What is Financial fraud and How to prevent it

We are back with another very different topic today. It is ‘what and how to prevent financial fraud in the business’. We, as owners of a business, should always analyze and inspect our books and financial statements of the company.

Fraud is an intentional act involving the use of deception to obtain an illegal or unjust advantage. It is as a criminal offense whereas, it can be punishable by a fine or imprisonment.

Error and fraud are 02 different subjects. Errors are unintentional mistakes, while fraud is intentional with a clear motive.

Financial Fraud is the use of deception to obtain an illegal financial advantage and deliberate misrepresentations of financial statements.

03 prerequisites are required for fraud to occur

Dishonesty: relates to the lack of honesty and integrity. An honest employee will never commit fraud.
Opportunity: the individual should have a chance for fraud to be committed. These opportunities arise due to weak internal inspection and control.
Motivation: The interests of committing the fraud while the individual feeling that the rewards earned by the fraud are more significant than costs if caught.

These are the 03 main factors. They are required for an employee to commit financial fraud.

These are the factors that might indicate that fraud is taking place in the business.

Lack of monitoring of control systems- Controls has to be monitored regularly
One person in charge of management- dominant individuals find it easy to deceive
Employees who do not take holidays- staff members are unwilling to pass their duties to other members in case they find what they are up to.
Unusual transactions- cash transfers to certain unknown bank accounts
Poor staff morale- if the staff doesn’t like to work in a particular company, it may give them additional motivation to commit fraud
Complex corporate structure- this makes it harder to identify fraud. In other words, it is easy for the employees to hide the fraud.

If a proper internal control system is established within the business, there is less risk of fraud committed in the business.

Examples of financial fraud in business organizations

By studying the examples of financial fraud, you will be able to understand the risk that such frauds may occur in your business, helping you respond and react properly to the particular threat.

Management and employees of the business carries out fraud in the business organization.

Frauds by management

Financial statement fraud. E.g., cooking the books
Using company assets for personal use. E.g., using company assets as collateral for a personal loan
False insurance claims. E.g., a manager may steal a high valued computer and claim it stolen. The company claims the insurance to remedy its loss.
Misappropriation of assets. E.g., managers may steal inventory and adjust the accounts, or they may sell intellectual property to a competitor.

Frauds by employees

Payroll fraud- a fake employee, is added to the payroll and to pay their monthly salary into the bank account of the fraudster.
Purchase ledger fraud- a fake purchase invoice can be added to the purchase ledger records with the cash being paid to a bank account set up by the fraudster.
Sales ledger fraud- stealing the cheques received and then writing the sale as a bad debt in the sales ledger.
Skimming schemes- the fraudster steals small amounts from a large number of transactions, as no one will check the missing small amounts.

Fraudulent financial reporting

Intentional misstatements in financial statements to deceive financial statement users of the business are fraudulent financial reporting.

These are also normally known as ‘cooking the books‘, ‘creative accounting’ and ‘earnings management’. These schemes may or may not comply with accounting standards.

Examples of creative accounting

Window dressing – window dressing involves misrepresentation of information, such as entering into of transactions before the year that is often reversed out after the year-end such as sales in the financial statements.
Delaying or accelerating a company’s expenses – showing an expense as an asset on the balance sheet than writing off it against profits is a way to improve the reported profits.If the company pays a bonus if the following year profits are high, you will write off many expenses this year, thus improving next years reported profit.

Manipulation of revenue recognition- when companies engage in long term contracts, they are supposed to recognize the revenue from the contract on a reasonable basis as the contract is fulfilled. It would be fraudulent to recognize all the revenue in the first year of the contract and none in the subsequent years.
Off-balance sheet accounting- exclusion of certain assets and liabilities from the balance sheets which misleads the shareholders about the organization’s financial obligations.

The Implications of fraud to the company

The collapse of the company
Loss of assets
Financial difficulties
Loss of shareholders and potential shareholders confidence
Fines

Measures to detect and prevent financial fraud

As I mentioned above, the principal strategy to detect and prevent fraud is through establishing a proper and effective internal control system. Internal control comprises these factors.

Controlling the environment
Identification of risks
Information management system
Controlling of activities
Monitoring the controls

The duties of management in preventing and detecting fraud

The Management consists of Board of Directors, Audit commitee and Employees.

The duties of the board of directors- to maintain a sound system of internal control and to report to the shareholders. The directors are the members who are mainly responsible for detecting and preventing financial fraud in the company.

The duties of the audit committee- to monitor and review internal control and risk management systems. They should also be responsible for detecting and preventing financial fraud.

The duties of employees generally- The employees of the company are given the roles and duties in the induction. They are responsible for working honestly and for reporting suspicious activities to prevent fraud.