Understanding, Detecting, and Preventing Fraud

• By Robert Schoch, William T. Hartman Ph.D.
• 08/01/08

Fraud happens. Sometimes it’s big and involves business relationships outside the organization; other times it’s small and deeply hidden within the detailed processes of the daily operations.
   
The Association of Certified Fraud Examiners’ 2004 Report to the Nation on Fraud and Abuse estimated that government and industry in the United States lose more than $650B annually due to fraud. Although the median loss for a small business is $98,000 per year, the Association of Certified Fraud Examiners’ report estimates that the average school district loses $250,000 annually.

The areas of risk for fraud are diverse. According to the Association of Certified Examiners, fraudulent disbursements involve billing, check tampering, expense reimbursement, payroll, and register disbursements. Skimming — the theft of cash before it has been recorded — and cash larceny — the theft of cash after it has been recorded — are responsible for significant financial losses.

Fraud most likely occurs when the elements of the fraud triangle are present: opportunity, motive, and rationalization. Often, individuals who commit fraud have the opportunity to do so, do not view themselves as thieves, and rationalize that the employer owes them or that others are cheating the system as well.

Elementary Fraud Prevention
The risks of fraud can be reduced by implementing the fundamental elements of fraud prevention. School districts should create and maintain a culture of honesty and high ethics, starting with a code of conduct, an ethics policy, or both.

Administrators and board committees should evaluate the risks of fraud and implement processes, procedures, and controls to mitigate those risks and the opportunities for fraud. An oversight process should be developed by the board of directors, the CEO, and the audit committee, and should include internal auditing policies and procedures.

Internal control principles include the following.

• Separation of duties. Duties are divided so no one person has complete control over a key function or activity.
• Authorization and approval. Proposed transactions are authorized when they are consistent with policy and funds are available.
• Custodial and security arrangements. Responsibility for the custody of assets is separated from related record keeping.
• Review and reconciliation. Records are examined and reconciled to determine whether transactions were properly processed and approved.
• Physical controls. Equipment, inventories, cash, and other assets are secured physically, counted periodically, and compared with amounts shown on control records.
• Training and supervision. Well-trained and supervised employees help ensure that control processes function properly.
• Documentation. Well-documented policies and procedures promote employee understanding of job duties and help ensure continuity during employee absences or turnover.
• Cost/benefit. Costs associated with control processes do not exceed expected benefits.

Regularly applying selected forensic auditing techniques is a strong proactive measure. This includes estimating dollar amounts based on reasonable assumptions, then comparing estimates with actual amounts and investigating variances.

Unusual transactions should be reviewed, including amounts close to limits and transactions on unusual days of the week or times of day. Adjusted journal entries, particularly at year-end, should be reviewed, as should any unusual documentation, such as checks cashed rather than deposited, invoices with the same date as the purchase order, or unusually “clean” documents.

Forensic auditors use specialized software to mine financial data and analyze transactions. Some of the routines can be applied with standard spreadsheet software to catch double payments and suspicious vendors, gaps or duplicates in sequential numbering, weekend transactions, and amounts with numerical digits out of statistical norms. Manual procedures should look for proper authorization by approved individuals within approved limits. Contract approvals should be scrutinized.

Although fraud can occur in any organization, understanding the fraud triangle is an initial step toward limiting fraud. Begin with the area in which the district has the most control: opportunity. Initiate steps to reduce the opportunities for fraud by strengthening internal control procedures. Establish and maintain an ethical culture so that honesty is expected from everyone in the organization.

Robert Schoch is the director of business administration for the Council Rock School District in Newtown, PA. He can be reached at rschoch@crsd.org.

William T. Hartman, Ph.D., is a professor of education at Pennsylvania State University in University Park, PA. He can be reached at wth@psu.edu.

Excerpted from the July/August 2008 issue of School Business Affairs, published by the Association of School Business Officials International. www.asbointl.org