definitely not be

dismissed lightly:

Big spenders: employees who seem to be living and spending outside of their

means --- probably are…

Just like big spenders, people with financial problems may be more motivated

to commit occupational fraud.

People who ignore company rules and regulations set a bad example and can

trigger fraud throughout the company.

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Weak internal controls: If employees feel they can get away with stealing and/or

there is no system of oversight, the fraud susceptibility index will be quite high.

Many times that hard working employee; always at the office; first to arrive and

last to leave; does not want anyone looking over their shoulder, etc. This

might just be the sign of a workaholic, then again…

So, what can be done? Discovering fraud in the workplace can be very difficult.

According to data maintained by the Association of Certified Fraud Examiners (ACFE)

found that the average length of a fraud scheme is generally 18 months from the time

the fraud began until it was found. (Ratley, 2012) Preventing and detecting fraud can be

accomplished by implementing the following:

A culture of honesty and high ethics in the workplace sets the “tone at the top”.

By setting achievable goals and expressing “zero tolerance” for unethical

behavior, the managing staff walk-the-walk.

Conduct regular sessions (both formal and informal) about the company’s

values and code of conduct and how to recognize and report illegal conduct.

Institute and maintain a strong system of internal controls; identify ways to

increase security in the company’s computer, record keeping and payment

systems.

Create internal mechanisms that alert on potential transgressions.

Build an environment and system for employees to anonymously report illegal

or unethical actions they have witnessed or suspect.

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Fraud prevention is a key component to running a good business and is well

worth the investment. Fraud has a direct impact on any company’s bottom line but more

importantly, it also threatens a very hard-earned reputation. The well-informed CSO

and their investigators will not only have the ability to thoroughly investigate instances of

fraud but also the will be able prevent it before it occurs and not to be left scratching

their heads wondering what happened.

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References:

FDIC, Initials. (2005, August 16). Financial institution letters. Retrieved from

http://www.fdic.gov/news/news/financial/2005/fil8005a.html

Schroeder , M., Schiller, Z., & Atchison, S. (1992, August 23). A scandal waiting

to happen. Retrieved from http://www.businessweek.com/stories/1992-08-23/a-

scandal-waiting-to-happen

Darius, J. (2006, February). Twenty ways to detect fraud. Retrieved from

http://getzoff.com/business_fraud/20_questions.htm

Phillipps, T. (2011). Framanagement wake-up call: fraud prevention no longer

discretionary. Retrieved from PI, now.com. (2011). Fraud investigation. Retrieved

from http://www.pinow.com/investigations/fraud-investigations

Yake, T. (2011). Yake & associates, inc. Retrieved from http://www.yake.com/

Owojori, A. A. & Asaolu, T. O. (2009, October). The role of forensic accounting in

solving vexed problem of corporate world. European Journal of Scientific

Research, 12(25), 183-189. Retrieved from http://www.eurojurnal.com

Ratley, J. (2012, July). Report to the nations. Retrieved from

http://citationmachine.net/index2.php?

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