Countering Fraud for Competitive Advantage - The Professional Approach to Reducing the Last Great Hidden Cost

2

The Fraud Problem

2.1 INTRODUCTION

In most organisations the fraud problem is under-estimated because senior managers confuse detected levels of fraud with the real level of fraud, and detected levels are often very low or even zero. This chapter will seek to dispel this myth. It will begin by illustrating the fraud iceberg which shows the detected levels of fraud as the small tip above the surface, but with the substantial undetected frauds below the surface. The chapter will then shock the reader with the wide variety of ways fraud can occur in an organisation. The amount of fraud an organisation can expect to suffer from will then be examined. It will show a loss rate of around 5 per cent to be normal, with much higher rates also possible. A brief analysis of recent trends in fraud will be undertaken to highlight the increasing risk. Finally the chapter will consider the impact of fraud and show that the effect upon an organisation is more than financial.

2.2 THE FRAUD PROBLEM

A very common view amongst many senior employees in organisations is that ‘there is no fraud in my patch’. This view is largely driven by the line of thought that if there is no detected fraud, then there can't be any fraud. When the authors discuss their and others' research with senior managers, which suggests levels of fraud around 5 per cent as average, they often just look bemused and cannot comprehend that their organisation could suffer such losses from fraud.

What these and many managers are doing is mistaking detected fraud for the true measure of fraud. Detected fraud, however, is the tip of the iceberg. Many frauds are never detected and many go undetected for a long time (some forever). Indeed the Association of Certified Fraud Examiners (ACFE) estimates that the median length of time internal frauds last before being detected is 18 months.1 Some actions are also disputed as to whether they are fraud, but may well come close to it. By its very nature most fraud is invisible with the malefactor determined to hide all traces of it. Thus what will be the real situation in most organisations is a tiny number of detected frauds and a substantially larger number of undetected frauds, as the pyramid in Figure 2.1 illustrates.

2.2.1 What is Fraud?

Fraud encompasses a wide range of behaviours. What unites most definitions is the act of deception to perpetrate the crime; as Wells argues, fraud is ‘any crime which uses deception as its principal modus operandi’.2 Legally there is also the distinction between civil and criminal definitions. The starting point for civil law definitions of fraud in England and Wales is the case of Derry v Peek (1889) (UK House of Lords). Here, Lord Herschell, giving judgement on the case, defined ‘fraud’ to include a false statement ‘made knowingly, or without belief in its truth, or recklessly, careless whether it be true or false’. This definition covers a number of possibilities, ranging from:

• where a person admits knowledge that a statement is untrue; through to …
• where it can be demonstrated from evidence that they knew the statement to be untrue (even if this is not admitted); through to…
• where it can be demonstrated from evidence that they did not care whether the statement was true or untrue – or in other words, that they knew it was possible that the statement might be untrue.

In 2005 the Swiss Institute of Comparative Law provided the following definition, which broadly follows the English law:

Civil fraud is the use or presentation of false, incorrect or incomplete statements and/or documents, or the non-disclosure of information in violation of a legally enforceable obligation to disclose, having as its effect the misappropriation or wrongful retention of funds or property of others, or their misuse for purposes other than those specified.3

In England and Wales the criminal definition of fraud has been codified with the passage of the Fraud Act 2006.4 There are a huge number of advantages this new law brings and there is much to debate about the use of it. As this book is aimed at an international audience, only the main provisions of it will be outlined. Those interested in it further should review Farrell et al.'s book.5 This sets out a number of ways in which fraud can be committed:

• Fraud by False Representation (this could cover the submission of false over-time sheets or a false invoice for services by a person).
• Fraud by Failing to Disclose Information (this could be a where a person is paid for 40 hours per week, but in fact only works 30 and fails to disclose this, or a prospective employee is asked for certain information on the application form but doesn't provide it).
• Fraud by Abuse of Position (this is where a person in a position of trust abuses their position, such as an accountant diverting funds to their own personal account).

The legislation also set out a series of other offences such as:

• Possession of articles for use in frauds and making or supplying articles for use in frauds (this is very wide ranging and could include catching someone at home with a paper or electronic copy of a false invoice which could be submitted to a company).
• Participating in a fraudulent business (this could be a car dealership founded on enhancing the value of cars by turning back the mileage clocks).
• Obtaining services dishonestly (this could be securing an insurance policy by providing false or inaccurate information).

In addition to this the old common law offence of conspiracy to defraud was maintained, which gives wide scope to the potential behaviours when two or more are acting together. Various fraud-related offences in sectors/activities were also maintained in social security, elections, forgery and counterfeiting, false accounting, insider dealing, etc.

It is also common to link fraud with corruption. Corruption is also very broad, covering a wide range of behaviours. The Asian Development Bank defines corruption as:

… behaviour on the part of officials in the public and private sectors, in which they improperly and unlawfully enrich themselves and/or those close to them, or induce others to do so, by misusing the position in which they are placed.6

Central to corruption is bribery, where a person covertly pays someone in a position of power to act in a particular way, where such payments are not allowed. Clearly there are elements of fraud where a person in a position of responsibility abuses that position by accepting a bribe. Thus many examples of occupational fraud where an employee is involved can also be seen as corruption. But the person paying the bribe may not be committing a fraud. There are also many frauds committed which do not involve the abuse of a position of responsibility, such as an external person submitting false invoices to a company to be paid. It is important to note that this book is focused upon fraud, but that clearly because of the overlap (see Figure 2.2) corruption is considered as well. It is not the intention, however, to become deeply involved in the different aspects of corruption.

It would now seem appropriate after this brief legal description of fraud to consider the huge variety of fraud, by illustrating some of the many diverse types.

2.2.2 Types of Fraud

Senior managers in organisations therefore need to be aware that there are numerous ways employees, contractors, suppliers, clients, etc. can defraud their organisation if they do not have an appropriate counter-fraud strategy in place. Fraudsters are often very creative and there is a risk in virtually every aspect of a business. To illustrate this we will now identify 43 ways that fraud can occur in an organisation. This list is by no means exhaustive.