According to the 2022 Report to the Nations on Occupational Fraud, there are 3 primary types of corporate frauds:
Table of Contents
Misappropriation is the most common type of fraud, accounting for 86% of all cases. These schemes typically involve an employee stealing or misusing the employer’s resources, and tend to cause the lowest median loss at just US$100,000 per case. Despite this, asset misappropriation remains a serious problem for businesses of all sizes. As such, it is important for businesses to have strong internal controls in place to prevent and detect asset misappropriation.
Corruption, which includes offenses such as bribery, conflicts of interest, and extortion, falls in the middle in terms of both frequency and losses. These schemes occur in 50% of cases and cause a median loss of US$150,000.While corruption schemes may not be as common as asset misappropriation or financial statement fraud, they can still have a significant impact on an organization. Corruption can be difficult to detect and can often go undetected for years.
Financial Statement Fraud
Financial statement fraud schemes are among the costliest(US$ 593,000) and least common (9% of schemes) types of fraud. In these schemes, the perpetrator intentionally causes a material misstatement or omission in the organization’s financial statements. This can have a significant impact on the financial health of the organization and can lead to losses of hundreds of thousands of dollars.
Types of frauds
The chart below provides a detailed break-up of the categories of fraud:
This list of common fraud scenarios can aid internal auditors and others tasked with conducting a fraud risk assessment in evaluating the effectiveness of internal controls over financial reporting.
A useful method for demonstrating the use of control activities in fraud prevention is to examine common fraud scenarios that cut across different industries. The following paragraphs contain examples of various types of fraud and how they can be carried out.
Fraud schemes and scenarios can be found across industries, but the methods used to perpetrate them may vary. The following paragraphs detail definitions and examples of specific fraud scenarios. To use these scenarios, follow these steps:
- Identify relevant scenarios that could materially impact the financial statements.
- For each identified scenario, describe how it would be perpetrated, who would be involved, and which financial statement accounts would be affected.
- Based on the scenarios, identify the controls that would prevent, deter, or detect each one.
- Compare the documented controls to the controls in place, and identify any gaps.
- Develop action plans to address significant gaps.
Here is the detailed explanation of each fraud scenario in alphabetical order:
Asset Misappropriation – Fraudulent Disbursements
When an employee intentionally misuses company funds for personal gain, it is known as a fraudulent disbursement scheme. Some examples of fraudulent disbursements include forging company cheques, submitting false invoices, and altering attendance records.
Billing schemes are a common form of employee fraud because they can offer significant financial gain. Since most businesses make a large number of payments in the purchasing cycle, it is easier to conceal larger thefts through false-billing schemes than through other types of fraudulent disbursements. There are three primary types of billing schemes: false invoicing through shell companies, false invoicing through non-accomplice vendors, and personal purchases made with company funds.
There are two main categories of bribery schemes: kickbacks and bid-rigging. Kickbacks are payments made by vendors to employees of purchasing companies without disclosure. They are typically intended to involve the corrupt employee in an over-billing scheme or to secure extra business from the purchasing company. Bid-rigging schemes, on the other hand, occur when an employee assists a vendor in winning a contract through the competitive bidding process. This fraudulent assistance gives the vendor an unfair advantage over other competitors.
Collusion can be a key factor in perpetrating fraud; for example, a supervisor knowingly authorizes false attendance information on behalf of an employee. This can occur when a supervisor signs off on fraudulent timecards, and the employee shares the overpaid wages with the supervisor. In some cases, the supervisor may take the entire overpayment. Because supervisors are often relied upon as a control for proper timekeeping, it can be particularly challenging to detect payroll fraud in such cases.
Concealment – Fictitious Sales and Accounts Receivable
This scheme involves making adjusting entries to perpetual inventory and cost of sales accounts without corresponding sales transactions recorded in the books. To conceal this problem, a perpetrator may create fictitious sales by debiting accounts receivable and crediting the sales account to make it seem like missing goods have been sold.
Concealment – Inventory and Asset Write-Offs
Employees may use the write-off of inventory and other assets as a means to conceal theft of those items. This method allows them to remove the assets from the books and eliminates the problem of inventory shrinkage that is common in cases of non-cash asset misappropriation.
Concealment – Physical Padding
While many methods of concealing theft involve altering inventory records, some employees attempt to make it appear as though more assets are present in the warehouse or stockroom than there actually are. This is known as physical padding, and it can involve stacking empty boxes on shelves to create the illusion of extra inventory.
Conflicts of Interest
A conflict of interest arises when an employee, agent, or fiduciary is in a position to serve their own interests rather than the interests of the organization they represent. For instance, a CFO who creates an off-balance sheet entity and then transacts business with it for personal gain. Such scenarios undermine the internal control system because independent parties are not dealing at arm’s length with each other. To waive the conflicts of interest provision of the code of ethics, board approval is required, and disclosure must be made.
One form of employee fraud is embezzlement, which involves the misappropriation of property belonging to someone else for the benefit of the perpetrator. This can include stealing physical assets, diverting funds, or manipulating financial records to cover up the theft.
Earnings management refers to the questionable practices that management may engage in to meet or exceed analyst expectations. This may include techniques such as “big bath” restructuring charges, manipulating acquisition accounting, creating “cookie jar reserves,” making “immaterial” accounting errors, and recognizing revenue prematurely. The desire to aggressively apply accounting principles, always be at the “edge,” and use “soft” methods that allow for significant estimates in the financial reporting process can contribute to an environment that compromises the quality of earnings and encourages earnings management.
Financial Statement Fraud
Financial statement fraud occurs when an entity’s financial statements are intentionally misstated or manipulated, with the aim of deceiving investors or creditors. This can involve either overstating revenue and revenue-related assets, or understating costs or expenses and their related liabilities, in violation of Accounting Standards. The use of false and misleading financial information through manipulation, deception, or contrivance is at the core of financial statement fraud.
Forgery is a method in which an employee falsifies a document by either forging the signature or initials of the authorized approver. Forgery can also occur in the approval of purchase orders. In this case, an employee may forge the signature of an authorized approver on a purchase order, authorizing the expenditure of company funds for goods or services that were never actually purchased. The fraudulent purchase order is then processed, and a payment is made to the vendor, who may be an accomplice in the scheme or completely unaware of the fraud. The forgery allows the employee to bypass the internal controls designed to prevent unauthorized spending and obtain the funds for personal use or to benefit an external party.
Fraudulent Journal Entries
One common form of financial statement fraud involves the use of fraudulent journal entries, which represents a type of management override of the internal control structure.
Fraudulent journal entries are entries that are made to manipulate an organization’s financial records for fraudulent purposes. Some indicators of such entries include:
- entries made to unusual or seldom-used accounts that are unrelated to the business;
- entries made by individuals who do not typically make journal entries;
- entries made with little or no support;
- entries made at the end of a period such as quarter or year-end that might be reversed in a subsequent period;
- entries that involve round numbers; and/or
- entries that affect earnings.
Some examples of fraudulent journal entries include entries that conceal fund diversion, improper reversals of reserve accounts, the use of intercompany accounts to hide expenses, and the capitalization of costs that should be expensed.
Ghost employees are individuals who are listed on a company’s payroll but do not actually work for the company. These individuals may be fictitious, or they may be real individuals who are not employed by the company. In order to create a ghost employee, a fraudster may falsify personnel or payroll records, causing paychecks to be generated for the ghost. The fraudster or an accomplice can then convert these paychecks for personal gain. Real individuals who are listed as ghost employees are often friends or relatives of the perpetrator. This type of fraud can be difficult to detect, particularly if the fraudster has access to the payroll or personnel records and can cover their tracks.
Improper Revenue Recognition
Improper revenue recognition occurs when companies manipulate the recognition of revenue to enhance their financial results. This can involve recognizing revenue before a sale is complete, before the product is delivered, or at a time when the customer has the option to terminate, void, or delay the sale. Examples of improper revenue recognition include recording sales to nonexistent customers, recording fictitious sales to legitimate customers, altering contract dates and shipping documents, entering into “bill and hold” transactions, and channel stuffing. Companies may also engage in other practices such as holding the books open until after shipment to record a sale in a desired period or entering into side agreements to artificially inflate revenue.
Kiting involves opening accounts in two separate financial institutions and writing checks between them to artificially inflate the balance of one or both accounts. The checks are not backed by sufficient funds and are typically deposited on the same day, before the checks have time to clear. The proceeds of the fraudulent deposits are then used for personal benefit. Eventually, the financial institutions involved will detect the fraud and take steps to stop it.
Lapping is a method commonly used by employees who skim receivables to conceal their actions. It involves the crediting of one account by using money from another account. This technique is also known as “robbing Peter to pay Paul.”
To classify instances of asset misappropriation, the term larceny is used to describe the act of feloniously stealing, taking, carrying, leading, riding, or driving away another person’s personal property with the intent to convert it or deprive the owner of it. In the context of inventory theft, larceny refers to the most basic type of theft, where an employee takes inventory from company premises without attempting to conceal the theft in the books and records. This is referred to as “Non-Cash Larceny”. In other cases of fraud, employees may engage in false documentation to justify the shipment of merchandise or tamper with inventory records to conceal missing assets.
Misapplication is a distinct offense that often occurs alongside embezzlement. It involves the wrongful conversion or taking of someone else’s property for the benefit of another person.
Money laundering is a process used to conceal the illegal origins of money or assets obtained through unlawful means, such as drug trafficking, fraud, or embezzlement. This is typically done through a series of financial transactions that make the funds appear to come from a legitimate source. One common method of money laundering is the use of offshore accounts to hide the true ownership and location of the funds. The ultimate goal of money laundering is to make the illegally obtained funds usable in a legitimate context, such as to make purchases or investments without raising suspicion.
Overstatement of Assets
Assets can be overstated through various means, such as manipulating inventory valuation, falsifying accounts receivable, inflating business combinations, and improperly accounting for fixed assets. In the case of inventory, this can involve failing to write down obsolete inventory, manipulating physical inventory counts, recording “bill and hold” transactions as sales and including them in inventory. Fictitious receivables and failure to write off bad debts can lead to overstatement of accounts receivable. Excessive merger reserves can be set up and taken into income to inflate the value of business combinations. Lastly, fixed assets can be overstated by capitalizing costs that should be expensed or booking an asset even if the related equipment is leased.
Payroll schemes involve the fraudulent disbursement of funds by an employee to themselves or another individual. These schemes are similar to billing schemes in that they both involve the creation of false documents to deceive the victim company. However, in payroll schemes, the perpetrator typically falsifies a timecard or alters information in the payroll records to cause an improper disbursement to an employee. The most common types of payroll schemes include ghost employee schemes, where a false employee is added to the payroll and their paycheck is diverted to the perpetrator, falsified hours and salary schemes, where an employee manipulates their hours or salary to receive more pay, and commission schemes, where an employee falsifies sales or commission data to receive an improper payment.
Round Trip or “Wash” Trades
Round Trip or “Wash” Trades are a type of transaction in which an investor simultaneously buys and sells an asset with the same counter-party at the same price, volume, and term. The purpose of these trades is often to create the appearance of activity or to generate fees for the broker or financial institution facilitating the trades, rather than to make a profit for the investor. Since the trades result in neither profit nor loss, they are sometimes referred to as “wash” trades. These types of transactions are generally illegal and can be used for money laundering or other illicit purposes.
Insider trading and market manipulation are two types of securities fraud that can occur in financial markets.
Insider trading is the illegal practice of trading on the stock market based on confidential information that is not available to the public. This can occur when insiders, such as company executives, board members, or employees, buy or sell securities based on non-public information about the company’s financial condition, future earnings, or upcoming events. For example, if a company executive knows that their company is going to announce better-than-expected earnings in the near future, they may purchase company stock in advance of the announcement to profit from the expected increase in the stock price. This is illegal because it gives the insider an unfair advantage over other investors who do not have access to the same information.
Market manipulation is the intentional effort to distort market prices to achieve a personal financial gain. This can be done through a variety of techniques, such as spreading false rumors about a company to drive down its stock price or artificially inflating the price of a stock by using deceptive trading practices. For example, a group of investors may coordinate to artificially drive up the price of a stock by buying large amounts of it in a short period of time and then selling it quickly at a higher price to take advantage of the temporary price increase. This is illegal because it harms other investors who are relying on the market to be fair and transparent.
Both insider trading and market manipulation are illegal because they undermine the integrity of financial markets and give an unfair advantage to a select few, at the expense of other investors who rely on accurate and timely information to make informed investment decisions.
Skimming is a type of fraud where cash is stolen from a victim entity before it is recorded in the accounting system. Skimming schemes are known as “off-book” frauds because the stolen money is not recorded in the victim organization’s accounts. Employees who skim from their companies typically steal sales or receivables before they are recorded in the company’s books. In some cases, the perpetrator may only keep the stolen money for a short time before passing it on to their employer, delaying the posting of the payment. This is known as short-term skimming.
Tax fraud is the deliberate avoidance or underpayment of taxes owed to a taxing authority. This can take many forms, such as the concealment of assets or income, keeping multiple sets of books, or the destruction of financial records. These actions are intended to deceive the tax authorities and illegally reduce the amount of taxes owed.
Turnaround Sale or Flip
A type of purchasing scheme that is sometimes used by fraudsters is known as the turnaround sale or flip. This scheme involves an employee taking advantage of their employer’s intention to purchase a certain asset by purchasing the asset themselves (usually in the name of an accomplice or shell company) and then reselling the asset to their employer at an inflated price. This can result in the employee profiting from the price difference between the purchase and sale of the asset, at the expense of the employer.
Understatement of Liabilities
An entity can understate its liabilities in several ways. One method is by failing to record liabilities and/or expenses in the financial statements. Another way is by failing to record warranty costs and liabilities. Additionally, an entity may fail to disclose contingent liabilities, which are potential liabilities that may arise in the future. In some cases, an entity may also hide its liabilities in off-balance sheet entities or affiliates, which can make it difficult to identify the true financial position of the company.