Protecting your business from Internal Fraud

Did you know businesses worldwide lose approximately 5% of their income to internal fraud annually? This article discusses how you can protect your business from internal fraud through timely detection to avoid unexpected financial losses.

Internal fraud, also known as occupational fraud, refers to fraudulent activities conducted by an organization's employees against the organization itself. All employees, but also contractors, can potentially be involved in fraudulent activities, regardless of their seniority level or responsibilities.  This kind of fraud is usually performed through financial or asset misappropriation but also includes behaviors intended to deceive the company.

When employees have access to internal systems and information, there is a chance they misuse it and exploit weaknesses in the organization. Although most employees act with integrity, internal fraud is a reality that potentially affects all companies, resulting in billions of dollars in losses annually. The ACFE (Association of Certified Fraud Examiners) estimates that organizations are losing 5% of their revenue to fraud each year.

In contrast, external fraud is committed by individuals or groups outside the organization. These external parties may use tactics like social engineering to access sensitive information or financial resources.

Internal fraud can have an enormous impact on an organization and can be difficult to recover from, especially for smaller businesses.

• Financial losses lead to diminished cash flow, affecting a company's ability to pay employees and suppliers. Furthermore, the organization may incur substantial costs from pursuing legal actions, investigation expenses, or paying contractual fines and penalties.
• Damage to reputation is in some ways more difficult to fix than a financial loss. Once bad publicity occurs it is difficult to undo the loss of confidence both from customers and employees. A prominent example is a drop in share prices as soon as any form of internal fraud is revealed.
• Interruption of business operations can create an unstable work environment, preventing the company from generating value as planned. Resources must be invested to restore production capabilities affected by fraud, draining resources and causing supplementary costs.
• Employee morale can decline: Businesses rely on motivated employees, and distrust in their employer or colleagues can lead to reduced engagement and an increased desire to leave the company.

Being aware of potential warning signs from a fraudulent individual within the organization is crucial for preventing internal fraud. When identifying key indicators for internal fraud, it is important to consider the following:

• Is an employee living beyond their means? Do they appear to be leading a lavish lifestyle that seems inconsistent with their salary? New cars, luxury holidays, and expensive properties could all be potential red flags.
• Have the employee’s work patterns changed? For example, are they in the office early or late when fewer colleagues could witness their fraudulent activity?
• Do they seem secretive or defensive when questioned about potential issues, such as budget overspending or missing items? Are they unwilling to share tasks with others, indicating they are concealing something?
• Do they insist on controlling certain processes or refuse to delegate tasks, suggesting they might be hiding fraudulent activities?

Several signs could suggest that internal fraud is occurring, such as:

• Close relationships with suppliers that appear unusually personal or preferential, potentially leading to conflicts of interest.
• Transactions that don't fit the usual pattern or seem out of place, such as large or frequent transfers to unknown accounts.
• Inconsistent or altered financial documents, such as invoices, receipts, or reports, that could indicate manipulation.
• Regular mismatches between physical inventory and recorded inventory, suggesting possible theft or misappropriation

Employees may be tempted to commit internal fraud if company systems make it easy to do so. For example, for an employee suffering from financial difficulties, spotting a loophole could be the tipping point to internal fraud.

Some examples of these factors include:

• Insufficient internal controls – one person is responsible for making payments with no secondary sign-off, no internal audits take place, or no whistleblower system exists so people are afraid to report suspicious activity.
• A high-pressure working environment where financial targets must be met, including commission-based roles. This also encompasses management that sets unrealistic goals and expects consistent high performance.
• Weak Ethical Culture: An environment where ethical behavior is not actively promoted or rewarded may lead employees to prioritize personal gain over company integrity, increasing the risk of internal fraud.

Internal fraud can be prevented by addressing the existing internal systems. 

Organizations should enforce and maintain strict internal fraud policies and conduct regular audits to detect any issues. The serious consequences of internal fraud must be highlighted so employees understand its impact.

Regular training sessions should be conducted to educate employees on recognizing and preventing fraud. By increasing awareness and understanding of fraud risks and prevention strategies, employees become better equipped to identify suspicious activities and contribute to a fraud-free environment.

With technology advancing rapidly, data analysis can detect abnormal patterns that might be overlooked. Particularly useful within the financial sector is fraud detection software, which can identify unusual transactions and audit financial records.

Human risk management tools can also help identify potential fraud risks. These tools assess employee behavior and attitudes to detect vulnerabilities and mitigate risks associated to human factors.  

Employees should know they can report potential internal fraud without any personal drawbacks. Introducing an internal whistleblower system demonstrates the organisation takes this form of fraudulent activities seriously. 

According to a report by the Association of Certified Fraud Examiners, 41% of internal fraud takes place at management level.

Positive behavior stems from influence, so senior executives should set an example and emphasize that fraud has no place in the organization.

The creation of an ethical culture can ensure that employees are aware of exactly what fraud is and how it affects the company at all levels, from bottom-line profit to reputation.

Internal fraud can have devastating effects on businesses and can amount to millions of euros. The following cases demonstrate how significant financial losses can occur when oversight is insufficient:

The Best Cover Story – Loss: €6.45 Million

An accountant at a construction company misappropriated €6.45 million over several years, using funds from subsidiary accounts meant for completed projects. He financed a lavish lifestyle, including luxury cars and properties in multiple locations, under the guise of a side job upgrading sports cars. The fraud was uncovered when a large transaction for a villa drew attention. Despite liquidating assets, the company faced a significant financial shortfall.

World-Beating Creative Accounting – Loss: €1 Million

The head of finance at an overseas subsidiary of a European group embezzled €1 million by maintaining four sets of books to hide forged checks and unauthorized purchases. The lack of task separation in the small branch allowed her to present different books to various parties, explaining discrepancies with tax provisions. Her scheme was discovered when repeated plausibility checks failed, prompting an audit that revealed the fraud.

When internal fraud is suspected, it is essential to follow a structured approach to address the issue effectively:

Promptly inform the appropriate parties, such as management, legal teams, or board members, to prevent further fraudulent activities. The scale of the fraud will determine who needs to be notified.

For minor incidents, notify department heads or internal audit teams. For larger-scale fraud, involve senior management, legal teams, and possibly the board of directors. If the fraud significantly impacts the company, law enforcement should be swiftly informed.

Assemble a dedicated team to gather evidence and conduct a thorough investigation to confirm the suspicion or accusation. This team should work methodically to ensure all relevant information is collected and analyzed.

After gathering all necessary information, involve law enforcement authorities to pursue legal action.

Additionally, inform relevant stakeholders, as their roles within the company may be impacted.

In the aftermath, implement secure procedures and controls to prevent future occurrences. This may include revising policies, enhancing oversight, improving processes and procedures, and reinforcing the organization's control and prevention mechanisms.

Protecting your business from internal fraud is crucial for maintaining financial stability and organizational integrity. Internal fraud can occur unexpectedly, involving trusted employees and leading to significant losses. By recognizing various forms of fraud and potential red flags, businesses can take proactive measures to safeguard their assets.

Implementing strong internal controls, fostering an ethical culture, and utilizing detection tools are key strategies to mitigate fraud risks. Training programs and a robust whistleblower system empower employees to report suspicious activities safely.

Ultimately, preventing internal fraud is a defining trait of a well-managed business, ensuring long-term success and resilience.