A proactive approach to combating fraud: seven preemptive measures can help internal auditors deliver a first-round knockout to fraudulent activity

Internal Auditor, April, 2005 by Carl Pacini, Richard Brody

INTERNAL AUDIT PROFESSIONALS SHOULD PLAY AN integral role in their organization's fraud-fighting efforts. In fact, evidence shows that organizations fare better in terms of fraud when internal auditors are present. In its 2004 Report to the Nation, the Association of Certified Fraud Examiners states that the median loss for organizations with an internal audit department was $50,000 less than in organizations without an audit department. The report also indicates that fraud schemes were identified by internal audits at more than twice the rate of external audits, despite the fact that victim organizations in the study were more likely to have external audits.

More is expected of internal audit departments with respect to the prevention and detection of fraud than ever before. The heightened risks associated with malfeasance--from fraudulent financial reporting to information security threats--make internal auditing's involvement in the process nearly imperative. Internal auditors can help management aggressively pursue possible fraudulent conduct instead of waiting for situations to be brought to the forefront. Corporate executives, audit committees, external auditors, and investors all stand to benefit from the expertise internal auditing can lend to anti-fraud initiatives.

Auditors can take numerous steps to combat fraud, many of which are listed in the "Fraud Prevention Checklist" on page 60. The needs and circumstances specific to each individual organization typically will dictate which measures would be of greatest benefit and achieve the most cost-effective results. Seven steps in particular, however, can be of value to almost any organization, regardless of size, industry, or location. These proactive measures can serve as an integral part of the audit department's regimen of fraud prevention, detection, and reporting.

PERFORM EMPLOYEE BACKGROUND CHECKS

One of the keys to mitigating fraudulent activity is to ensure that the organization is composed of ethical, trustworthy employees. By performing employee reference checks, organizations can help minimize the threat of theft and other employee wrongdoing.

An employee with a history of fraud perpetration may move from one organization to another, leaving behind a trail of misconduct and abuse. Dishonest employees can defraud an unsuspecting organization of tens of thousands of dollars and move on to a new job before the fraud is discovered. When employee references are not checked, fraudsters may easily slip through the hiring process.

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Before hiring a new employee, organizations should review the candidate's resume carefully and verify stated information. The organization should not rely on telephone numbers listed for prior employers, as they may be false. Instead, employer phone numbers should be obtained independently. In addition, professional credentials should be checked and academic degrees confirmed.

Employers should also consider performing a second reference check six months after an employee begins working for the organization. The reason for an employee's dismissal from a recent job may not have had time to become part of his or her record during the initial search.

Lastly, employers should conduct a criminal background check on prospective employees that identifies any known criminal activity or other offenses perpetrated. Any information gleaned from the search allows the employer to ask direct questions of the candidate and obtain a complete, accurate set of facts before making employment decisions.

Auditors can be of great assistance with regard to background checks and other employee investigations. As explained in "The Fair Credit Reporting Act" on page 61, organizations can ensure compliance with U.S. legal requirements by employing the investigative services of internal auditors instead of hiring an outside party.

INCREASE THE USE OF ANALYTICAL REVIEW

Fraud can affect financial statement trends and ratios, and accounts that are manipulated to conceal fraud may manifest unusual relationships with other accounts that have not been manipulated. Moreover, fraudsters may engage only sporadically in fraudulent activity, creating erratic patterns in periodic account balances. By conducting financial analysis, internal auditors may reveal unexpected relationships or the absence of relationships that should be present.

Auditors should consider analyzing several years of financial statement data, using different techniques to obtain a clear picture of the financial impact of any fraud scheme. Various analytical review techniques that could be used include trend (horizontal) analysis; ratio (vertical) analysis, or common size statements; budgetary comparisons; comparisons with industry averages; and review of general ledger and journal entries. Any unusual items found should be pursued to determine whether fraud could be the cause of the aberration.

PERFORM CONTRACT REVIEWS

Review of company contracts and agreements can help identify possible contract fraud, including kickbacks, bribery, or conflicts of interest among the organization's employees. Contract fraud can occur when a trade supplier fraudulently takes advantage of a contract to make illegal profits. It may also involve a conspiracy between entity personnel and a trade supplier or between two or more vendors.