Fraud and Countermeasures - Case Study Example

Fraud and countermeasures Introduction This essay will involve analysis of how a large proportion of fraud is carried out by persons who have well-established relationship with the victim and provide fraud countermeasures, which acknowledge this relationship. First, however, I provide the definition for fraud and outline people who might have an established relationship with the victim. The essay will also provide case studies to illustrate how perpetrators of fraud are often related to the victim. This will entail employment of criminology theory to explain these cases (Qing & Eloff, 2000). In criminology, fraud is a deception that is intentional that is committed for personal gain or to damage another individual (Neuhierl, Scherbina & Schlusche, 2010). Fraud entails misrepresentation of a matter of fact, which deceives and is intended to deceive another in order for the individual to act upon it to her or his legal injury (Tipton & Krause, 2007). Fraud is a crime and is a violation of civil law. It is not easy to prove fraud in a court of law because one is expected to show that the actions of the defendant involved five separate elements (Blackwell, 2009). First, the actions of the defendant ought to be proved that they contained a false statement of a material fact (Vacca, 2009). Second, one needs to prove that the defendant had the knowledge that the statement he or she was giving was false (Jakobsson & Myers, 2006). Third, one is required to prove that the defendant intended to deceive the alleged victim (Lee, 2008). The fourth element that is needed to prove that one committed fraud is justifiable reliance by the alleged victim on the statement (Neuhierl, Scherbina & Schlusche, 2010). Finally, one ought to prove that the victim was injured as a result of the defendant’s actions. The elements needed to prove that one has committed fraud are often difficult to prove in some instances (Lee, 2008). This is because not all statements that are false are fraudulent (Vacca, 2009). A false statement ought to relate to material fact for it to be fraudulent (Shaffer, 2010). In addition such as a statement ought to substantially influence the decision of an individual to enter into a contract or pursue a certain course of action (Qing & Eloff, 2000). Thus, any statement that is false but does not bear on the disputed transaction cannot be considered fraudulent. The fact that the defendant must know that the statement is untrue for it to be considered fraudulent and that the false statement is made with the intent of deceiving the victim can only be easily proved once falsity and materiality are proved (Tipton & Krause, 2007). This is because most material false statements are usually designed to mislead. In UK the Fraud Act of 2006 states that a person is guilty of fraud if he or she is in breach of fraud by false representation, fraud by failing to disclose information and fraud by abuse of position (Lee, 2008). Fraud by false representation refers to any person dishonestly makes a false representation and intends by making the representation to make a gain for himself, another or to cause loss to another or expose another to risk of loss (Qing & Eloff, 2000). Fraud by failing to disclose information refers to dishonest failure to disclose to another person information which he is under legal obligation to disclose and intends, by means of abuse of that position, to make a gain for himself, another or to cause loss to another or expose another to risk of loss (Tipton & Krause, 2007). Fraud by abuse of position refers to dishonest abuse of a position in which he is expected to safeguard or not act against , the financial interests of another person and intends to make a gain for himself, another or to cause loss to another or expose another to risk of loss. Fraud perpetrators People who have an established relationship with the victim or the firm are often the ones involved in perpetration of the fraudulent vice (Tipton & Krause, 2007). These include owners of organizations, executives and employees. It is estimated that most organizations lose approximately five percent of their annual revenue to fraud (Vacca, 2009). Of these frauds, owner and executive committed frauds are more that nine times as costly as employee fraud (Lee, 2008). The most affected organizations by fraud are usually banks, manufacturing and government organizations. Research has shown that the average fraud perpetrator has no prior fraud charges or convictions. Studies further indicate that these fraudsters are often aged between 31-45 years and most of them are men as compared to women (Vacca, 2009). Most fraudulent activities are committed by owners/executives, managers or employees. Majority of occupational fraud cases are committed by employees (Qing & Eloff, 2000). However, the greatest damage to a firm is caused by fraud committed by owners/executives. This kind of fraud is three times more costly than that committed by managers. It has also been established that fraud committed by executives usually takes long to be detected. Research furthers indicates that fraud offenders are likely to be found in accounting, operations, sales, executive/upper management, purchasing or customer service department (Neuhierl, Scherbina & Schlusche, 2010). Most fraud offenders display warning signs, which indicate that they are engaged in illicit activity. One of the most common behavioural red flags that fraud perpetrators display is living beyond their means in addition to experiencing financial difficulties (Lee, 2008). In such cases, employees acquire expensive cars, homes, jewellery and clothes that do not match their income (Dowland, 2005). Furthermore, they incur significant personal debt and credit problems. Other red flags may include behavioural change, which may be an indication of alcohol, drugs, gambling or just the fear of loosing the job. Refusal to take vacation or sick leave and lack of segregation of duties in the vulnerable area is also fraud red flags (Qing & Eloff, 2000). There are management specific fraud red flags (Neuhierl, Scherbina & Schlusche, 2010). One of such red flags is the reluctance to provide information to auditors. In addition, engagement of management in frequent disputes with auditors could also be an indication that fraud is being committed. Significant disrespect to regulatory bodies by management could also be a fraud red flag (Vacca, 2009). Laxity or inexperience among accounting personnel could also be an indicator of potential fraud being committed in the firm (Tipton & Krause, 2007). Firms that undertake decentralization without proper structures of monitoring may be an indication of potential fraud being committed. Other indicators of fraud in a firm include excessive number of checking accounts, frequent changes in banking accounts and external auditors, selling of company assets under market value, significant downsizing in a healthy market and continuous rollover of loans (Lee, 2008). Such indicators are often used by owners, anti-fraud professionals, managers and law enforcement personnel with insight into the risk factors of fraud. Fraud often crops from poor internal control, overriding of internal controls by the management, collusion between employees and collusion between employees and third parties. Some organizational profiles may provide favourable environment for fraud to be committed (Qing & Eloff, 2000). Research has indicated that most costly frauds occur within firms with less than 100 employees (Lee, 2008). Ignorance of irregularities by the management can also facilitate occurrence of fraud. Lack of training in a firm and high employee turnover can also facilitate occurrence of fraudulent activity in a firm. An example of the effect of fraud is the failure of Barings Bank (Talib, Clarke & Furnell, 2010). One of the causes of Barings bank failure is the failure by its management to institute a proper financial, managerial and operational control system. This poor management resulted in the ability of the management to manage derivative trading. As a result, Leeson who was involved in derivatives trading took advantage of this and engaged in dubious trading, accounting and reporting practices, which concealed the losses that he was incurring. He took speculative unauthorized positions in Futures and options on the Nikkei. He managed to hide his trading in an unused BSF error account (Qing & Eloff, 2000). Even though the firm was making losses, the concealed loses were reported as profits and hence the profits which were reported were not correct (Vacca, 2009). The management allowed Leeson to be in charge of both the dealing desk and control over the back office operations that enabled him to manipulate the accounts of the bank (Neuhierl, Scherbina & Schlusche, 2010). Therefore, the bank lacked segregation of duties, which is critical to ensuring the accuracy and integrity of information (Tipton & Krause, 2007). Thus, the risk for irregularities was heightened failure by the Barings Bank management to institutionalize time-tested fundamentals necessary for effective internal controls. Another example of fraudulent activity is the Madoff investment scandal. Bernard Madoff was the founder of the Wall Street firm Bernard L. Madoff Investment Securities LLC in 1960. Until his arrest in 2008, Madoff was the chairman of the firm. Madoff operated what has been described by The Market Oracle as the largest investor fraud ever committed by an individual (Qing & Eloff, 2000). This is an example of owner-committed fraud. Investigations of the fraud indicate that Madoff collaborated with his two back office workers to create false trading reports based on the returns that Madoff ordered for each customer (Tipton & Krause, 2007). For instance, investigation found that once Madoff determined a customer’s return, one of the back office employees would enter a false trade from a previous date and then enter a false closing trade in the amount of the required profit. Another person who was convicted in the fraud was David Friehling who was Madoff’s accounting front. He pleaded guilty to securities fraud. Enron scandal was an example of financial accounting fraud. The executives at the institution manipulated books of accounts to appear as if they had profits each quarter when in real sense they were deeply in debt (Vacca, 2009). The firm claimed in 2000 that it had about $101 billions in revenue. However, investigations revealed that the firm’s reported financial condition was sustained by institutionalized, systematic and creatively planned accounting fraud (Neuhierl, Scherbina & Schlusche, 2010). Consequently, Enron has since become a popular symbol of wilful corporate fraud and scandal (Tipton & Krause, 2007). Jeffrey Skilling was behind the whole Enron fraud (Jones, 2004). When he was hired, he developed a staff of executives, which employed accounting loopholes, special purpose entities, and poor financial reporting to hide billions in debt from failed deals and projects (Lee, 2008). Andrew Fastow who was chief financial officer at the firm and other executives misled Enron’s board of directors and audit committee on high-risk accounting in addition to pressurizing Andersen to ignore the issues. The no transparent financial statement of Enron did not depict clearly the operations of and finances of the firm with shareholders and analysts (Qing & Eloff, 2000). The firm’s complex business model and unethical practices compelled the executives to use accounting limitations to misrepresent earnings and modify the balance sheet to portray a favourable depiction of its performance (Vacca, 2009). It is argued that the Enron scandal was a result of a steady accumulation of habits, values, and actions that started years before and finally spiralled out of control (Lee, 2008). The off balance sheet vehicle created by Fastow and other executives, complex financing structures and bewildering deals facilitated the occurrence of the fraud since no one could understand them. Fraud countermeasures Fraud is facilitated by three elements, which make up the Fraud Triangle. Every situation of fraud is described by these three factors. They include opportunity, motive (or pressure) and rationalization. Opportunity is the first and most critical element of the fraud triangle. Opportunity is the ability to commit fraud (Neuhierl, Scherbina & Schlusche, 2010). More often, fraudsters exploit their responsibilities to defraud their victims. Many opportunities for committing fraud are provided by firms unwittingly or unwisely (Talib, Clarke & Furnell, 2010). The most common opportunity-providing factor is the lack of adequate controls for monitoring employee behaviour. For instance, the Barings bank management allowed Leeson to be in charge of both the dealing desk and control over the back office operations (Tipton & Krause, 2007). This lack of segregation of the two responsibilities gave Leeson an opportunity to manipulate the accounts of the bank. Therefore, the bank lacked segregation of duties, which is critical to ensuring the accuracy and integrity of information. Thus, the risk for irregularities was heightened failure by the Barings Bank management to institutionalize time-tested fundamentals necessary for effective internal controls (Qing & Eloff, 2000). Poor management oversight and or abuse of ones position and authority can create fraud opportunity. This is what created opportunity for committing fraud at Madoff firm (Neuhierl, Scherbina & Schlusche, 2010). Madoff and some of his employees abused their power to fleece their investors. Abuse of position at Enron is also key issue, which created an opportunity for committing fraud at the firm. Opportunity is the only element that firms have the most control over. Firms that are able to build processes, procedures and controls that do not place employees in a position to commit fraud and that effectively detect fraudulent activity if it takes place can effectively prevent occurrence of fraud (Malik, 2010). Motive/pressure is the need for committing fraud. This element is founded on the basis that not all employees will exploit opportunities to commit fraud (Talib, Clarke & Furnell, 2010). Thus, pressure is the second element of the fraud triangle (Brytting, Minogue, & Morino, 2011). It refers to what causes a person to commit fraud. Financial pressure can emanate from a variety of sources, which includes lifestyle, personal debt and business losses. Lifestyle pressure includes the perceived need to maintain a high standard of living (Neuhierl, Scherbina & Schlusche, 2010). Personal debt may emanate from credit cards, gambling losses, alcohol, drugs or poor investments. Business loses may compel one to commit fraud. Such loses may emanate from inflation, poor economy, lack of demand or high interest rates (Qing & Eloff, 2000). Such financial pressures make employees or fraudsters to desperately search for ways of relieving the pressure (Vacca, 2009). When such individuals are put in positions that provide them with an opportunity to commit fraud, they will execute it promptly and hence they ought not to be given such positions (Lee, 2008). However, not all frauds are committed due to pressure; some of them are committed out of greed alone. The final element of fraud triangle is the rationalization element, which is the mindset of the fraudster that justifies them to commit fraud. Under this element, the fraudster usually psychologically justifies the fraud (Lee, 2008). When rationalizing, a potential fraudster tries to reconcile his or her behaviour with the commonly accepted notions of decency and trust. The common rationalizations include: “I’m only borrowing the money. I’ll pay back.” “They owe it to me. I deserve to get paid more.” “Nobody will miss it. The company can afford it” “Everyone does it. I’m not hurting anyone” Research has shown that people with low integrity are able to come up with rationalizations to defraud others. Rarely do fraudsters think that they will be caught in their heinous activities of defrauding others. Fraud can thus be deterred by breaking the fraud triangle. Thus, the firm ought to remove one of the elements in the fraud triangle in order to break the fraud triangle. This will in turn reduce the probability of a fraudulent activity taking place (Talib, Clarke & Furnell, 2010). Proper and adequate internal controls can help in breaking the fraud triangle by removing the opportunity. Internal controls are the most actionable route to deter fraud from taking place in a firm. If such controls were in place at Barings Bank for instance, Leeson could not have gotten the opportunity to defraud the bank through his heinous activities (Tipton & Krause, 2007). Properly designed internal controls effectively instil in the minds of employees the perception that fraudulent activity will be detected. Thus, internal controls help in safeguarding assets and records, minimizing opportunities to commit fraud and monitoring employee behaviour (Brytting, Minogue, & Morino, 2011). Creation of an environment which endorses a ‘good ethics is good business’ philosophy encourages people within an organization to do the right thing at every turn and makes perpetration of fraud an unattractive option to most players in the firm (Talib, Clarke & Furnell, 2010). In addition, cultural assimilation into a system of high integrity and values represents a form of human mind programming that cannot be easily compromised (Vacca, 2009). Thus, a culture of ethics has a significant potential of reducing integrity risks (Neuhierl, Scherbina & Schlusche, 2010). A culture that enhances rewarding of people for doing the right thing sends the right signal to others in the firm (Tipton & Krause, 2007). Thus, in order for audit committees to discharge their monitoring and oversight functions effectively they need a primer on the psychology of the perpetrators of fraud in addition to insight about their own and the auditors’ cognitive weaknesses (Brytting, Minogue, & Morino, 2011). From the Madoff’s and Enron scandal, it is apparent that high-level fraud is frequently a team sport that often involves collusion (Qing & Eloff, 2000). This implies that internal control systems that presume proper segregation of duties are not effective against collusion and management override of controls (Neuhierl, Scherbina & Schlusche, 2010). Thus, external and internal auditors need to learn that “absence of evidence is not evidence of absence”. Managers and employees ought to act as stewards who are on look out for any red flags of fraud. In order to be able to carry out such tasks firms ought to initiate educational programs on how to combat fraud and its detection (Tipton & Krause, 2007). Most fraudsters present with some common personality traits such as domineering/controlling behaviour, unwillingness of other people to review their work, and having strong desire for personal gain (Qing & Eloff, 2000). Other personality traits include having the beat the system attitude, living beyond their means, have a close relationship with customers or vendors, are usually unable to relax, are often to good to be true in work performance, are usually unwilling to take vacation or sick time and usually work excessive overtime (Vacca, 2009). In addition, such people appear to be very trustworthy outwardly and often display some sort of drastic change in behaviour and personality. In addition to personality traits, most fraudsters experience one of common sources of pressure such as medical problems, unreasonable performance goals, spouse loss of a job, divorce, struggling personal businesses, criminal convictions, civil lawsuit, purchase of new property, need to maintain a certain lifestyle, excessive gambling or drug or alcohol addition (Statman, 2010). Fraudsters often have some common changes in behaviour once they have executed the heinous activity (Talib, Clarke & Furnell, 2010). Some of these behavioural changes include: sudden buying of material items; bragging about new purchases; carrying of unusual amounts of cash; creditors or bill collectors shows up at workplace or call frequently; borrowing and of money from co-worker. Others include becoming more irritable or moody, unreasonably upset when questioned or territorial over their area of responsibility; rarely take vacation or sick time; working excessive overtime. Moreover, other factors include turning down promotions; reporting early and staying late at work place; rewriting work to make it neat; mentioning family or financial problems; exhibiting signs of gambling or drug addiction; or exhibiting signs of dissatisfaction (Qing & Eloff, 2000). In UK, the department of finance and personnel has established an anti-fraud policy, which sets out the actions that one must take to help in preventing fraud. The policy details responsibilities in regard to the prevention of fraud and highlights procedures that need to be followed in the event of a fraud being detected or suspected (Neuhierl, Scherbina & Schlusche, 2010). The policy requires that all staff to act honestly and with integrity at all times and to safeguard the public resources for which they are responsible (Peck, 2010). The policy recognizes that fraud is a present threat and that it ought to be a concern to all members of staff (Tipton & Krause, 2007). The policy requires that the accounting officer be responsible for the establishment of a sound system of internal control, which supports the attainment of departmental policies, aims, and objectives (Brytting, Minogue, & Morino, 2011). This system of internal control is aimed at identifying the principal risks, evaluation of the nature and extent of these risks and their effective management. The National Fraud Authority (NFA) is the UK’s government agency, which coordinates the counter fraud response in the UK (Ec-Council, 2009). The authority works with many partners to ensure that it is more difficult to commit fraud in UK (Talib, Clarke & Furnell, 2010). A 2006 government fraud review found that fraud was a significantly under reported crime and that there was need to increase cooperation among various agencies and organizations involved in tackling the issue to attain a real impact in the public sector. This led to establishment of NFA (Tipton & Krause, 2007). NFA is involved tackling frauds across the spectrum and working on fraud types and fraud issues which are notable problems such as identity fraud, accommodation addresses, mortgage fraud, mass marketing fraud and fraud affecting small and medium sized businesses (Qing & Eloff, 2000). The authority also produces the annual fraud indicator, which provides an estimation of the cost of fraud. In order to prevent fraud, the Fraud Act 2006 provides definition fraud, gain, and loss in addition to penalties for obtaining services dishonestly and for companies and fraudulent business. Under the act gain or a loss refers to a gain or loss in money or property, which includes intangible property, that may be permanent or temporary (Neuhierl, Scherbina & Schlusche, 2010). A gain may also refer to gaining by keeping their existing possessions while loses may also refer to losses of expected acquisitions in addition losses of already held property. Under the act, it is a statutory offence to obtain services dishonestly. This implies that services that were to be paid for were acquired with the intention or knowledge that no payment would be made (Qing & Eloff, 2000). Persons found guilty of obtaining services dishonestly are liable to a fine or imprisonment of up to twelve months on summary conviction or a fine or imprisonment for up to 5 years on conviction on indictment (Tipton & Krause, 2007). The penalty for the fraudulent behaviour of companies under the act is ten years imprisonment (Brytting, Minogue, & Morino, 2011). Section 9 of the act also established a new offence for a sole trader participating in a fraudulent business (Lee, 2008). Maximum sentence for such sole traders, trusts and partnerships is ten years. Section 12 of the act defines the responsibility of a fraud committed by a body corporate (Vacca, 2009). Conclusion In criminology, fraud is a deception that is intentional that is committed for personal gain or to damage another individual. In UK the Fraud Act of 2006 states that a person is guilty of fraud if he or she is in breach of fraud by false representation, fraud by failing to disclose information and fraud by abuse of position. People who have an established relationship with the victim or the firm are often the ones involved in perpetration of the fraudulent vice. Fraud often crops from poor internal control, overriding of internal controls by the management, collusion between employees and collusion between employees and third parties. This is exemplified by the failure of Barings Bank. The bank’s management failed to institute a proper financial, managerial and operational control system. This allowed Leeson to be in charge of both the dealing desk and control over the back office operations that enabled him to manipulate the accounts of the bank. This case illustrates how a person who knows the victim is often the perpetrator of fraud. Leeson was an employee at Barings bank and this gave him the opportunity to commit fraud. Fraud is facilitated by three elements, which make up the Fraud Triangle. They include opportunity, motive (or pressure) and rationalization. Opportunity is the ability to commit fraud. The most common opportunity providing factor is the lack of adequate controls for monitoring employee behaviour. More often, fraudsters exploit their responsibilities to defraud their victims. As witnessed in the Madoff scandal, Madoff and his trusted employees colluded to manipulate accounts of their customers. Firms that are able to build processes, procedures and controls that do not place employees in a position to commit fraud and that effectively detect fraudulent activity if it takes place can effectively prevent occurrence of fraud. Motive/pressure is the need for committing fraud. The Enron executives were compelled to commit fraud by the pressure mounted on them by failed investment so they colluded to hide financial transactions that were making loses. Rationalization is the psychological justification of fraud. In order to deter fraud firms ought to break the fraud triangle. Proper and adequate internal controls can help in breaking the fraud triangle by removing the opportunity. However, collusion among executives may be able to perpetrate fraud even where proper internal structures exist. Thus, creation of an environment which endorses a ‘good ethics is good business’ philosophy encourages people within an organization to do the right thing at every turn and makes perpetration of fraud an unattractive option to most players in the firm. The Fraud Act 2006 and the National Fraud Authority (NFA) helps the UK government to detect and fight fraud in various fields. Reference Blackwell, C. (2009). The insider threat: Combatting the enemy within. New York: IT Governance Ltd Brytting, T., Minogue, R., Morino, V. (2011). The anatomy of fraud and corruption: Organizational causes and remedies. London: Gower Publishing, Ltd. Dowland, P. (2005). Security management, integrity, and internal control in information systems: IFIP TC-11 WG 11.1 & WG 11.5 Joint Working Conference. London: Birkhäuser Ec-Council. (2009). Ethical hacking and countermeasures: Attack phases. London: Cengage Learning. Jakobsson, M., & Myers, S. (2006). 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