Category Archives: Employee Theft

Detect and Prevent

I got a call last week from a long term colleague, one of whose smaller client firms recently discovered a long running key-employee initiated fraud. My friend has been asked to assist her client in developing approaches to strengthen controls to, hopefully, prevent such disasters in the future.

ACFE training has consistently told us over the years, and daily experience repeatedly confirmed, that it is simply not possible or economical to stop all fraud before it happens. The only way for a retail concern to absolutely stop shoplifting might be to close and accept orders only over the Internet. Similarly, the only way for a bank to absolutely stop all loan fraud might be for it to stop lending money.

In general, my friend and I agreed during our conversation, that increasing preventive security can reduce fraud losses, but beyond some point, the cost of additional preventive security will exceed the related savings from reduced fraud losses. This is where detection comes in; it may be economical when prevention is not. One way to prevent a salesclerk from stealing from the register would be for the security department to carefully monitor, review, and approve every one of the clerk’s sales. However, it would likely be much more cost effective instead to implement a simple detective control: an end-of-shift reconciliation between the cash in the register and the transactions logged by the cash register during the clerk’s shift. If refunds are not given at the point of sale, the end-of-shift balance of cash in the register should equal the shift’s sales per the transaction logs minus the balance of cash in the register at the beginning of the shift. Any significant failure of these numbers to reconcile would amount to a red flag. Of course, further investigation could show that the clerk simply made an error and so did not commit fraud.

But the cost effectiveness of detective controls, like preventive controls, imposes limits. First, such controls are not cost free to implement, and improving detective controls may cost more than the results they provide. Second, detective controls produce both false positives and false negatives. A false positive occurs when a detective control signals a possible fraud that upon investigation turns up a reasonable explanation for the indicator. A false negative occurs when a detective control fails to signal a possible fraud when one exists. Reducing false negatives means increasing the fraud detection rate.

Similarly, the cost effectiveness of increasing preventive security has a limit as does the benefit of increasing the fraud detection rate. To increase the detection rate, it’s necessary to increase the frequency at which the detective control signals possible fraud. The result is more expensive investigations, and the cost of such additional investigations can exceed the resulting reduction in fraud losses.

As we all learned in undergraduate auditing, controls are essentially policies and procedures designed to minimize losses due to fraud or to other events such as errors or acts of nature. Corrective controls are merely special control types involved once a loss is known to exist. With respect to fraud, an important corrective control involves the investigation of potential frauds and the investigation and recovery process from discovered frauds.

More generally speaking, fraud investigations themselves serve not only a corrective function but also detective and preventive functions. Such investigations are detective of fraud to the extent that they follow up on fraud signals or red flags in order to confirm or disconfirm the presence of fraud. But once fraud is confirmed to exist, fraud examinations shift toward gathering evidence and become corrective by assisting in recovery from the perpetrator and other sources such as from insurance. Fraud investigations are also corrective in that they can lead to the revelation and repair of heretofore unknown weaknesses.

The end result is that the fraud investigation functions to correct the original loss, and the related discovery of the fraud scenario leads to prevention of similar losses in the future. In summary, the fraud examination has served to detect, correct, and prevent fraud. However, fraud investigations are not normally thought of as detective controls. This so is because fraud investigations tend to be much more costly than standard detective controls and therefore are normally used only when there is already some predication in the form of a fraud indicator triggered by a typical detective control. Therefore, the primary functions of fraud investigations are to address existing frauds and help to prevent future ones.

In some cases, the primary benefit of a fraud investigation might be to prevent future frauds. Even when recovery is impossible or impractical (e.g., because the thief has no assets), unwinding the fraud scheme may still have the benefit of leading to the prevention of the same scheme in the future. Furthermore, a company might benefit from spending a very large sum of money to investigate and prosecute a very small theft in order to deter other individuals from defrauding the company in the same way. Many State governments have statutes specifying that every fraud affecting governmental assets, whether large or small, must be fully investigated because taxpayer funds are involved (the assets affected are public property).

There is never a guarantee that investigating a fraud indicator will lead to the discovery of fraud. Depending on the situation, an investigation might lead to nothing at all (i.e., produce a reasonable explanation for the original red flag) or to the discovery of losses due to simple errors, waste, inefficiencies, or even uncontrollable events like acts of nature. If a lender is considering a loan application, a fraud indicator might indicate nothing, fraud, or an error. On the other hand, in regard to the possible theft of raw materials in a production process, a fraud indicator just might indicate undocumented waste or scrap.

Two important factors to consider concerning the general design of a fraud detection process are not only the costs and benefits of detecting, correcting, and preventing a given fraud scenario but also the costs and benefits of detecting, correcting, and preventing errors, waste, uncontrollable events, and inefficiencies in general. Of course, the particular costs that are relevant will vary from one type of business process to another.

As a general rule, we can say that both preventive controls and detective controls cost less than corrective controls. Corrective controls tend to involve hands-on, resource-intensive investigations, and in many cases, such investigations do not result in recovering the loss. On the other hand, preventive controls can also be quite costly. Banks pay armed guards and incur costs to maintain expensive vaults and alarm systems. Companies surround their headquarters with high fences and armed guards, and use security checkpoints and biometric key card systems inside. On the information technology side, firms use sophisticated firewalls and multi-layer access controls. The costs of all these preventive measures can add up to staggering sums in large companies. Of course, losses that are not prevented or corrected in a timely fashion can lead to the ultimate corrective measure: bankruptcy. In fact, some ACFE estimates show that about one-third of all business failures relate to some form of fraudulent activity.

One positive aspect of the cost of preventive controls is that unlike detective controls, they do not generate fraud indicators that lead to costly investigations. In fact, they tend to do their job in complete silence so that management never even knows when they prevent a fraud. The thick door of a bank vault with a time lock prevents bank employees from entering the building at night to steal its contents. Similarly, passwords, pin numbers, and biometric data silently provide access to authorized individuals and prevent access from others.

The problem with preventive controls is that they are always subject to circumvention by determined and cunning fraudsters. There is no perfect solution to preventing acts of fraud, so detection is necessary as a secondary line of defense, and in some cases, as the primary line of defense. Consider a lending company that accepts online loan applications. It may be difficult or impossible to prevent fraudulent applications, but the company can certainly put a sophisticated (and expensive) system in place to analyze applications and provide indicators that suggest when an application may be fraudulent.

In general, the optimal allocation of resources to prevention versus detection depends on the particular business process under consideration. So, there is no general rule that dictates the optimal allocation of resources between prevention versus detection. But there are some general steps that can assist in making the allocation:

1. Analyze the target business process and identify threats and vulnerabilities.
2. Select reasonable preventive controls according to the business process and customs within the client’s industry.
3. Estimate fraud losses given the assumed preventive controls.
4. Identify and add a basic set of detective controls to the system.
5. For a given set of detective controls, identify the optimal mix of false negatives versus false positives. The optimal mix depends on the costs of investigations versus the costs of losses. Large losses and small investigation costs favor relatively low false negatives and high false positives for red flags.
6. Given the assumed mix of false negative and false positive errors, estimate the incremental cost associated with adding the detective (and related corrective) controls, and estimate the resulting reduction in fraud losses.
7. Compare the reduction in fraud losses with the increase in costs associated with adding the optimal mix of detection and correction controls.
8. If increase in costs is significantly lower than the related reduction in fraud losses, consider adding more detective controls. Otherwise, accept the set of detective controls under consideration.

The Ideal Employee

It was late on a dark November evening in 2002 when the corporate counsel of the Victoria Paper Corporation contacted our Chapter member Jay Magret, CFE, CIA about a suspected irregularity involving the team of Tim Clark, the world-wide maintenance manager for Victoria’s most complex automated paper manufacturing equipment.

Clark had been hired after a long exhaustive search by one of Victoria’s many employment contractors, Global Image, Inc. Clark was hired to oversee the entire maintenance program at Victoria’s plants worldwide.  Victoria’s management was elated because Clark seemed ideal for the position, seemingly having spent half of his professional life providing automated systems savvy support to major paper companies around the world. He was used to working in foreign locals and had collected an array of impressive skills that enabled him to be appreciated as a through professional. Once hired, Tim requested four additional staff members for his unit, whom he said he personally knew, and contracted for through Global Image. The names and resumes of the four new staff members were subsequently provided by Grayson Employment, another job agency that also specialized in providing labor to the paper industry. Because the four new staff members were already registered in Grayson’s employee database and were explicitly requested by Tim Clark, Victoria and Global Image didn’t feel the need to complete the usual background verifications.

Such a chain of job agencies is common in the labor market: international paper companies, like companies in other industries, manage large projects in disparate, sometimes isolated locales around the globe, and they are stressed by production deadlines. Accordingly, companies find themselves continuously short on the highly specialized people who are qualified to manage and support such projects. Such international companies rely heavily on job agencies to provide contractors already skilled in the business and available to work in remote destinations.

When a business sector is booming, it becomes crowded with personnel interested in exploiting opportunity and, in the resulting complicated labor market, the temptation to cut personnel supply corners in response to tight deadlines often emerges. The result is that, with a plethora of job agencies providing labor, sometimes to a single project, the final employer sometimes doesn’t know with precision what the hourly fee paid to each individual contractor is after it is redistributed along the chain of multiple job agencies.

Under Clark’s direction, his team was charged with the ambitious task of assuring the continuous performance of maintenance activities at Victoria’s paper plants around the world. On paper, Clark’s team worked long hours each week and most weekends, sometimes flying throughout Europe and Asia with little rest. Each hour worked by a member of the maintenance team was certified and signed off on personally by Clark, on behalf of Victoria.

During their year-and-a-half of service, the four individuals hired by Tim Clark claimed to have worked an excessive number of hours, which triggered an internal review by Grayson Employment’s personnel management. During their review, personnel management found that the four employees’ employment files did not include appropriate identification documents. When the agency requested copies of their passports, the four employees immediately submitted their resignations, and soon after Clark did the same. The day after Clark resigned, Grayson contacted Victoria whose corporate counsel, alarmed, contacted our Jay Magret.

Setting to work immediately and working closely with Victoria’s auditors and the corporate counsel, Magret quickly uncovered evidence that Clark had falsified records and documents for three of the individuals on his team. It became apparent to Jay that those individuals were ghost employees; they did not exist. Clark had created fake resumes for three ghost employees, falsified contracts, signed time sheets, and forged the resignation letters. Further analysis showed that the fourth individual did indeed exist, was related to Clark, and had collaborated on the scheme. Clark and his accomplice had to work hard to carry out the duties of four employees.

Jay’s analysis also showed that Omega’s employee interviews were sometimes conducted solely by line managers involved in the hiring process, without the support of the Human Resources Department. The same line managers were then responsible for certifying the time sheets of their employees, including contractors, while their identification documents weren’t systematically collected or retained. Moreover, the contracts and procedures in use didn’t clearly establish or document each step of the selection and job assignment process.

Magret’s final report specified that the fraud was possible, and profitable, because the paper company client paid the wages of each ghost employee through the chain of job agencies and directly into the accounts of the contractors, which were registered in the name of a private company and managed by Clark. By the time Victoria realized the scope of the fraud scenario with Magret’s help, Clark and his associate had already disappeared with more than a million dollars paid to them during their year-and-a-half scheme. The paper company later discovered that even Clark was not who he claimed to be. He had used a fake identity and was untraceable, leaving little to no chance of recovery of the stolen money.

In response to management’s request that he proactively suggest controls to strengthen Victoria’s anti-fraud program, Magret suggested, as a matter of normal practice, that:

–Companies should perform time assessments to ensure they know how long a job will take to complete.

–Strict procedures should be in place during the hiring process, especially regarding segregation of duties. Human resources should always be involved in the process and responsible for checking identification documents with the physical person.

–The company should limit the opportunity for line managers to recommend hiring people they know. In some cases, it is unavoidable, so managers should always try to guarantee a higher level of segregation, especially in the authorization of time sheets.

–When using a job agency, the company should be sure that the relationship with contractors will be directly between the company itself and the agency. By doing this, the company will save money and be more assured about the contracted personnel.

— Client in-house auditors of the personnel function should perform a periodic analysis of office records by selecting a sample of employees and verifying their effective presence in the office or on the job site, making sure appropriate identification is included in their records.
–Excessive hours claimed is as a red flag, especially when it is common among off-site employees. Establishing key performance indicators for each department or business process can serve as a reference for red flag comparisons.

–A wide-ranging and fragmented work environment can make the ghost employee phenomenon possible. A strong internal control framework and strictly enforced personnel policies are the only ways to prevent and discourage this type of fraud scheme.