What is Fraud? Definition, Types, Reasons, and Managing

Definition:

Fraud is the intentional activity to gain personal benefit directly or indirectly illegally, against organization or entity policy. It is ultimately different from error and corruption. An elementary example of fraud is that the accounting staff pay salary to fake employee’s account that creates by himself is also called fraud.

In such a case, accounting staff intentionally creates the employee’s name and bank account order to make payment and then get a direct benefit from it.

It happens in various forms and differently from time to time based on the situation and opportunity that the fraudster has, and It also based on the subject matter.

Fraud is one of the highest expenses in the organization that could lead to bankruptcy, and having strong control should be one of the most important tasks to be done by leaders in the organization.

This article will discuss the most important part of the fraud, including types, reasons why it happens, and the presentation program.

Types of Fraud

Fraud is classed into two different main types,

Misappropriation of Company Assets

Misappropriation of company assets is a kind of fraud mostly committed at the staff level by stealing a company’s assets, such as cash, inventories, care, or other support for personal use or sale.

Such fraud could be prevented by setting up solid internal control, segregation of duty, or job rotation. Creating the fake customer’s name or account in order to get the commission, creating the counterfeit suppliers’ funds, or making payment to the fake supplier is also the common type of misappropriation of assets. We will talk about its prevention in detail in this article.

Fraud over Financial Reporting

Fraud Over the Financial Statements is done by management manipulating the financial statements’ financial figures. This type of fraud is committed at the management level.

There are many ways that management could manipulate the figure in the Financial Statements. For example, management could improve the Net Profit for the year by decreasing depreciation expenses through depreciation policies. Typically, deprecation policies are decided by the administration, and yes, they could affect the net profit by this.

Preparing the Financial Statements is significantly affected by many assumptions and judgments made by management. Somehow, management could help them make sure the Financial Statements look like they want to be.

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Another example of how management could commit it through Financial Statements is revenue recognition. The management team will be awarded the bonus if the revenue reach target says USD100,000,000 at the end of the year, 31 December 2016.

Right now, on 25 December 2016, and the sale revenue is USD98,000,000. See, by this figure, management has almost reached its target.

In such a case, management could manipulate the sale revenue that does not exist to make sure the sale revenue reaches 100M. Then they take the bonus.

Here is how,

Let say that management knows that in January 2017, there will be a big contract with new customers. They then sign the contract with customers and recognize part of the revenue in 2017 as the revenue in 2016 through manipulation of accounting treatments. In this case, if external and internal audits could find or figure out any error in revenue recognition, management could get their bonus quickly.

This is how frauds happen through Financial Statements; however, it is just a simple example. There are many types and ways to manipulate the financial figure in actual practice, especially when management has the incentive to do it.

Why does Fraud Happen?

Many factors lead to fraud, but here are the three common reasons that cause fraud to the organization, and also they are also the three factors that we need to assess whether it could happen.

Inventive and Pressure

Employees in the organization have come from many different backgrounds, live style, and living conditions. The study found that if the employees face financial pressure, they need a lot of money to pay for car rental or home. Then they will find a way to obtain another source of finance by borrowing from a bank, company, or sometimes they think about committing fraud in the company if they could. Don’t be confused with opportunity. They are different.

When people face financial pressure, they will find solutions and among the best solution, fraud could be one of them. This is how it starts.

Opportunity

Usually, the opportunity is the main factor that leads to fraud, and it results from the leak of internal control over those opportunities.

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Let say. The employee is responsible for purchasing and making payments to suppliers while no one controls them. See the opportunity here?

The fraud could happen by employees paying suppliers for those goods or products that the company does not receive; in the state, it could be done by employees themselves.  

Another example is that sales staff could access that warehouse, and no one controlled or checked him whenever he took the goods in the warehouse.

By leaking internal control, the employee could see the opportunity to bring the goods outside and sell for himself. Opportunity typically happens when there is weak internal control and trust in people who link with finance pressure. When employees have financial pressure and see possibilities, fraud could have happened.

Rationalization

The fraud might happen when the employee or management team thinks they get less than they should. For example, this year’s company gains a lot of profit, but the management salary and bonus are pretty small.

In such a case, it could lead them to think about any way to get some more benefit. Rationalization is sometimes linked to financial pressure and opportunity.

For example, a cashier works a very long time with the company, and the company never has any experience with her about the cash she controls.

She has some financial pressure, and she noted that she could make money for a while to solve her financial problem, and then she will take it without authorization. If the auditor finds the situation, she proves that she borrowed the money and returned it. So, fraud is happened because of these three reasons: Inventive or Pressure, Opportunity, and finally, rationalization.

Managing Fraud in Your Company

Employee Due Diligence

This is the important point to do, and it normally does at recruitment. The company has to set proper recruitment policies and procedures to ensure that all-important information about employees is obtained and the background is checked. Doing this company could minimize the risk of hiring an employee whose fraud was ever committed.

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Mandatory Job Vacation

This is one of the most recommended procedures that the company should have to manage fraud, especially for high-risk positions. Those positions include payments, correction, purchasing, and sales. Sale says the correction officer is a vacation for three weeks and replace the new one and let see if the new one found and problem made by the old. These policies are mandatory and should not have any exceptions.

Setting up Internal Audit or “Fraud Department”

Setting up the internal audit department or fraud department is one type of fraud risk management by the Board of Directors. Now it is globally aware and accepted word wild as an effective strategy. For effective use of internal audit, internal audit must be disconnected from the operation and under supervision by the audit committee or Board. For a small company, the management and owner are the same.

No matter what it is, the audit department must be under the owner’s control.

Build the Culture of Honesty and Integrity

This is an important part of fraud risk management and is morally done by top management by showing a sense of honesty and integrity. Management should show honesty to its staff and then make it become culture and core value.

Whistle-blowing Policies

Well, whistle-blowing policies are morally set when the Board of Directors wants to promote Honesty and Integrity in the company. This is also set when the Board believes that staff might know it has happened in the company, but they are afraid to disclose it to management.

The whistle-blowing concept allows staff to report the fraud to top management, usually the audit committee or Board. The report could be done by email, phone, or mailbox.

Setting up Sound Strong Internal Control

The company should set up sound string internal control, for example, segregation of duty, physical control. Segregation of duty; for example, one person should not control the whole process. One person is responsible for purchasing, receiving goods, and paying suppliers. The security camera should be set at the warehouse, cashiers, or another sensitive place.