Embezzlement:  Prevention!  Detection!  (The Final Part in a Three-Part Series)

I conducted a seminar for the Long Island Chapter of the Association of Certified Fraud Examiners regarding “Embezzlement.”  The handout from that presentation lists some of the types of schemes that can be detected or, hopefully, prevented as follows:

Theft (not all theft is embezzlement), kickbacks, cash skimming , voids/under-rings, swapping checks for cash, alteration of cash receipts and cash disbursements documents, fictitious refunds and discounts, fictitious employees, kiting,  lapping, unauthorized bad debt write-offs,  fictitious accounts receivable, appropriating inventory for personal use, embezzlement of scrap proceeds, false charges to inventory, fictitious invoices,  excess purchasing of property and services, over-billing, duplicate payments, conflicts of interest, overtime abuses, and personal expense reimbursement schemes.

Sometimes combinations of schemes are utilized, for example lapping and unauthorized bad debt write-offs.  The combinations are virtually limitless.  Sometimes collusion is present.  If enough people are embezzling together, internal controls are inadequate as a preventive.  If it happened at Enron, it can happen anywhere!

This presentation does not permit an in depth study of any particular aspect of detection and prevention.  I will provide an overview of the process and fill in some of the missing pieces.  (If readers wish to obtain more detail on a specific aspect of fraud, white-collar crime, or related topics, please contact me: slinker@rwcpas.com.

Many investigations of embezzlement are based on suspicions about a certain type of misappropriation or about a specific employee.  In those cases the investigator can focus on the possible acts that the suspect could perform.

On the other hand, a general concern about embezzlement sometimes arises.  Examples of those situations include:

a. A business owner believes assets of the business are depleting with no apparent cause.

b. Business partners question why they have incurred significant losses on their investment.

c. A company wishes to assess the risk that embezzlement is occurring at a possible acquisition company

d. A bankruptcy trustee wishes to determine whether a bankrupt company’s losses may have resulted from embezzlement.

In those cases, an investigator might perform some procedures to help determine if embezzlement is occurring or has occurred.  If it appears likely that misappropriation of assets is occurring, the investigator might be requested to investigate further.

So how do we detect that embezzlement is occurring or has occurred?  Theoretically, if there has been no specific allegation of embezzlement, one way to detect it would be to thoroughly investigate all aspects of the business.  Of course, this approach would be costly and impractical.  The process of detection is intended to help the investigator focus on areas where embezzlement is most likely to occur.

The specific steps in detection are a matter of judgment, based on factors such as which assets are likely to be susceptible, the type of business, and the facts known about the business and its current situation.  The process normally involves the following steps:

A.     Identify embezzlement exposures.

B.     Look for symptoms of embezzlement in the exposure areas.

C.     Consider pressures and motivations to commit embezzlement.  This step might be combined with one of the other two steps.

Identifying specific embezzlement exposures involves looking at factors that make certain assets more vulnerable than others.  Internal control weaknesses in certain aspects of the business will become evident as an investigation or analysis progresses.

As to symptoms of embezzlement, different symptoms apply to different types of embezzlement.  Examples of embezzlement symptoms include:

A.     Analytical symptoms, such as unusual changes in gross profit percentages.

B.     Employee symptoms, such as unusual changes in an employee’s lifestyle or attitude.

C.     Tips and complaints, such as comments from employees, customers, or vendors.

I want to note here that the presence of one or more symptoms does not necessarily mean that embezzlement has occurred or is occurring.  For example, analytical symptoms or changes in an employee’s lifestyle or attitude might arise for legitimate reasons other than misappropriation of assets.  In addition, an employee tip might be a mistake or a scheme to get a coworker in trouble.  The investigator should use judgment in evaluating symptoms and considering whether further investigation is warranted.

As to pressures and motivations, embezzlement often involves a pressure or motive to commit the misappropriation and a perceived opportunity to commit it and conceal it.  Identifying embezzlement pressures can help the investigator assess the likelihood that embezzlement is occurring and focus on individuals who might have pressures and motives to embezzle.

Reviewing Internal Controls - Probably the most important deterrent to embezzlement and other fraud is effective internal control.  Strong internal control can prevent or detect most types of misappropriation of assets or fraudulent financial reporting.  So a determination of whether embezzlement is occurring generally involves consideration of internal control.

What is Internal Control? - Internal control is a process, put into place by an entity’s board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in categories relating to operations, financial reporting, and compliance with applicable laws and regulations.

Only some aspects of an entity’s internal control will be relevant in particular investigations.  The controls to be reviewed depend upon the organization, the particular embezzlement concerns, and other factors.  Controls relating to the safeguarding of assets are designed to provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of an organization’s assets.  These are primarily controls over operations but might also be financial reporting controls.

Future articles will address the details of the components of internal control, the implementation of internal control, and the monitoring of internal control.  For now, suffice it to say that in most small companies, fraud and, in particular, embezzlement can be prevented to a great extent when owners are committed to the internal control process.  This includes monitoring the flow of paperwork, subtly noting the activities and attitudes of personnel, and reading and acting on financial reports.

Determining if misappropriation of assets is occurring or has occurred requires writing a program of procedures, which includes review the relevant internal control procedures, identifying weaknesses, listing all of the possible symptoms, noticing which symptoms exist, investigating, and evaluating the information on a step by step basis.  The investigation program will change at a particular juncture when necessary, that is when a lead is not producing results or when a new lead surfaces.

This concludes my three part series on “Embezzlement.”  Future articles will be presented on specific subtopics within the area of business valuation, forensic accounting, commercial financial damages, and personal financial damages.

I encourage our readers and their colleagues to contact me at slinker@rwcpas.com with suggestions for topics of future newsletter articles or questions, whether or not related to a newsletter article.