Importance of Fraud Deterrence

As reported in “Occupational Fraud and Abuse, Part I” in the August issue of this magazine, studies have shown that once fraud has been detected, victim organizations will rarely make a full recovery of the losses they suffered. In addition to lack of recovery, organizations are also faced with the possibility of negative publicity that tends to surround known and suspected acts of fraud. As such, fraud deterrence is the best weapon that an organization can employ to limit fraud losses and protect their assets.

How is Fraud Detected?

In an effort to better design fraud deterrence programs, it is important to know how fraud is detected. Generally speaking, the primary methods of fraud detection are through tips from employees, customers and outside vendors and accidental discovery within the organization, representing 60 percent of all initial fraud detections. Internal audit, internal controls, external audits and police notification (in that order) are the remaining methods of fraud detection.

Frauds in small businesses (those with fewer than 100 employees) were less likely to be detected by tips, internal audits and internal controls, but more likely to be detected by accident. While businesses of this size are less likely to have an internal audit department, the statistics also suggest that small businesses do not do a very good job at taking a proactive approach to fraud detection.

Anti-Fraud Measures

When gathering information on how organizations limited fraud losses, the Association of Certified Fraud Examiners (ACFE) tested five specific anti-fraud measures, as follows:

• Did the victim organization have a fraud hotline or anonymous reporting mechanism?
• Did the victim provide fraud awareness or ethics training for employees and managers?
• Did the victim have an internal audit or fraud examination department?
• Did the victim perform surprise audits on a regular basis?
• Was the victim audited by external auditors?

Victim organizations were asked what, if any, of the anti-fraud measures listed above they used in the operation of their business. It was discovered that external and internal audits were the primary methods used 75 percent and 59 percent of the time, respectively. An interesting item to note is these measures ranked fifth and third, respectively, as fraud detection measures. This tends to suggest that there is a certain level of disconnect between the anti-fraud measures used in an organization and the effectiveness of the measure used.

Effectiveness of Anti-Fraud Measures

To test the effectiveness of the anti-fraud measures listed below, median losses were measured in situations where a particular anti-fraud measure was present and then compared to situations where the same anti-fraud measure was not present. Additionally, the study measured the length of time it took to detect the fraud when an anti-fraud measure was present compared to when it wasn’t present.

1. Fraud hotlines. In the study, 479 organizations utilized fraud hotlines, compared to 581 that did not. Of the organizations with the hotlines, the median losses suffered were $100,000 per scheme and detected within 15 months of inception, compared to losses of $200,000 per scheme, detected within 24 months.
2. Fraud awareness/ethics training. The purpose of fraud training is to inform employees of the many ways in which fraud can be perpetrated and to emphasize the importance of being watchful and reporting of any observed or suspected activity. In this study, 45.9 percent of the victim organizations provided their employees with fraud awareness and ethics training programs. Results of implementing this anti-fraud measure were the same as those for implementing fraud hotlines.
3. Internal audits. At the time a fraud occurred, 59 percent of the victim organizations interviewed had either an internal audit or fraud examination department. Of the organizations with an active internal audit department, median losses per scheme were $120,000 and detected within 18 months of inception, compared to losses of $218,000 per scheme, detected within 24 months.
4. Surprise audits. Often cited as an effective method to fraud prevention and detection, the study identified that surprise audits were the least-used anti-fraud measure of victim organizations. Only 29 percent regularly used surprise audits as part of their business operations. For these organizations, sustained losses per scheme were approximately $100,000, half as much as those for organizations that did not use surprise audits, with fraud schemes being detected nine months sooner.
5. External audits. Overall, external audits ranked fifth out of six measures for detecting fraud and only accounted for 12 percent of the cases reported in this study. As such, data gathered from this study for the effectiveness of external audits to detect fraud was counterintuitive. Median losses suffered by those organizations who utilized external audits actually suffered higher median losses with detection times averaging 23 months compared to 18 months for organizations that did not have external audits.

Anti-Fraud Measures in Small Businesses

Small businesses tend to suffer a disproportionate share of fraud losses, likely due to their lack of implementation of anti-fraud measures. Of the small businesses interviewed in this study, fewer than 50 percent utilized the external audit function and nearly 20 percent did not implement any of the above-mentioned anti-fraud measures at all. This may help explain why frauds in small businesses are detected more often by accident than any other method.

Protecting Your Assets

The ACFE is the world’s premier provider of anti-fraud training and education, awarding the CFE (Certified Fraud Examiner) designation to individuals who have demonstrated knowledge in four critical areas and requires continual annual education to retain such designation. While fraud losses appear to be slightly on the decline since 2004, nearly five percent of U.S. organizations’ annual revenues are still lost to fraud. Businesses and organizations wanting to strengthen their ethical environment and minimize fraud losses are encouraged to contact a CFE for assistance in assessing current and implementing additional anti-fraud measures.

To locate a CFE in your area, visit the ACFE website at www.ACFE.com. Click on Fraud Resource Center, then Find a CFE. Input the necessary parameters for the search and click Go. Information and statistics in this article were obtained from the 2006 ACFE Report to the Nation on Occupational Fraud and Abuse. IBI