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Fraud in government entities: the perpetrators and the types of fraud.

Government employees are not immune to the pressures that lead to fraud and a drain on the community's cash and assets. Managers who are aware of the kinds of fraud most prevalent in government offices can create a proactive prevention and detection environment.

Jason Montgomery is director of purchasing for the City of Alexandria, Georgia. In that position, he is in charge of buying supplies of all types as well as securing certain contract services for the city. Jason has worked for the city for 16 years. His integrity and dedication have earned him a reputation of being an outstanding employee and his responsibilities have been increased as a result.

Jason is married and has four children. His salary, combined with that of his wire, total $46,000 per year. With their combined earnings, the Montgomery have been able to live a comfortable lie in a middle-class neighborhood in Alexandria, but their savings are almost nonexistent, The Montgomerys are proud people and it has always been their goal to send their four children to college. Two years ago their oldest son started school at State College and next year their second son also will be in college.

One year ago, Jason faced a serious crisis. He did not have the money to pay for his son's college expenses and he realized the would not be able to send his other children to school. In his postion, Jason has become quite familiar with various suppliers, and the buyer for one, a paper products firm, the past had offered Jason favors if he would give them a bigger percentage of the city's business. Jason approached the buyer with a proposition. He would give the supplier more volume if the supplier would "pay" him and honorarium of $1,000 per month. What ensued became the biggest nightmare of Jason Montgomery's life.

The supplier started shipping a cheaper grade of certain supplies as well as increasing prices. When Jason confronted the supplier about the changes, the supplier basically said, "We have no plans to go back to the original prices and quality of products and you can't do anything about it. What are you going to do, tell your supervisors that you have been taking kickbacks?"

The fraud continued for two years until a colleague of Jason's noticed some problems and started to investigate. The fraud was discovered, and the cost to the city was an overpayment for paper products of approximately $300,000.

The above case is real, but both the name of the perpetrator and the city have been changed.

The Extent of Fraud

Unfortunately, these types of frauds are becoming quite common in all kinds of organizations today. A recent study estimated that 31 percent of all Americans are dishonest (up from 12 percent in 1961) and another 40 percent are situationally honest, meaning they will be honest if it pays to be honest and dishonest if it pays to be dishonest.(1) Employee fraud is estimated to cost American businesses and organizations $200 billion per year, far outshadowing the $11 billion cost of violent crime. In banks, 95 percent of the losses are from employees-going out the back door-while only 5 percent are caused by bank robbery and customer fraud. In retail establishments, employees cause 70 percent of the losses while shoplifters and customers account for only 30 percent of the losses. At an alarmingly increasing rate, frauds are becoming more commonplace in government, business and all types of organizations.

Why is fraud becoming such a significant problem and what are the reasons people commit fraud? Jason Montgomery had been an honest employee for nearly 16 years: Why would someone with his background suddenly become dishonest?

Research has shown that individuals commit fraud when a combination of three factors exist: * perceived pressure, * perceived opportunity to commit and

conceal, and * a way to rationalize the behavior as

acceptable.

These three factors combine to create the "fraud triangle." The fraud triangle is very much like the "fire triangle." In order to have a fire, three conditions must exist: there must be oxygen, heat and fuel. If any one of these is removed, there will be no fire. Likewise with fraud: if either the pressure, opportunity or rationalization is removed, fraud does not occur.

For Jason, the pressure was financial in that he needed money to keep his children in school. He was too proud to admit to them and others that he could no longer pay for their school expenses. Unfortunately, very few people in today's society are free from pressure. Some of the most common pressures are high debts, financial losses, health expenditures, alcohol, drugs, gambling, greed or high lifestyle. Some pressures, however, are not financial. Rather, they include such factors as frustration with work, as desire to get even with one's employer, the challenge to beat the system, and peer of family pressure.

The confessions from some reformed gamblers illustrate how significant and compelling various pressure can be.

"Once I was hooked," says a reformed

gambling addict, "any wager would do.

I would give odds on how many cars

would pass over a bridge in the space of

10 minutes."

"When I caught that first whiff of the

race track, I was king in my own

fantasy world. There is no other high

like it."

"I stole vacation money from the

family sugar jar. I spent every waking

hour thinking about getting to the

track."

"I degraded myself in every way

possible. I embezzled from my own

company; I conned my six-year-old

out of his allowance."

People who will steam from their own children will certainly steal in the work place.

The second element in the fraud triangle is opportunity. Opportunity arises when controls are absent or when existing controls are overidden. One recent survey of 467 audits performed in small cities found significant internal-control weaknesses in all areas of cash-collections, expenditures and so forth.(2) This study found that the most common internal-control weakness was inadequate documentation for transactions, followed by inadequate separation of duties, inadequate authorization for transactions, inadequate physical security over assets or records, inadequately trained individuals and lack of independent checks, in that order.

While many organizations believe they have excellent internal controls, they never quite work in practice the way they are supposed to work in theory. People make controls work. People come to work with many other agendas on their mind, and following controls often has a low priority. Clearly, many workers in governmental organizations have an opportunity to commit fraud. Jason Montgomery's opportunity was that he was in a position to exert pressure over vendors and enter into a kickback arrangement.

The third element is rationalization. This writer is convinced, after interviewing several criminals and others, that everyone rationalizes. Most perpetrators rationalize that "they are going to pay the money back and, therefore, are only borrowing," "that the organization would understand if they know how badly I needed it," "that it is really for a good purpose," that no one is going to get hurt" and that "being successful is more important than being honest."

No one's actions are consistent with his or her intentions: everyone intends to wake earlier, exercise more, eat more sensibly or be a better parent, etc. The ability of everyone to rationalize is best understood when rationalizations are personalized. If a father is asked, "Are you a good parent?" he might say, "yes," reasoning, "I coach little league, I am a scout leader and so forth." Then, asked to analyze what it means to be a good parent, he agrees, "A good parent should spend time with his or her children," even while realizing that he is a workaholic and doesn't spend enough time at home.

That father thought he was a good parent because he was judging himself by his intentions, and he intended to be a good parent. He rationalized that he worked hard so his family could enjoy the benefits of his success, but a friend's judgment, "maybe you're really not such a good parent," is based on observed actions.

Rationalization is used by fraud perpetrators: because they judge themselves by their intentions, they do not perceived themselves as criminals-they intended to pay the money back. Even though others look at them and say, "You are a crook, and I don't want anything to do with you; you stole from the city," they do not think of themselves as criminals. In Jason Montgomery's case, he really did intend to pay the money back once his children's college expenses were paid. Jason probably would not have committed any other type of crime.

The Element of Confidence

Jason's scheme and other fraud schemes are being repeated with increasing regularity in government organizations. Employees, managers, elected officials and even citizens are taking advantage of governmental entities in a variety of ways. Fraud, by its very nature involves deceit by trickery rather than force. There are two ways to obtain something illegally: 1) by force, by putting a gun next to someone's head - this is called robbery, or 2) by trickery. To understand how trickery occurs, it is helpful to review one of the first famous frauds in America.

In 1919 Charles Ponzzi (his real name was Charles Bianci) devised an investment scam. Establishing a fraudulent business in foreign stamps, he convinced investors that with their money he would buy foreign stamps and then, after they increased in value, he would sell the stamps at a profit. He promised investors a 30 percent return per year, that an investor who put in $1,000 would earn $300 per year. Even in 1919 this was a good return.

Two interesting things happened in Ponzzi's investment scam. First, he never once bought a foreign stamp. Second, he did, at least initially, pay the 30 percent returns. Where did he got the money to pay the returns? When an investor put in $1,000, Ponzzi would return $300 of the original investment, supposedly as earnings. While the investor thought there was still $1,000 in the company, there was really only $700. Actually, there wasn't even $700 because Ponzzi spent what remained.

Having confidence that the investment was working, investors quickly told their friends, coworkers, family members and others about their good fortune and the high returns. When they started to invest, Ponzzi was able to use entire subsequent investments to pay returns to earlier investors. By 1920, Ponzzi had embezzled several million dollars from his investors.

The same element that allowed Charles Ponzzi to bilk his investors allows employees and others to embezzle from governments. Ponzzi's scam would never have worked if he hadn't paid early returns and earned the confidence of his investors. Likewise, government employees and others would not be able to embezzle if confidence was not placed in them. Only after confidence is placed in people can they take advantage of a situation.

The word "con" comes from the word confidence. The comment almost always heard in fraud investigations is "I can't believe he (or she) would have done that." "He (or she) was my most trusted employee." Of course it was a trusted employee that committed fraud-those who are not trusted cannot con their employer.

Kinds of Frauds

The three types of fraud perpetrated against most organizations are depicted in Exhibit 1. The first, called "receipts" fraud, occurs when cash is collected. Type 2 fraud is theft of assets (cash, supplies, property, etc.) from an organization. the third type is disbursement fraud, which occurs when an organization pays its bills,

There are several varieties of each type of fraud. The common schemes used to commit Type 1 fraud are lapping, credit memo fraud, stealing receipts, stealing duplicate payments and bad debts fraud.

Lapping. Money is stolen when citizen or customer A makes a payment; then customer A's account is credited when customer B pays.

Credit Memo Fraud. Credit memo fraud usually involves stealing the payment made by a citizen or customer and issuing that customer a credit memo indicating that the service rendered or good received was unacceptable.

Stealing Receipts. This type of fraud involves stealing receipts remitted to the organization rather than crediting them to the proper account. Stealing receipts can take many forms including under-ringing sales, not recognizing the receipt or stealing money from parking meters, concessions and other sources before it is acknowledged as being received.

Stealing Duplicate Payments. As odd as it may seem, duplicate payments are quite common. When duplicate payments are made, such as for utility bills, it is very easy to accept the payment rather than giving the citizen/customer a refund.

Bad Debt Fraud. This type of fraud involves pocketing money paid on delinquent accounts and charging off the account as uncollectible.

Type 2 frauds involve stealing funds or other assets from warehouses, petty cash funds, inventory stocks and so forth. While these types of frauds are quite common, they tend not to be large and are quite easy to catch. Some of the common type 2 frauds are:

Petty Cash Theft: Stealing funds from various petty cash and other funds.

Cash Register Thefts: Stealing funds from cash registers and other cash receiving locations.

Inventory Theft: Stealing inventory or supplies from warehouses, supply cabinets, office supplies stockrooms, motor vehicle service centers and other similar facilities.

Theft of Fixed Assets: Stealing various types of assets-tools, motor vehicles, computers, office equipment, furniture.

Using Assets for Personal Use: Using the organization's assets for personal reasons such as surfacing one's driveway, trimming one's hedges, personal use of public property such as automobiles.

Type 3 frauds involve stealing funds by either paying someone who should not be paid, paying too much to someone, paying for something that should not be purchased, receiving inferior goods and other types of payment frauds. The payment to any individual or organization can involve fraud as seem in the following common examples of type 3.

Vendor Fraud. Vendor fraud involves paying suppliers money that should not be paid, paying too much for goods purchase, receiving inferior goods and other types of abuses. Vendor fraud can take many forms. Probably the most common type of vendor fraud involves collusion between buyers and suppliers. This type of fraud is often characterized by kickbacks, the receipt of inferior goods, overcharging and late shipments. Fraud involving kickbacks is probably the hardest type of fraud to detect because there are no organizational records to search through. Kickbacks include cash payments, reduced-cost purchases, promises to hire one's spouse, children or even provide subsequent employment and other types of gifts, and can be made anywhere including bars, restaurants, automobiles or other hard-to-track locations.

In a second type of vendor fraud, the purchaser, acting without the knowledge of vendors, typically sets up dummy companies, orders goods of personal use or diverts funds that are paid to suppliers. Another kind of vendor fraud in which the vendor acts without the knowledge of purchasing employees usually includes overcharging, delivering inferior goods or short shipments.

Payroll Fraud. One of the biggest cash outflows of most municipal organizations is payroll. Payroll frauds can take the form of ghost employees, terminated employees left on the payroll, paying when not working, inflation of hours worked, working unnecessary overtime, diverting payroll withholdings or stealing paychecks. Payroll frauds are quite easy to detect.

Travel Reimbursement Fraud. Travel reimbursement fraud involves overcharging for travel expenses such as hotels and meals, including personal items on travel reimbursement forms, charging for expenditures not incurred or creating fraudulent documentation to support various types of purchases. One large company with a $500 million travel budget believes that one-tenth of their reimbursement are for illegitimate claims.

Health Claims Fraud. This type of fraud involves overpaying doctors, hospitals, clinics, chiropractors, dentists, HMOs and other providers of health services or paying these same providers for services not performed. Like vendor fraud, this type of fraud can involve the employee only, the vendor only or can involve collusion between vendor and employee. Health claims fraud is becoming a significant problem; it is estimated to cost between $20 and $30 billion per year in the U.S. As an example of this type of fraud, one pediatrist billed a single insurance company more than $40 million in fraudulent billings. In another, case, a claims payment manager for a self-insured defense contractor established 20 phony doctors and billed the company more than $12 million in fictitious billings before she was caught.

Retirement Benefits Fraud. This type of fraud can take many forms including using pension funds assets and overwithholding or underfunding pension costs.

There are many additional examples of frauds that fall into each of these three categories. While all three types of fraud can be serious, the most significant losses in terms of dollars occur in type 3 fraud: the dollar losses from disbursements-type frauds exceed the combined losses from both type 1 and type 2 frauds.

Dealing with Fraud

Organizations that are serious about reducing fraud realize they must take a proactive approach, or fraud will simply continue to escalate. Those that have successfully reduced fraud have worked on the three elements of the fraud triangle: they provide avenues that will assist employees in reducing or dealing with pressures, they reduce opportunities for committing fraud and they learn to recognize rationalizations.

Reducing Pressures. Most of the pressures that motivate fraud are personally inflicted. It is hard to stop an employee from getting too far into debt, from becoming addicted to spending, gambling, drugs or alcohol, or from being preoccupied with financial success. Organization can, however, help employees deal with these pressures. Employee assistance programs that deal not only with substance abuse, but also provide financial counseling are very helpful. Many people steal because they have no one to talk to. Managers who are willing to listen and who have open-door policies can reduce significantly the amount of fraud in an organization. Creating a work environment where employees feel positively rewarded and accept ownership in programs is also very important. If employees feel mistreated, underpaid or abused, they are much more likely to commit fraud against an organization.

Reducing Opportunities. Most organizations rely on their internal control system to prevent fraud opportunities. They feel that if there is proper segregation of duties, sufficient independent checks, proper authorizations, physical safeguards and adequate documentation, fraud will be prevented. However, internal controls seldom work as they are supposed to, and they are not designed to detect or prevent collusive fraud, which accounts for 29 percent of all frauds.

Employees, not auditors, are in the best position to detect fraud. While internal controls are extremely important, other actions can be taken to reduce fraud opportunities: an increasingly popular one is the installation of fraud hotlines, which facilitate the reporting of fraud by employees.

The most successful hotlines are those that involve programs to report substance abuse, safety violations, discrimination and fraud. Very few employees want to work in an unsafe environment, to tolerate discrimination or to work around someone using drugs or alcohol. When fraud is combined with these other types of abuses and employees are given several options for reporting, including a toll-free telephone number, fraud tips will be forwarded. Hotlines not only help detect fraud, but they provide a strong deterrent because every employee understands that fellow employees know what action to take if they suspect fraud.

It is extremely important that such hotlines be included in a general abuse awareness program where employees receive training and encouragement to report abuses. As an example of the value of a fraud hotline, one organization that established a hotline received 130 legitimate tips of suspected fraud in the first four months. Many of these turned out to involve substantial amounts of losses.

Another way to reduce fraud opportunities is to adopt an aggressive prosecution policy. When organization seek prosecution of all offenders, no matter how large or small the crime, people are less willing to be dishonest. A strong prosecution and termination policy has a great deterrent effect on employees.

Finally, organizations must train their employees to listen for rationalizations. When a manager or fellow employee hears that a person feels underpaid, overworked or abused, he or she must make sure the controls are followed and that the employee does not work in a high opportunity fraud environment. In addition, organizations must carefully screen their new employees to hire only individuals who have high integrity. (With tough privacy laws, this will be a challenging job.) Obviously, the less honest an individual is, the less rationalization and pressure it takes to commit fraud. One organization that decided to take hiring very seriously made it a rule to call three previous references and have two trained interviewers question every prospective hire. In one year, they found more than 800 individuals that they otherwise would have hired who had concealed such problems as previous arrest records, dishonorable discharge from the military, uncontrollable temper, and drug or alcohol abuse.

Concluding Comments

Both incidences and amounts of fraud are increasing dramatically in the United States, and, since fraud hits the bottom line and eliminates discretionary income, it is a very costly proposition for both profit and not-for-profit organizations. All the factors that contribute to fraudulent behavior seem to be increasing. Financial pressures of all types are increasing dramatically. Opportunities to commit fraud are all around us. With electronic funds transfers, color copies, fax machines and increased use of computers, not only is fraud easier to commit, but larger amounts can be stolen. (The average compute fraud in the U.S. is $500,000.) Recent studies have shown that people are increasingly less hones now than previously.

Fraud can be reduced. A proactive prevention and detection approach can stabilize the conditions that lead to fraud. One organization with a proactive approach has reduced its known fraud from approximately $25 million per year to less that $1 million.

The latter approach is recommended. Those who do not proactively work to prevent, detect and investigate fraud, risk experiencing the same fate as many small businesses and savings and loans. (One out of three new businesses that fail does so because of fraud, and more than one-third of the approximately 600 savings and loans that failed last year involved significant amounts of fraud.)

Many people are governmental entities as an easy target to abuse. A government can choose to ignore the problem of fraud and pretend that it does not occur, but this approach usually results in a crisis whenever a fraud incident occurs. Government managers can choose not to make it easy for the perpetrator of fraud.

NOTES

(1) Hollinger, Richard C., Dishonest in the Workplace: A Manager's Guide to Preventing Employee Theft, London House Press, Park Ridge, Il. 1989.

(2) Baron, David, "Audit Findings from Small City Single Audit Reports," Association of Government Accounts Journal, Spring Quarter 1989, pp. 3-9.

W. Steve Albrecht is Arthur Andersen Alumni Professor and director, School of Accountancy and Information Systems, Brigham Young University and president of the National Association of Certified Fraud Examiners. Much of this paper is excerpted from a on-day seminar preceding the 1991 annual conference of the Government Finance Officers Association. Other topics covered in that seminar were 1) the red flags of fraud, 2) fraud detection methods and 3) various types of evidence needed to substantiate fraud.
COPYRIGHT 1991 Government Finance Officers Association
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Author:Albrecht, W. Steve
Publication:Government Finance Review
Date:Dec 1, 1991
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