?Today’s headlines are filled with reports of unprecedented investment losses, economic uncertainty and the near collapse of financial markets. Record oil and gas prices of less than a year ago have declined precipitously, by two-thirds.

An insidious result of the economic downturn is an expected increase in corporate fraud. Although fraud occurs even during strong economic times, weakened economic conditions further fuel one of its root causes—financial need. Exacerbating this concern are reductions in employee headcount and internal controls, as well as diminished morale, which seed the other root causes of fraud—opportunity and rationalization.

The Enron, WorldCom and Tyco frauds earlier in this decade caused many companies to take steps to guard against fraud. They initiated new accounting procedures; complied with the Sarbanes-Oxley Act (Sox), legislation that affects how public organizations and accounting firms deal with corporate governance, financial reporting and public accounting independence; and improved screening of new employees.

Yet there has not been a noticeable decrease in fraud overall. Corporate fraud causes losses to companies of between 5% and 6% of revenues every year. This level has not changed for the past 12 years. When applied to the U.S. GDP, these losses total about $660 billion per year.

“In addition to the direct losses, corporate fraud can also lead to governmental penalties, damages from private lawsuits and the associated legal fees of investigating the fraud, and defending against government enforcement and private lawsuits,” says Tony L. Visage, a partner in the trial and internal investigations practices at Bracewell & Giuliani LLP, Houston. “These costs can be significant and material to a company—in the tens of millions of dollars and higher.

“We have seen a recent increase in both governmental enforcement activity and private lawsuits against companies following the companies’ disclosure of fraud.”

According to estimates, one-third of American workers has stolen from his or her employer. Many of these thefts are immaterial to the financial statements, but not all are—especially to the majority of all businesses, which are small. Although “theft” and “fraud” are commonly used terms, a more encompassing term is “asset misappropriation.”

For purposes of this discussion, asset misappropriation means more than theft or embezzlement. Company personnel who wrongly use company equipment (for example, color printers or company-issued cell phones) for personal benefit have not stolen the property, but have misappropriated it.

Company personnel, from the C-level suites to entry-level staff, can be very imaginative in the ways they scam employers. “We have seen fraud at literally every level of a company—from a board member ignoring a conflict of interest to an owner fraudulently beefing up raw-material inventory to obtain a higher price for his company, a field-level accountant delaying reporting a loss to corporate so the company would not miss an earnings target, and a project manager not reporting delays and cost overruns in an effort to save his bonus,” says Visage.

Fraud is hard to detect, as there is no typical “profile” of a person who commits the crime. They are ordinary employees, usually with no known history of fraud, and 92% have no prior criminal charges or convictions related to fraud. Men and women commit a fairly equal amount of fraud, but fraud committed by men costs companies more than twice as much as that committed by women.

The higher a person’s position in the company, the greater the fraud. Higher-level personnel have expanded access to people, data and opportunity. There also may be less scrutiny and oversight of these people.

Large, well-publicized frauds, including those recently revealed to have been led by Bernard Madoff and Allen Stanford, were all financial-statement “Ponzi” schemes in which the executives created fictitious revenue and hid expenses to make the investment and financial results appear stronger. Financial-statement fraud generally involves manipulating the statements for some indirect benefit to the executives engaging in the fraud. This might mean an increased stock price, a larger year-end bonus or meeting requirements for bank financing.

Financial-statement fraud is by far the most expensive type, costing companies an average of $2 million per scheme. Yet, it is also the least common type, occurring in fewer than 10% of fraud incidents.

The most common type of fraud, occurring in 91% of instances, is asset misappropriation, and 90% of those cases involve the misappropriation of cash. The reasons are obvious—cash is fungible, has a specific value and is easily transported. All other assets, including inventory, have limited usefulness to a thief; an employee in a pipe-rolling mill, for example, may find it difficult to convert stolen product into cash. And as the economy increasingly becomes more service-based, many businesses don’t have a physical inventory at all.

A study by Accumyn Consulting of more than 2,600 cases of occupational fraud and abuse shows that misappropriation of cash falls into three specific types: skimming, larceny and fraudulent disbursements. • Skimming is the removal of cash prior to its entry into the accounting system. • Larceny is the removal of cash after it has been entered into the accounting records. Most of these schemes are detected through bank reconciliations and cash counts. Larceny is therefore not a favored method; it accounted for only 3% of the cases in the study and 1% of the losses. • Additional research of 732 fraudulent-disbursement cases showed at least six specific types: check tampering, false register disbursements, billing schemes, payroll schemes, expense-reimbursement schemes and other fraudulent disbursements. Employees who set up dummy companies for fraudulent disbursements often leave clues. They use their own initials for the company name, rent a post-office box or mail-drop to receive checks, or use a dummy company name and their own home address.

Red flags

The three common schemes employees use to misappropriate cash can show up early in accounting records. Employers should be alert to simple trends when determining their risk of material embezzlement.

Signs of skimming include a decreasing ratio of cash to total current assets, a decreasing ratio of cash to credit card sales, flat or declining sales with increasing cost of sales, increasing accounts-receivable compared with cash, and the delayed posting of accounts-receivable payments.

Signs of larceny include unexplained cash discrepancies, altered or forged deposit slips, customer billing and payment complaints, and rising “in transit” deposits during bank reconciliations.

Signs of fraudulent disbursements include increasing “soft” expenses (e.g., consulting or advertising), an employee’s home address matches a vendor’s address, a vendor’s address is a post-office box or mail-drop, the vendor name consists of initials and/or a vague business purpose (such as “GWB Solutions”), and excessive voided, missing or destroyed checks.

Besides watching for signs of these red flags, employers can take steps to reduce the risk of fraud. • Establish an anonymous hotline for reporting. These cut fraud losses in half, because they give employees an opportunity to report without getting involved. Co-workers may spot a problem long before it becomes apparent to management. • Make the ethics of the corporate culture clear. Values and ethics flow from the top down. Management should be modeling ethical behavior at all times. • Create a code of conduct for employees. The boundaries and rules should be clear so that employees know what is expected. Don’t allow “gray areas,” where employees substitute their judgment for what is right and wrong. • Implement simple fraud-prevention procedures. These include segregation of duties, random audits of records and monitoring access to assets and data. Establish levels of authority for financial transactions with multiple signatures required. Every organization needs a program of proactive measures to avoid or mitigate fraud. Fraud is pervasive, affecting businesses in every market and sector, regardless of size. Failure to put fraud-prevention procedures and deterrents in place could have disastrous consequences, even putting a company out of business within days.

Scott A. Bayley is a CPA and certified fraud examiner (CFE). David N. Eliff is a CPA and certified in financial forensics (CFF) by the American Institute of CPAs. Both are managing directors of Accumyn Consulting, a financial-advisory services firm that provides fraud-detection and -prevention services.