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Fraud makes headlines every day. Mega-companies like Adelphia, Enron, Global Crossing, Tyco and WorldCom have reported fraud on its grandest scale. As a result of these major scandals, President Bush signed the Sarbanes-Oxley Act of 2002, the most far-reaching legislation regulating public accounting firms and public companies in decades. While executives are eager to calm investors’ fears, corporate counsel must remember that the battle against smaller cases of employee fraud and embezzlement is far from over. In its 2002 report to the nation, the Association of Certified Fraud Examiners estimated that occupational fraud and abuse will dupe U.S. companies out of $600 billion this year — roughly $4,500 per American employee. The reasons for the boom in fraud and embezzlement include the usual combination of greed and opportunity. Compounding environmental factors — like corporate downsizing, resulting in reduced internal controls and decreased employee loyalty — fuel the motivation to commit fraud. Headline-grabbing financial scandals, which often focus management attention elsewhere and cause bitterness and resentment in lower-level employees (i.e., “look at what they get away with, I deserve some too”), employee losses in the stock market and a slow economy are also factors. The old favorite frauds are still the most successful: creating fictitious invoices, ghost employees, phantom vendors, skimming cash sales and padding expenses. In general, the larger the organization, the more difficult the discovery of material weaknesses in internal control systems becomes. And, while sophisticated computer systems have made some aspects of work life more secure, they have hardly eliminated fraud. In many cases, they present new opportunities. As corporate counsel are often privy to the inner workings of company operations, aware of everything from financial statements to specific employee problems, they are often best equipped to build teams that identify and investigate signs of fraud. By being attuned to the factors that allow perpetrators to successfully execute illegal schemes in the first place, systems can be put in place to deter and prevent fraud at any size or type of business. While certain basic control procedures — such as the need to segregate the accounting and bookkeeping functions from the cash receipt and disbursement functions, and restrictions on check-signing authority — are important, management oversight is another critical, basic control that is often undervalued. Limited oversight is typically attributed to trust between co-workers, normally a desirable trait. Unfortunately, well-trusted employees sometimes violate management and organizational confidence to satisfy their own personal financial needs or desires, which is quite devastating to trusting victims. It’s tough to imagine that long-time employees with extensive ties to the company would embezzle funds. But it happens more often than anyone would like to believe. Corporate counsel should always be mindful of the most common fraud schemes: serial embezzlement, revenue recognition fraud and collusion. Serial Embezzlement The serial embezzler goes from job to job stealing from each one, sometimes stealing from the second employer to pay restitution to the first. This means, of course, that the second employer did not perform adequate due diligence in hiring, and/or the first employer kept the embezzlement quiet in order to avoid embarrassment and distasteful publicity. Employers who hire serial embezzlers tend to have certain things in common: they do not perform adequate background checks, including credit checks, on prospective hires. They trust the embezzler, and they give them a significant amount of responsibility. Serial embezzlers have an uncanny ability to identify and hone in on trusting employers and internal control weaknesses that can be exploited. Serial embezzlers are willing to take on responsibility and handle details — the more details the embezzler handles, the more theft and cover-up opportunities are provided. They also suffer from selective messiness that is a convenient explanation for missing documents, continued adjustments and confusion that helps mask the theft. Revenue Recognition Fraud The term ‘revenue recognition fraud’ usually indicates large frauds against shareholders, but it can also occur on a much smaller scale. Occurring inside the company, revenue recognition fraud is typically committed to protect job security, often in response to pressure from management to achieve earnings targets. For example, in a division of a publicly traded company, management created an environment in which achieving budgeted earnings was of paramount importance and needed to be accomplished at any cost. Of course, bonus money was at stake. To accomplish unrealistic goals placed upon them by management, required write-offs were delayed and the books and records were kept open for an extra few days to allow for additional revenue to be recognized within the budget period. Revenue recognition fraudsters may not believe that their actions are criminal or, if they do, they may feel they are committing a victimless crime. They may feel that, since they were not stealing money from the company, per se, that they were not embezzling. This type of fraud demonstrates that not all schemes are outright attempts to pilfer cash. Collusion Collusion typically occurs over a number of years, and makes fraud more difficult to detect and prevent, because it overrides safeguards that departmental segregation may prevent. This form of fraud most commonly involves employees in the accounting department. A recent case of collusion involved the creation of false accounts payable vouchers; falsification of accounts payable checks; misuse of check signing equipment and/or forgery; recording false expenses in the general ledger; and removing the forged checks when they were returned with the bank statements. Additional side frauds included theft of petty cash and creation of phantom vendors in the accounts payable system. This fraud totaled millions of dollars and endured — despite the closing of various bank accounts — the switching of general ledger packages and accounts payable systems several times, and the locking up of the check-signing machine. Fraud Alerts All fraud alerts, no matter how frivolous or petty they may seem, should always be investigated immediately and extensively. Tips in the forms of anonymous phone messages or letters should be a concern. Lifestyle indications like an obvious discrepancy in earnings and lifestyle can be a red flag indicating fraud. Surprising or unexpected changes in behavior could also indicate that an employee is under severe pressure in connection with the perpetration of a fraud. Safeguarding Against Fraud A few basic steps could protect millions in company assets. Counsel should advise management to keep everything from the books to employee workspaces organized; it’s hard to “lose” receipts and other documents without clutter. Additionally, counsel and managers should pay close attention to details (i.e. know the company’s daily checking account balance, require that bank statements are immediately reconciled, scan paid bills to make sure there is no overpayment, spot check inventory on a surprise basis, review the mail when it first arrives unopened, etc.). Finally, and most challenging in an organization where counsel is in-house and has been for years, never fully trust anyone; or, if counsel does trust someone, always use Ronald Reagan’s motto- “Trust, but verify.” If You Have Been Defrauded If a fraud perpetrator slips through the cracks, don’t make the mistake of keeping the fraud quiet. Just as keeping any crime silent can be a liability, so it goes with a fraudster, as secrecy permits him or her to continue criminal behavior elsewhere. Without a strong public statement announcing the fraud, the company leaves itself open to further violations by others who realize the fraud went unpunished. Even if management thinks there is nothing left to recover, counsel should always recommend prosecution to the fullest extent of the law. In order to prevent a similar occurrence, it is critical that a full investigation uncovers the methodology employed by the fraudster, the total amount of the loss and how it was allowed to occur. Learning how controls were circumvented will aid in preventing future frauds. Always remember the old adage, “Fool me once shame on you, fool me twice shame on me.” KYLE ANNE MIDKIFF is a principal in nihill & riedley, a forensic accounting firm in Philadelphia. For more information, call 215-238-8450 or visit www.nihillriedley.com.

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