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Business Readings
By Richard A. Turpen and Frank M. Messina Reprinted with permission of the Institute of Management Accountants, from Management Accounting, February 1997; permission conveyed through Copyright Clearance Center, Inc. We’ve implemented JIT, TQM, ABM, BPR, and SCM, but what are we doing about F-R-A-U-D? Over the last decade management accountants have had to be quick learners, embracing a bewildering array of new concepts, all designed to transform their organizations into world-class competitors. While success stories of the latest management innovations abound, news concerning an old problem is not encouraging. Fraud is still a major threat to businesses, and statistics show that it is getting worse. A recent KPMG Peat Marwick survey of America’s largest companies found both a greater incidence of fraud overall and a higher rate of occurrence within companies as compared to the previous year.1 We will look at a similar survey of smaller organizations, a group that represents the more typical American business. Patterned after the KPMG study, our project tried to identify areas where management accountants might be most effective in preventing and detecting fraud, as well as areas where their companies are the most vulnerable. Given the numerous management initiatives of recent years, what we found was surprising. Although sophisticated frauds still occur, employee theft of cash and other assets continues to be the most reported type of fraud plaguing U.S. businesses. Who the Companies Are With support from the Cooperative Management Division of the USDA’s Rural Business and Cooperative Development Service (RBCDS), KPMG Peat Marwick, and the National Society of Accountants for Cooperatives, we mailed a survey to each of the more than 4,000 U.S. agribusiness cooperatives that RBCDS tracks annually.2 Their database includes a wide range of industries with different operating volumes. On the whole, however, most cooperatives are relatively small and thus more typical of many American businesses. There were many reasons for choosing cooperatives. First, they represent a major sector of the American economy. More than 47,000 co-ops operate in the United States, in industries that span agriculture, food, retail, hardware, utilities, and healthcare.3 These companies generate over $100 billion annually. Agricultural co-ops alone account for $59 billion in value and hold 13 places on the list of the Fortune 500.4 In fact, this prominence is expected to grow. The Wall Street Journal reports that cooperatives are poised to dominate the small business sector in the next decade as this form of organization spreads to new fields.5 Second, cooperatives were chosen because they are typical of many businesses both in form and function. They are corporations, organized by the stockholders to provide economic benefits to their members. The members also enjoy a tax benefit in that cooperative earnings derived from member business are taxed once (like partnerships and S-corporations), unlike income from general business C-corporations. As for operations, co-ops purchase supplies, provide services, and engage in marketing, processing, distribution, and even research and development. About a quarter (24%) of the co-ops in our sample perform multiple functions and nearly half (46%) operate in more than one industry. Finally, cooperatives are generally small to midsize and often have less investment in sophisticated security and control systems. Almost all the co-ops in our sample (95%) reported total annual sales/revenues of $50 million or less. Like most small businesses, they may be at greater risk of fraud and abuse, making them a useful population for study. The Frauds Discovered Of the 563 cooperatives that participated in our survey, nearly half (47%) reported known or suspected occurrences of fraud. The highlights of their survey disclosures are summarized in Figure 1. Theft of current assets tops the list of the most common types of fraud, with nearly half of the victims reporting known thefts of inventory/supplies (49%) or cash (47%). An even greater percentage (58%) of .the cooperatives suspected further instances of stolen inventories. Other areas of known or suspected vulnerability include check fraud (16% and 7%), equipment theft (12% and 19%), and kickbacks (7% and 19%). Although sometimes inappropriately regarded as less serious offenses, improper purchases made for personal use (10% and 14%) and expense account abuse (8% and 10%) also were frequent problems for the cooperatives. As they did for inventory theft, more co-ops reported suspected than known incidences, indicating the difficulty employers often have in uncovering these types of fraud. Other offenses also reported by the respondents include accounts receivable manipulation, false invoices or phantom vendors, credit card fraud, bid rigging or price cutting, conflicts of interest, payroll fraud, falsification of financial statements, diversion of sales, and product substitution. None of the reporting rates for these frauds exceeded 5%. Loss estimates provided by the cooperatives for the most common of these frauds—current asset thefts—range from less than $100 to $350,000—substantial numbers when you consider that the largest loss disclosed by a single co-op for all fraud types combined totaled approximately $600,000. More telling perhaps are the overall loss figures represented as percentages of income. The data indicate that for 30% of the co-ops, total known fraud losses amounted to 5% or more of net earnings. The survey presents a profile of the perpetrators. The majority were employed as staff personnel in marketing, sales, or customer service and had been working for the co-op for three to five years. Most of the fraud took place over a period of one year or less. Figures 2–4 summarize the cooperatives’ disclosures as to what allowed these frauds to occur and how they were discovered. Not surprisingly, co-ops most often blamed poor internal control (48%, Figure 2). A sizable number (39%), however, indicated a weak ethics policy or code of conduct as having contributed to the fraud. These responses provide further evidence that developing a corporate culture that stresses honesty and scrupulous behavior is not only the right thing to do, but also it produces real savings as well. Some industries are at greater risk for fraud, the third most often mentioned factor (20%) contributing to theft. Sound control systems and strong ethics policies become all the more important in such an environment. An important control is adequate segregation of duties. Lack of attention to this feature was the fourth most cited problem in the survey (17%), followed closely by collusion (14% and 15%). As professional auditing standards state, collusion is always a possibility, even in the most strictly controlled environment. Where fraud prevention is difficult, fraud detection takes on greater importance. In the majority of cases reported in our survey, certain "red flags" appeared prior to the fraud discovery, most often in the form of unexplained losses (54%, Figure 3). Poor internal control also was listed by about a quarter of the co-ops (22%), indicating at least an awareness of their susceptibility to fraud even if they chose to do nothing about it. This failure to act serves as a warning to companies because it suggests that many of the frauds reported here might have been prevented. Finally, a third major omen, one often ignored, was a marked behavioral difference in the employee—either a decline in morale (20%) or a change in lifestyle or behavior (20%). Severe depression, discontent, and living beyond one’s means can signal fraudulent activity. Managers who ignore such signs clearly put their companies at risk. Many of the frauds were uncovered through specific investigations, initiated in response to these early warnings (35%, Figure 4). Other good news from the survey is that for the majority of co-ops (40%), fraud most often was revealed through internal controls. Internal audit procedures also frequently were cited as an important means of detection (29%). On the other hand, a large number of discoveries were the result of information coming to management’s attention outside formal channels, either through employee (34%) or member (9%) tips, or merely by accident (18%). How They Responded Management’s response to a known or suspected fraud can serve as an effective deterrent. In this respect, our survey results are not encouraging. Although the dismissal of the employee involved (44%, Figure 5), a formal investigation (21%), or the involvement of law enforcement agencies (18%) were frequent outcomes, a sizable number of cooperatives chose to keep quiet about the matter (27%) or merely to allow the employee to resign (16%). As for other steps taken (21%), the one most often mentioned was no action at all, either due to a lack of proof or the employee’s departure prior to the detection of the fraud. Relatively few co-ops chose to use their discovery as an opportunity to set an example (8%, not shown). The reasons for not bringing fraud to light are varied. Some companies simply may want to avoid adverse publicity. Others may fear copycat reoccurrences of the fraud. Ironically, unless companies show a willingness to pursue wrongdoers aggressively, they may create the impression of weakness, if not outright tolerance for misconduct. Thus, they may foster the very activity they’re seeking to prevent. Some of the findings do give reason for optimism. A number of the cooperatives indicate that they now have taken or plan to take steps designed to prevent future frauds. Not surprisingly, reviewing and improving internal controls (93%, Figure 6) and segregating critical duties and functions (76%) were the measures most commonly cited, followed by performing more extensive background checks of employees (72%) and bonding those who have access to negotiable assets (64%). Focusing management’s attention on fraud (64%) and developing or revising ethics policies or codes of conduct (63%) also frequently were mentioned. The latter result is significant because data from the U.S. Sentencing Commission shows that an effective ethics program can prevent an organization from being prosecuted, or it can help reduce fines in federal cases involving employee wrongdoing.6 The Lessons They Offer For management accountants concerned about the potential for fraud in their own organizations, the experiences of our survey participants provide several important lessons. The traditional types of fraud are still the most common, and they require continual management attention to basics. Companies always are vulnerable to theft of cash or other assets. Adequate background checks of employees are essential, as is an ongoing program for monitoring and evaluating internal control. Above all, red flags should never be ignored. Management must respond immediately to any warning sign. Perhaps the most significant finding in our survey comes from those cooperatives that did not report fraud. The following comment was all too typical: "We are a small town business and employees are from our local area. There is no reason to suspect fraud, because our employees are trustworthy and competent." Unfortunately, many companies learn too late that certain employees are able to commit fraud chiefly because management does consider them "trustworthy." Management accountants continue to face new challenges and a business environment characterized by accelerating change. In the drive to ready their organizations for the next century, they must make sure that among the management initiatives there is a sound program of fraud prevention. Discussion Questions
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