Red Flags: Are You Paying Attention?
By Arlen Lasinsky, CPA, CFE, CFF, CVA, CTP, Director, Advisory Services
Imagine you are driving your car and the engine light appears on your dashboard. What do you do? Ignore it and hope that it is a fluke and that whatever the issue is will go away, or do you take your auto to your mechanic to find out what the problem is and what the cost will be to repair it? The engine light is a reg flag, a warning sign that something is amiss with the engine. There may be an engine light issue or a serious problem that needs immediate attention. Regardless of which one it is, conventional wisdom tells us to pursue the potential problem with the engine.
A business may have red flags, warning signs to let you know if something is not right in your business. If one is aware of the red flags, you should be able to see if you are a victim of fraud. It is important to note that these red flags do not mean fraud is occurring. It means the red flag should be investigated.
According to the Association of Certified Fraud Examiners’ Occupational Fraud 2022: A Report to the Nations (the “Report”), the median loss per case was $117,000.1 However, the median loss perpetrated by the employee who was at the company for more than ten years was $250,000.2 More significant, the median loss for executives who committed fraud was $337,000.3 Frauds committed by higher-level perpetrators also typically take longer to detect. The medium duration of a fraud committed by an executive was 18 months, whereas frauds committed by staff-level employees had a medium duration of only eight months.4
Sociologist and criminologist Donald R. Cressey developed a study in the 1950s.5 In his research, he observed and documented why people steal. Cressey’s hypothesis has become known as “The Fraud Triangle,”6 and this concept is still used today by criminologists and fraud investigators. The Fraud Triangle, like any triangle, has three points, and The Fraud Triangle’s points are motivation, opportunity, and rationalization.
Motivation or more commonly known as financial needs, can be perceived or real. An individual tends to do what it will take to satisfy those financial needs. Although this motivation may be real or perceived, the perpetrator believes the financial needs are real. Alcoholism, drugs, debt, gambling, and even ego or greed are examples of motivating factors. Human behavior has shown that stealing is one of the ways to relieve pressure when backed into a corner and not knowing how to get assistance.
Opportunity, the second point of the triangle, like motivation, can be real or perceived. The perpetrator sees opportunity as the ability to steal and believes they can conceal the theft, and it won’t be detected. A typical example of an opportunity is when an individual can perform more than one procedure unchecked and is able to manipulate their acts. In doing so, the perpetrator believes they will not be found to have committed any wrongdoing. For example, the employee in charge of the bank reconciliations is also the same employee with check signing authority. That employee is in a position to manipulate their work and commit fraud. Segregation of duties and effective supervision and review can remove or limit opportunities.
Rationalization, the final point on the triangle, allows the perpetrator to reconcile their actions with their morals. This allows the perpetrator to justify their behavior. The perpetrator believes they have a good reason to commit fraud and rationalizes it to validate their actions.
For example, assume an employee working in a company’s financial area is sick and accumulating insurmountable medical bills. They may rationalize that they are only “borrowing” the money and “deserve” it because they are sick. Additionally, employees often steal because they believe they are underpaid and deserve it.
To be clear, a red flag is only an alert that something may be amiss. It indicates that fraud may be occurring but does not mean it is actually taking place. It is imperative that once a red flag is observed, action is taken to investigate if fraud has been or is still occurring.
The following are some more common red flags that should not be overlooked. Again, each one of these examples does not affirmatively mean that fraud is occurring, but one would not be exercising their fiduciary responsibility if they were to ignore it.
Employee Lifestyle
Is an employee living a lifestyle that is not necessarily commensurate with their salary? What type of vehicle is the employee driving? What kind of attire do they wear? The house or neighborhood in which they reside? If the answers to these questions do not coincide with their salary, this may be a red flag. To be fair, the employee may have won the lottery, have a life partner who is the primary wage-earner for the family, or had inherited some money. However, unless one of these exceptions applies (and there may be others), an employee’s lifestyle may be a telltale sign that fraud exists.
No Vacation
An employee who refuses to take a vacation may indicate that fraud could exist. Take note of employees who do not take off for vacation time, appear to be very protective of their work and does not want to share any of their work product with other employees. Think about it; why wouldn’t an employee want time off?
First In and Last to Leave
Very often, an employee who is the first to arrive at the company and the last to leave may be a red flag that fraud is occurring. Again, the employee may perform fraudulent activity before other employees arrive at work or after they leave. Being alone allows this individual to manipulate the books and records or remove assets from the facility, including but not limited to inventory.
No Cross Training
One type of internal control is to have employees trained in other areas, i.e., cross-trained, so if an employee is ill or on vacation, another employee can fill in for the absent employee. An employee opposed to cross-training other employees is another signal that fraud may be happening in the company. Such an employee does not want any other employee(s) to know what they are doing or not doing, and cross-training may be contrary to their hidden agenda. Such employees will argue their work has been perfected over the years and do not like change. Additionally, they may contend that any changes to their duties and responsibilities would only “disrupt the value and efficiencies” the employee has developed.
“Fire Drill” Mindset
When there is an attitude of completing everything now, that is a “Fire Drill” Mindset, and there may be deceptive activity taking place in the company. It is more difficult to follow standard procedures and normal operations in a crisis or perceived crisis situation. Although it is natural to concentrate on “putting out the fire” in a crisis, paying close attention to the details is essential when discovering fraud. For example, if an employee is asked to provide a report that is not normally prepared, does the report take longer to prepare than expected? There could be several reasons for the time it takes to prepare the report; however, it could also indicate an employee is attempting to hide fraudulent activity.
Laptop Computers
Unless the standard procedure is for employees to take their laptop computers home, employees who consistently take them home may be doing so to hide fraud. By taking their laptop computer home, the employees believe their computers will not be subject to any analysis, evaluation, or scrutiny. More often than not, perpetrators will look to protect their workspace, including their electronic files.
Decline of Promotions
When an employee declines a promotion or other type of advancement, including transfers to another office, be aware of this red flag. Typically, employees work towards advancement for larger wages, benefits, and responsibilities. An employee may have ample reasons why they would want to decline a promotion or a transfer. However, the fact that an employee would reject such an opportunity should raise an antenna as to a potential fraud occurring.
A Lack of Internal Controls
The purpose of internal controls is to safeguard company assets and to provide assurance that the recording of transactions is accurate and consistent. Good internal controls include the segregation of duties. No one person should be in a position to consummate the transaction, record the transaction, reconcile the transaction, and have custody of the asset. In many instances, the opportunity prong of The Fraud Triangle becomes apparent when there is a lack of segregation of duties and an employee has an opportunity to commit fraud. Additional employees may be required to increase the segregation of duties, but many times there are other alternatives that can be implemented to improve the internal controls without significantly increasing the cost of labor.
No matter your organization’s size, all companies are obligated to safeguard their assets and should not take fraud for granted and believe they will not be a victim. Preventing fraud should be one of the primary focuses for all businesses. Unfortunately, fraud is a common occurrence, and red flags provide a company advanced notice that a fraud may be occurring and an opportunity to pursue any fraud before that becomes the start of destroying a successful business. If you would like more information or assistance on fraud prevention and evaluating your existing internal controls, please reach out to Arlen Lasinsky at [email protected].
Sources
- Occupational Fraud 2022: A Report to the Nations, p. 4.
- Ibid, p. 46.
- Ibid, p. 45.
- Ibid, p. 44.
- Joseph T. Wells, Corporate Fraud Handbook, Third Edition (Hoboken, New Jersey: John Wiley & Sons, Inc., 2011), p. 12.
- Ibid., p. 8.
