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The three factors of fraud.

IT IS ALMOST IMPOSSIBLE TO READ A newspaper today and not find some mention of fraud. The Institute of Financial Crime Prevention (now the National Association of Certified Fraud Examiners) estimated in 1988, its most current study, that corporations were losing between 1/2 and 2 percent of their sales to employee dishonesty.(1) If this statistic is correct, a $2-billion company loses between $10 million and $40 million a year to fraud. And if this same company has a return on sales of 10 percent, it will take between $100 million and $400 million in additional sales to recoup the income lost from this dishonesty.

To gather current data on employee fraud, the authors sent a survey to the Fortune 500. Questionnaires were sent with instructions requesting that the individual most responsible for fraud prevention complete the form. Many respondents wrote back saying that their company did not have a single person who was responsible for fraud prevention.

Of the 500 companies surveyed, 242 responses were received. One hundred and fifty responses, or 62 percent, came from internal audit directors; sixty-seven responses, or 28 percent, came from corporate security directors; and twenty-five responses, or 10 percent, were returned by personnel or human resources directors.

Employee fraud appears to be increasing. One reason may be that no one is taking responsibility for preventing it. That theory is supported by the diversity of the job titles and the comments from respondents that no one person is responsible for preventing fraud in their organization.

External auditors say they are only responsible for auditing the company's financial statements to verify the accuracy of the financial records. They also claim that the numbers they are dealing with are so large that, unless a scheme involved a significant amount of money, it would probably go unnoticed. Internal auditors stress that their function is to evaluate controls and improve operational efficiency. If they happen to find fraud, then they will pursue or report it.

The role of corporate security is typically investigative, not preventive, although the department will pursue specific frauds if reported. Management says its responsibility is to run the business and seldom even acknowledges that fraud could happen. Employees are usually in the best position to detect and prevent fraud, but they are often afraid of the consequences or do not know who to talk to.

Respondents knew of an average of three to five frauds in their companies in the past year and eleven to twenty in the past five years. Only 13 percent of respondents think employee fraud in their company is decreasing, while the remainder think it is increasing or staying the same.

Research shows that employees commit fraud when a combination of three factors is present: a situational pressure (usually a financial need), a perceived opportunity to commit and conceal a crime, and a way to rationalize the dishonest act.(2) The three fraud factors can be likened to the three elements of the fire triangle: it takes heat, fuel, and oxygen to produce a fire. When only two of the three are present, a fire cannot occur.

Although fraud, unlike fire, cannot be eliminated completely, it can be significantly reduced by removing opportunity, pressure, or rationalization. To reduce the opportunity for fraud, management should make employees aware of how co-worker dishonesty hurts profitability. The staff needs to recognize that fraud takes a bite out of everyone's benefits. Companies with successful fraud awareness programs have packaged fraud training together with other issues that are important to employees, such as safety, antidiscrimination, and employee assistance programs (EAPs).

Only 19 percent of respondents said that their company's EAP teaches employees about fraud, the costs to the company, and the effects on their paychecks. As for who in their company receives fraud training, 71 percent of respondents said internal auditors, 56 percent identified corporate security, 22 percent said middle management, and 16 percent noted personnel. Only 13 percent said that employees receive fraud training.

The opportunity for fraud can be reduced with good internal controls. Criminology research indicates that one of the greatest deterrents to crime is the fear of punishment. Companies have recognized this and have implemented comprehensive internal control programs. For example, when the authorization, custody, and accounting functions for assets are separated, fraud is less likely to occur. Internal controls, however, are usually not effective in preventing or detecting collusive fraud and, in many cases, even enable solo frauds to be perpetrated. Simply having controls in place is not enough. They must be enforced. In a study of 212 employee frauds, the most common element contributing to fraud was not the lack of internal controls but the failure to enforce existing controls.(3)

A good internal control system should include prevention and detection, as well as segregation of duties and procedures for authorization and documentation. Other concerns include the hiring of honest and competent employees and physical safeguards.

A formal system for reporting dishonest activities reduces the opportunity for fraud. Companies need to make it easier for employees to report embezzlement and other schemes. Staff members must be assured that they can report suspicions anonymously. Only 52 percent of respondents said their company has a formal system for reporting fraud. Of those companies, 29 percent instruct employees to contact corporate security directly, 17 percent direct employees to talk to their manager, and 16 percent have toll-free hot lines.

Unfortunately, in most companies, opportunity is the only element of the fraud triangle that is addressed. Employee pressures and the ways employees rationalize dishonesty are often overlooked. Two kinds of pressures lead people to commit fraud. The first is a perceived financial need that cannot be satisfied with available resources. Financial need can be the result of major financial losses, drug or alcohol dependencies, gambling losses, greed, or overextended credit. Once their financial need is met, however, most people continue to steal. They use the money to increase their standard of living, pay for outside business interests, or increase expensive habits. Those who hoard their ill-gotten gains are rare.

While financial pressures are a major factor in most frauds, frustration accounts for about 5 to 10 percent of employee thefts.(4) Frustration can result from a number of situations, such as not being promoted, a perception of being underpaid, dislike for a supervisor, a feeling of alienation from other employees, a lack of devotion to the company, fear of losing one's job, or

boredom with the work. A company can help reduce pressure on employees by having an open-door policy to encourage communication and by developing an EAP. In many cases, employees have on one turn to, and all they need is someone to listen.

Sixty-seven percent of respondents said their company has an EAP. EAPs deal with a number of problems, including alcohol and drug dependency (67 percent), emotional difficulties (63 percent), family and marital disputes (57 percent), gambling addictions (38 percent), personal financial pressures (37 percent), legal troubles (32 percent), and investment counseling (11 percent). Only 8 percent of respondents thought that fraud could not be prevented by assisting employees with personal financial pressures.

Given the right pressures, opportunities, and rationalizations, every employee is capable of committing fraud. Most employees who commit fraud do not perceive themselves as criminals. They judge themselves by their intentions, not their actions. They do not intend to do anything wrong or hurt anyone.

Common rationalizations used to justify fraud include the following: "I'm only borrowing the money temporarily and I'll pay it back," "I'm not hurting anyone," "The company would understand it if they knew how badly I need it," "Everyone is a little dishonest," "The money is for a good purpose," and "What I'm doing is not that serious."

To reduce rationalizations that lead employees to commit fraud, companies must carefully screen prospective employees. Individuals with gambling, financial, drug, or other problems should not be hired, if possible.

Discriminating between honest and dishonest job candidates is difficult in today's environment of privacy rights and legislation. Checking on second and third references and conducting in-depth interviews of prospective employees are two ways a company can minimize the chances of hiring a problem individual.

One company that worked hard to screen employees discovered that 851 prospective employees, or 14 percent of its candidates, had problems such as unsatisfactory employment history, false education or military information included on their resume, a criminal record, poor credit rating, physical or mental illness, alcoholism, or an uncontrollable temper.(5) People with these types of problems find it easier to rationalize dishonest acts.

Companies should also conduct formal fraud awareness training. When employees are explicitly told that fraud will not be tolerated under any circumstances, it is more difficult for them to rationalize committing a crime.

A formal code of conduct is yet another way to reduce rationalizations. Justifying dishonest acts becomes easier when employees are confused about the rules. For example, when people hear that IRS agents answer tax questions correctly only 60 percent of the time, it is easier for some to rationalize taking questionable deductions.

Employees should be required not only to read the code of conduct but also to sign it. This way they know what is acceptable. It also shows that senior management takes the issue seriously. Sixty-seven percent of respondents said their company has a formal code of conduct.

Rationalizations are more difficult if companies take a hard-line approach with criminals. A strong prosecution policy lets employees know that dishonest acts will not be tolerated and violators will be harshly punished. Although prosecution is expensive and time-consuming and stimulates concerns about unfavorable press, not prosecuting only saves the company money in the short run. In the long run, failure to prosecute dishonest employees sends a message to other employees that the company tolerates fraud and that the worst thing that can happen to them is termination.

With the current tough privacy laws and the high rate of job turnover, termination is no longer a strong deterrent. Yet, 49 percent of respondents said the most common action their company takes against employees who commit fraud is termination. Another 45 percent terminate and prosecute, and 4 percent take disciplinary action only and retain the employee.

Trying to prevent employee fraud with internal controls alone is like trying to extinguish a fire in a skyscraper with a garden hose. Internal controls deal with only one of three contributors to fraud--opportunity--and they do not even deal with that element completely. Reducing fraud takes a more concerted effort toward reducing pressures and rationalizations as well as opportunity. The survey results reported here suggest that some programs address these concerns, but in most companies significant improvements can be made. Reducing corporate fraud must be a priority for the future. The problem is too expensive to ignore.

1 "Employee Assistance Programs," The White Paper, National Association of Certified Fraud Examiners, (Spring 1988): 10.

2 W.S. Albrecht, K. R. Howe, and M. B. Romney, Detecting Fraud: The Internal Auditor's Perspective, The Institute of Internal Auditors Research Foundation, 1984, 4-7.

3 W. S. Albrecht, K. R. Howe, and M. B. Romney, Detecting Fraud: The Internal Auditor's Perspective, The Institute of Internal Auditors Research Foundation, 1984, 28.

4 W. S. Albrecht, M. B. Romney, D. J. Cherrington, I. R. Payne, and A. J. Roe, How to Detect and Prevent Business Fraud (Englewood Cliffs, NJ: Prentice-Hall, Inc., 1982), 118.

5 Michael J. Comer, Corporate Fraud (London: McGraw-Hill Book Company Limited, 1977), 310.

W. Steve Albrecht, PhD, CPA, CFE (Certified Fraud Examiner), is the Arthur Andersen alumni professor and director of the School of Accountancy & Information Systems at Brigham Young University in Provo, Utah. Gerald W. Wernz, CPA, is director of internal audit and corporate security for Boise Cascade Corporation in Boise, Idaho. He is a member of ASIS.
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Title Annotation:Investigations; employee fraud
Author:Albrecth, W. Steve; Wernz, Gerald W.
Publication:Security Management
Date:Jul 1, 1993
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