How to Prevent and Detect Acccounts Receivable Fraud

INTRODUCTION

Bank accounts with false names and forged signatures. Stolen and counterfeit checks. Deposits that were never made and withdrawals that were never recorded. Understated sales and false receipts. These and many other types of accounts receivable schemes are an auditor?s worst nightmare and are occurring right now in thousands of companies across the U.S. and possibly, even in your company.

Recent fraud studies reveal that asset misappropriations account for more than 80% of the fraud cases, which include accounts receivable fraud. In addition, nearly 9 in 10 misappropriations involve the cash account since cash is easy to take and difficult to track. 

The top accounting deficiencies in detecting accounts receivable fraud include too much trust in the organization?s employees and management, lack of internal controls and improper segregation of duties. The importance of internal controls was underscored in a recent fraud study revealing that as much as 66% of employees admitted they would steal if they saw other employees stealing without consequence.

If you are an internal or outside auditor, controller, finance executive, business owner, or public practitioner, the following information about accounts receivable fraud will help you: 1) evaluate whether your assets are at risk and 2) offer valuable tools and guidelines for preventing and detecting accounts receivable fraud in your organization.

EVALUATING YOUR COMPANY?S VULNERABILITY TO ACCOUNTS RECEIVABLE FRAUD

When accounts receivable fraud is detected in an organization, the auditor is usually one of the first people whom company management will turn to for an explanation. As an accounting professional, you are responsible for evaluating whether a company?s financial assets are at risk for asset misappropriation.

To conduct an effective audit, the auditor must fully understand the organization?s industry and internal and external business processes. ?Auditors count the beans, but they don?t often understand where the beans came from. Often, accounting professionals focus on one specific industry and suddenly find themselves responsible for auditing a company in a completely different sector, which requires different auditing tools and criteria. The AICPA is also making progress in this area and is continuing to develop industry-specific accounting and audit (A&A) guidance for financial statement preparers and CPAs in public practice.

Although accounts receivables vary from company to company, the following checklist applies to all accounts receivables reviews:

A successful accountant will combine financial and analytical skills with a good dose of professional skepticism. Before you start ?crunching? those numbers, ask yourself the following questions to evaluate whether your company is at risk of accounts receivable fraud:

1. Are customer payments and cash vulnerable to misappropriation?
2. Are employees experiencing financial difficulties?
3. Is the relationship between management and employees strained?
4. Are the appropriate monitoring controls in place?
5. Is there proper segregation of duties?

Fraud studies show that the type of companies more susceptible to incoming cash fraud include check cashing and wiring outlets, foreign currency exchanges, art dealers, dealers of precious metals, automobile dealers, boat dealers, dealers of precious gems, real estate agents or brokers, banks, brokerage firms, insurance companies and gambling establishments.

If an auditor determines that the risks for fraud are high, the next step is to assign more experienced personnel to the engagement and to hire a certified fraud examiner.

TYPES OF CASH FRAUD SCHEMES

To evaluate whether cash schemes are occurring in an organization, an auditor must first become familiar with the different forms of ?cash.?  Frauds relating to cash theft are not restricted to employees stealing currency but rather, they include bank deposits, checks, bank drafts and money orders.

Following are the different types of cash fraud schemes that accounting professionals should be aware of when conducting audits:

Fraudulent disbursements of cash

Fraudulent disbursements of cash include the falsification of invoices to nonexistent companies and recording excessive hours that were not really worked.

Skimming

Skimming is the most common form of occupational fraud and occurs most frequently in the retail industry during the point of sale when an employee first receives cash from a customer. Skimming is the hardest fraud to detect since fraudsters do not leave an audit trail and the cash is stolen before it is documented in an organization?s records.

The level of skimming in an organization is determined by the levels of: 1) employee access to cash, 2) monitoring/supervision of employee activities and 3) segregation of duties.

Hiking/Lapping of Accounts Receivables

Lapping is the most prevalent internal fraud scheme and occurs when customer payments are stolen and are concealed by recording subsequent customer payments. Employees often falsify customer receipts and record different amounts than what was actually paid by the customer to conceal the stolen cash.

Employees who become involved in lapping schemes must devote a lot of time and energy to concealing their fraud, since the fraudster must wait for additional funds to arrive before making the next bank deposit to conceal the stolen money. Signs of a lapping fraudster might include working long hours and refusals to take vacations, since lappers must intercept NSFs in the mail and personally collect customer payments to ensure they are not caught.

Lapping is more easily committed when one person is responsible for both the record keeping and custody of cash.  The best method to avoid lapping schemes is to segregate duties.  Accounting professionals can also detect lapping by performing the following procedures:

 Calculate age of receivables and turnover of receivables (lapping increases the age and decreases turnover)

•  Confirm receivables and investigate all exceptions noted.
•  Emphasize accounts that have been written off and old accounts.
• Pay close attention to delayed postings of cash receipts. For example, when a reply to a confirmation suggests that the account was paid on December 29, investigate when the posting occurred.
• Obtain authenticated deposit slips from bank and compare names, dates and amount on remittance advices to information on deposit slips (where possible)
• Perform surprise inspection of deposits, and compare deposit slip with remittances

For Bookkeeping system:

• Compare remittance advices with information recorded
•  Verify propriety of non-cash credits to accounts receivable
•  Foot cash receipts journal, customers? ledger accounts, and accounts receivable control account
•    Reconcile individual customer accounts to accounts receivable control account
• Compare copies of monthly statements with customer accounts

Fraudsters who commit lapping often rationalize their actions by telling themselves they are simply borrowing the money for a short time period and will pay it back later.

TYPES OF ACCOUNTS RECEIVABLE FRAUD

Kiting of checks/cash

Kiting is a type of fraud that overstates cash by including it in two or more bank accounts. Fraudsters take advantage of ?float periods? since checks take several days to clear. Following are a few methods for evaluating whether kiting is occurring in your organization:

•   Prepare a bank transfer schedule
•   Prepare a four-column bank reconciliation of bank account
•   Obtain cutoff statement for second bank account

Understating sales

Employees often skim a portion of a sale only and record the transaction with a lower amount that what was actually paid.  The fraudster usually falsified the merchant?s copy of the receipt to show a lower sales price. 

To detect understating sales schemes, accounting professionals can implement one or more of the following practical recommendations:

 Create perception of high detection at point of sale by installing video cameras and ensuring that a supervisor is present at all times.

•  Perform customer satisfaction survey to verify price paid, mode of payment, etc.
• Spot-check customers who received discounts to verify authenticity
• Establish a hot line or other channel for employees to report unethical conduct.
• Perform frequent, unannounced cash and inventory counts
• Require supervisory authority for all price modifications
• Build a confirmation system for re-order forms by having the customer indicate products previously purchased.
• Check receipts/invoices for alterations
• Scrutinize handwritten receipts
• Analyze trends comparing sales to inventory
• Review costs of goods sold per employee
• Look for drop in gross profit margin
• Spot check invoices against price list
• Create a ?low margin/loss sales? report to detect sales that generated losses or lower-than-normal margins.
• Monitor average unit sales price

Improper posting of cash/receipts

This type of fraud occurs when a customer?s payment information does not correspond to the payment history recorded in the internal accounts receivable system.

Check/cash substitution

According to the latest American Bankers Association survey, check fraud has increased by 20% at community banks and 27% at regional banks since the previous survey two years earlier. Check fraud at large banks has doubled in the last two years.

WHO ARE MY SUSPECTS?

Any employee involved in the cash collection process can commit accounts receivables fraud and includes salespersons, waitpersons, bank tellers and other employees who receive cash directly from customers.

The Controller is also likely to commit accounts receivable fraud since that person often has the authority to receive cash, post it to the accounts receivable and reconcile it. Following is an example of how a Controller took advantage of a company?s lack of internal controls and segregation of duties:

A/R Fraud Case Example:  A controller with a personal financial need noticed the lack of monitoring in the cash collection process.  As a result, he visited each customer personally, collected cash payments and pocketed the money. Next, the Controller prepared a deposit ticket and posted payments as if the cash were actually received by the company.  One of the Controller?s challenges to his fraud scheme was the need to wait a longer time period until enough checks were collected to replace the stolen cash.  Since the auditor failed to notice the delays in deposits, the fraud was discovered when it was too late, checks started to bounce at the bank and the company suffered financial damages in the hundreds of thousands of dollars.

The case of the Controller is clearly an improper segregation of duties and can lead to financial disaster. A careful auditor will invest the time and effort to learn more about a company?s employees including possible financial difficulties, job dissatisfaction and unusual changes in behavior.

WHAT SHOULD I BE LOOKING FOR?

Fraud schemes often become intricate balancing acts that can become very time consuming and stressful.  The financial picture of an organization becomes very skewed when a substantial fraud is being committed and accounting professionals should be aware of the following important red flags to incoming cash and accounts receivable fraud:

HOW CAN I PREVENT ACCOUNTS RECEIVABLE FRAUD?

Accounts receivable fraud can be easily avoided by implementing basic accounting controls, audits and proper supervision and monitoring. However, careful accounting practices are worthless unless the auditor reacts appropriately to any clues that might be found. If a document is a wrong color or an employee is exhibiting unusual behavior, then look into the matter further.

Improving internal control processes is one of the most effective methods for eliminating opportunity for accounts receivable fraud. The threats of accounts receivable fraud can often be addressed by implementing one or more of the following fraud prevention and detection mechanisms:

Segregate those duties!

One person handling receipts, posting, accounting of transactions and write-offs is a recipe for disaster. Although duty segregation might seem obvious to most auditors, the reality is that many companies do not provide the funds or have an interest in hiring extra employees for the sake of more regulated internal processes.

• Require that employees with similar duties regularly alternate specific tasks
• Separate the custodial, record keeping and supervisory functions of the cash collection process.
• Make sure individuals handling receipts do not have access to posting, write-offs or other accounting functions

• Require a person who is not responsible for handling or recording cash to perform bank records

Increase Supervision and Monitoring

Oversight was recognized as the single more effective deterrent to fraud in a recent study conducted by the Association of Certified Fraud Examiners. Employees who are aware of fraud detection mechanisms will hesitate to commit fraud in fear of getting caught.

Increase oversight in your organization by implementing the following recommendations:

• Make sure a manager or supervisor is present at all times
• Place a video camera in a visible location
• Make sure employees are informed about the audits that will be conducted. By knowing that an audit is occurring in the organization, an employee or executive will be more concerned that something might be found.

Don?t just look at the numbers!

Many auditors have admitted that they are often so pressed for time to meet an audit deadline that they ?only look at the numbers? and often pay less attention to the internal processes and controls that are used to actually reach those numbers. A careful accounting professional will take the time to question the exceptions and numbers that seem unusually high or low. Make sure your organization?s accounts receivables are valid by:

• Obtaining a bank deposit detail and comparing to cash and A/R posting on a periodic and surprise basis
• Comparing freight bills or shipping documents to sales records

• Comparing employee addresses and phone numbers to vendor master files

• Conducting a Cut-off Analysis
• Confirming receivables on a regular and surprise basis
• Reviewing exception reports and investigate deviation/exception files such as changes to Master File
• Requiring supervisory approval for write-offs
• Performing regular financial ratio analysis
• Switching to lock-box receipts

• Investigating long standing deposits-in-transit and unreconciled items on bank reconciliation
• Considering a lock-box for receivables
• Performing financial ratio analysis
• Eliminating off-book receivables

CONCLUSION

A company can never become fraud-proof. However, it is an auditor?s responsibility to exercise professional skepticism, question unusual trends and financial data and more importantly, ensure that the proper internal controls are in place. An organization?s accounts receivables should always be confirmed and auditors who do not confirm them should record how they overcame that presumption.

The fight against fraud will become easier as soon as companies realize the importance of investing time and money toward its prevention rather than its detection.

Christiana Zouzias, CPA, a Principal at Zouzias & Zouzias, Inc. is an experienced forensic accountant and financial specialist in divorce. As a financial fraud investigator, Ms. Zouzias helps organizations decrease their risk of fraud and litigation, enhance business practices and protect corporate reputation. Ms. Zouzias also provides fraud training seminars customized to the needs of each organization including ?Red Flags of Financial Fraud? and ?Interviewing Techniques: How to Elicit Information and Assess Truthfulness.?  She provides litigation consulting for a variety of litigation support engagements including divorce, business valuations, shareholder dispute, breach of contract, business interruption and breach of franchise/royalty agreements.  Ms. Zouzias can be contacted at (630) 470-9350 or chris@zouzias.com or visit www.zouzias.com.

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