This post was updated as of August 2, 2022.
With all of the responsibilities that come with owning and operating a successful manufacturing business, fraud detection and prevention may not make the list of high-level priorities. Business owners may not even acknowledge the potential threat of fraud, especially when key positions are filled with long-time, trusted employees. Yet survey data tells us that persons with a deep knowledge of the business, a high level of responsibility, and the ability to operate with limited supervision are precisely the ones who are most susceptible to criminal activity.
Fraud is a surprisingly big issue. According to the Association of Certified Fraud Examiners (ACFE), organizations lose up to 5% of their total revenue to fraud. Common schemes include:
Accepting cash from a customer but not recording the sale.
Creating a shell company and invoicing the company for fictitious goods or services.
Stealing company checks and making them out to self or stealing outgoing vendor checks and depositing them in one’s own bank account.
Adding ghost employees and paying them wages or claiming overtime that was never worked.
Stealing inventory or confidential data and converting them to cash.
Engaging in bribery or extortion, taking kickbacks, or concealing conflicts of interest with vendors.
Financial Statement Fraud
Reporting non-existent revenue, accelerating revenue recognition, or manipulating judgment accruals.
Most fraud goes undetected. Of reported instances, the ACFE reports median losses equal to $117,000 and average losses equal to $1,783,000, with the underlying behaviors in effect for 12 months before detection.
Beyond direct financial loss, fraud damages the company’s reputation. It may hinder its ability to attract and retain business partners, customers, and employees. It could cause the company to breach banking covenants or expose it to regulatory costs, legal fines, and sanctions. It could threaten the company’s ability to maintain its competitive advantage.
Regrettably, the overwhelming majority of companies don’t get around to instituting effective anti-fraud controls until after they’ve been burned by their absence.
Risk Factors for Fraud
The fraud triangle identifies three broad categories of risk that set the stage for fraud.
Opportunity knocks in environments characterized by weak operating and/or financial controls. Astute employees identify gaps and exploit them. Organizations with reduced headcount are particularly vulnerable as they are less likely to segregate duties with the associated procedural checks and balances.
Incentive and/or pressure may push employees to commit fraud. Unrealistic performance expectations and/or financial reward structures could induce employees to find creative ways to “cook the books,” making the business look more profitable, report higher growth, or produce more attractive financial ratios. Individual pressure could stem from unwieldy credit card debt, difficulty maintaining social status in a tight market, or cash-consuming vices (e.g., gambling, substance abuse).
Rationalization enables perpetrators to justify their actions. They may steal from the company to compensate for feeling overworked, underpaid, and underappreciated. In the wake of layoffs, they may feel the need to bolster personal income to shield their families from looming unemployment. Or they may simply let themselves off the hook because “everyone does it.”
Occupational frauds are most committed by operations (15%), accounting (12%), upper management (11%), and sales (11%).
How to Prevent and Detect Fraud
Fraud prevention starts with a management team committed to a culture of honesty and integrity. They institute a formal code of conduct with a strong, unfailingly enforced policy on fraud. An active training program ensures employees understand fraud, its impact on the company, and the seriousness with which management takes the matter. Employees should have ready access to resources should they have questions as well as a whistleblower hotline through which they can report questionable activity anonymously. In 2020, email and web-based hotlines surpassed telephone hotlines as the most commonly used reporting mechanisms used by whistleblowers.
Management also prevents fraud by establishing a positive and productive work environment. Reasonable performance expectations and incentive programs ease the temptation to game the system. Staffing key departments with the right skill sets and headcount allows for a segregation of duties and appropriate checks and balances for operational and transactional control. Regular employee reviews set expectations for performance and create the means by which poor performers are either rehabilitated or terminated. Finally, management demonstrates they are deeply invested, involved, and interested in the company’s financial affairs, business processes, and employee opinions and contributions.
Corporate culture and managerial activism should be buttressed by the following activities:
- A fraud risk assessment to identify exposures and provide recommendations to mitigate them.
- A properly designed system of internal controls that includes: physical security of assets and records; authorizations for disbursements, journal entries, new vendors, new hires; timely account reconciliation and review; segregation of duties; cross-training with mandatory vacations; surprise audits.
- Periodic review of the payroll register to tie employee profiles to real people whose compensation aligns with their positions/responsibilities.
- A careful review of financial statements with a particular focus on the underlying revenue recognition, credit memos, accruals, and budget-to-actual comparisons.
- High-level oversight by the Board of Directors and/or Audit Committee.
- Zero tolerance for fraud combined with swift action toward its perpetrators.
While fraud may not be the brightest blip on the company radar, the consequences of ignoring this potential threat can be grave. Fortunately, experts in the field can put structures and processes in place to mitigate the risk with minimal impact on day-to-day performance.
Meet the Author
Kellan Davis, CPA
Aldrich CPAs + Advisors LLP
Kellan has over five years of experience with national and regional public accounting firms working in a variety of industries including manufacturing, construction, software, lending, retail, telecommunications, nonprofit and benefits plans. He now actively serves his clients as a member of Aldrich Manufacturing and Distribution group and specializes in revenue recognition. Kellan is originally from... Read more Kellan Davis, CPA
- Revenue recognition
- Certified Public Accountant
- Lease accounting