Fraud Risk – External fraud and small business

This is the third and final segment in my three part series on fraud risk.  My first post on 7/19/2011 discussed the fraud triangle and the three elements that must be present for fraud to occur in any organization.  My second post on 8/22/2011 discussed a few ways in which employees steal from their employers.   This post focuses on external fraud risk which is perpetrated by people within a company with the intent to deceive an outside party or, that is perpetrated by outsiders who are hoping to deceive you.  It’s a huge topic so I have  only touched on some of the types of external fraud that every business owner should be aware of.  The purpose of this article is to give you some tips on what to look for.

According to the Credit Research Foundation (CRF) and the Association for Certified Fraud Examiners (ACFE), small businesses are more vulnerable to fraud than large businesses.  This is simply because small businesses usually do not have the policies, procedures and financial controls in place that most big companies do to prevent, or at least mitigate the fraud risk.  Nor do they typically have  the inclination to invest in fraud prevention because of the perceived cost.  This is really false economy because whatever costs would be incurred would pale in comparison to even a modest fraud against a company

The essential  characteristic of fraud is the intent to deceive.  In my last article on fraud risk I discussed how  employees may attempt to deceive their employers.  But, some business people may also attempt to  deceive others outside the company or, conversely, others outside the company  may attempt to deceive you – count on it.   Here is a partial list of categories of external fraud.  Below the list is a description of a few of  them.

  • Corporate  espionage
  • Investment  schemes
  • Pyramid  or Ponzi schemes
  • Securities  fraud
  • Insurance  fraud
  • Bankruptcy  fraud
  • Bribes and kickbacks
  • Financial  statement fraud
  • Money  laundering

Corporate espionage involves the theft of a company’s  intellectual property or secret information.   Such information may include; client lists, strategic  plans, pricing plans, marketing data, confidential financial information, software  code, personnel data, etc. that is critical to the success of a company.

Kickbacks are a common corruption scheme. The scheme  requires someone on the inside to participate in the fraud along with a vendor.   The kickback occurs when a company  overpays for goods and services and the vendor gives part or all of that  overpayment to the perpetrator.  It is  often not difficult for a purchasing agent of a company to engage in a kickback  scheme which is why it is so important for a company to put good controls in  place.  Anyone who has the authority to  award contracts or purchase products or services on behalf of the company is a  risk for engaging in a kickback scheme. Even those who have the power to  influence purchasing decisions represent a risk

Financial statement fraud may be the most  prevalent crime.  The most common way  that financial statement fraud is carried out is through revenue overstatement.   Here are few ways this can be done:

  • Book  fictitious sales
  • Recognize  legitimate sales early
  • Ship  items not ordered by customers and book the “sales”
  • Book  revenue before it has been earned on projects in progress
  • Record  sales for items produced but not yet shipped or only partially shipped
  • Book  sales but delay shipment to customers
  • Don’t  properly record allowances for returned goods

Other fraudulent ways  to make the books look better than they really are include, but are not limited  to:

  • Overstating  assets
  • Understating  liabilities and expenses
  • Manipulating  reserves
  • Misrepresenting  or omitting information
  • Improperly  recording information related to acquisitions or mergers
  • Falsifying  earnings and cash flow

Keep in mind that all  the above are really just a sample of fraudulent activities.

Here are a few ‘real life’ examples of how frauds are perpetrated. . .

  1. A  business owner seeking to get money from an outside party may alter financial  records to make past performance look better than it really was
  2. Phony  trade and bank references may be used to obtain a loan or line of credit that is  not intended to be repaid
  3. Financial  records may be altered to reduce tax payments
  4. Merchandise  is intentionally ordered on a credit basis from a company that has lax (or no)  controls for validating the credit worthiness of a new client and/or has lax  (or no) procedures for monitoring and controlling previously approved credit terms and limits
  5. A  good customer with a good credit relationship with a seller or bank suddenly  finds himself in a desperate situation or sees an opportunity to take advantage  of the seller’s (or bank’s) loose financial controls.  A bank I am familiar with was the victim of a
    multi-million dollar mortgage fraud that was possible because they grew  complacent with a long-time “good” client
  6. Orders  may be received from someone claiming to be an affiliate of an existing  customer to get special pricing, payment terms or other consideration when, in  fact, there is no relationship
  7. Merchandise  is ordered on COD.  The buyer pays with a  phony certified or cashier’s check.  By  the time the check bounces the thief is gone.

Fraud risk can be found in  every industry and every type of business.   It is all too easy for un-suspecting business people to be duped by  outsiders or even by trusted employees within their own organization.    As a  perpetrator, the legal and financial penalties are severe.  For those who have been cheated, the losses  can be catastrophic.  Worse, in almost  every case, losses from fraud could have been  prevented if the right policies,  procedures and financial controls had been in place.  As an experienced CFO and partner at B2B CFO®
I can help you make that happen.


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