Looking for Fraud in All the Right Places

Guidance for Asset Based Lenders

Author: Howard ReinComponents of Fraud

Fraud is most likely to occur in one of these departments:  accounting, customer service, executive/upper management, operations, sales or purchasing — according to the Association of Certified Fraud Examiners (AFCE). In fact, in the ACFE’s most recent Report to the Nations on Occupational Fraud and Abuse, some 77% of frauds are committed in at least one of these departments.

While most employees won’t even consider fraudulent behavior, others may look at fraud as a great way to get ahead. So, what should you know about conditions that make fraud likely to happen?

3 conditions that can spark fraud

Just as fire requires fuel, oxygen, and heat, occupational fraud requires motive, opportunity and rationalization. These are what forensic accountants call the “fraud triangle.” And economic downturns, such as the one we’re currently in, can ignite fraud by fueling all three factors.

When you meet with borrowers or tour their facilities, make sure you look for circumstances that are ripe for misstatement or theft. For example, employees with upside-down home mortgages or unemployed spouses may rationalize the need to steal property and resell it. Unethical managers may try to conceal deteriorating financial performance with creative journal entries to avoid defaulting on a loan. Or they may try to inflate their sales record in order to preserve their bonuses (and their jobs).

Weak economy weakens resolve

ABLThe weak economy can also add opportunities to defraud. Layoffs typically spread remaining employees thinner, which can make it harder for companies to implement strong internal control procedures, like segregation of duties and supervisory review.

Owners and top managers alike may become distracted from fraud prevention and detection efforts as they scurry to focus on cost containment or recover lost sales. In addition, employees working harder without more pay might be more likely to rationalize a fraudulent act.

Controlling fraud

Lenders can make all the difference when it comes to controlling fraud. Let’s look at a purely hypothetical case, in which a client’s CFO used the recession to her advantage. In 2010, Laura secretly diverted some $80,000 in customer payments to her personal bank account. She then wrote off these amounts as bad debts, knowing that lenders and shareholders would expect poor results because of the lackluster economy.

When Laura’s first scam went unnoticed, she colluded with a supplier to overcharge for materials. The fraudsters then split the difference between the invoice amount and the actual market value of the material. The owner blindly accepted the explanation that materials prices had increased because of rising energy prices. The fraud wasn’t discovered until one very observant loan officer noticed that the business’s profits had suffered disproportionately when compared to other borrowers in the same industry.

Be proactive

Detection efforts shouldn’t wait until fraud appears on your doorstep. It’s critical that you be proactive in meeting with borrowers to explain how the fraud triangle works and how it applies to them. Teach them appropriate internal control procedures, especially as borrowers try to cut costs. Warn them against taking internal control shortcuts — such as eliminating fraud reporting hotlines, training programs or job rotation.

Advise borrowers to watch for any changes in their employees’ standards of living, personal behaviors (such as personal bankruptcy, drug abuse, divorce or gambling habits), or lifestyles. These may be warning signs that require a closer look at employee behavior.

Identify irregularities at the top

C-level fraud, in which owners and managers have complete authority to override a company’s internal controls, is more costly and trickier, according to the ACFE. Such scams typically involve financial misstatement, which often leaves less physical evidence than an outright theft. In order to minimize fraud opportunity, lenders need to keep a diligent eye on owners, managers and the company’s internal controls. Audits may be helpful, but they can’t provide any guarantee against wrongdoing.

Regardless of the cause of fraud, be it mismanagement, fraud or macroeconomic misfortune, irregularities need to be identified and ultimately rectified. Lenders simply can’t assume that conditions will improve when the economy gets back on track.

Keep your eyes open

It’s quite obvious that owners and lenders alike must be diligent in looking for any signs of fraudulent behavior. Because the average fraudster will likely have no prior fraud charges or convictions, the fraudster just might be one of the last people that anyone would suspect.

For any questions about issues facing asset based lenders, contact Freed Maxick’s asset based lending team here, or call us at 716.847.2651.

Global Fraud Report