Customers face two types of fraud risks: employees who misappropriate assets and those who “cook the books” to make the company appear healthier than it is. Ask your borrowers if they’ve prepared a profile that reflects both these fraud risks. Managing such risks is key to your customers’ success — and yours.
Use this checklist to create your own customized fraud risk profile for each borrower. The left side identifies some of the most common risks, and the right side rates the borrower’s relative risk on a scale of 0-5.
A score of 0 indicates no risk. A 5 indicates an imminent threat of material loss or misstatement with few or no controls in place to mitigate risk. If you’re unsure about the appropriate rating for any factor, contact the customer for more information.
Potential fraud risk factor (0-5)
Excessive pressure. Evaluate whether conditions exist that tempt employees to massage the numbers, such as deteriorating financial performance, expiring credit lines and performance-based compensation.
Informal attitude. Assess whether fraud risk management is a priority or is done merely to satisfy the board of directors or external auditors. Evidence of formal fraud risk policies and procedures includes internal audits, surveillance cameras and computer passwords, formal job descriptions, whistleblower hotlines, and corporate codes of conduct.
Changes. Pinpoint any major changes — such as a new product line, updated accounting software, a pending merger or acquisition, IRS audits, insurance claims or lawsuits — that could provide opportunities to conceal fraud or result in a significant monetary loss.
Volatile industries. Assign higher scores to volatile industries with high growth and failure rates, strict legal regulations, significant competition, and imminent changes in technology and product obsolescence.
Unusual activities. Watch for unusual activities that warrant additional investigation, such as the use of accounting estimates, complex business transactions, proprietary intellectual property, competitive bidding, offshore activities, contingent assets or liabilities, and related-party transactions. Look beyond footnote disclosures for clarity.
Conflicts of interest / personal problems. Beware of employees who have close relationships with co-workers, suppliers, competitors and customers — or financial interests in other businesses. Also watch for employees with gambling, addiction, legal or credit problems.
High turnover. Consider whether the company has changed managers, owners, attorneys, lenders or accountants over the last five years. Frequent disputes or unreasonable demands could signal that the company is in crisis mode.
Cash. Gauge how much cash the company has on-site and where it (and the checkbook) is stored. Mitigate risk with physical controls, independent bank statement reconciliations, and background checks on employees who handle cash.
Receivables. Expect a stable relationship between sales and receivables (as well as receivables and total assets) over time. Also evaluate aging schedules and write-offs.
Inventory. Evaluate controls over inventory receipts, shipments, and write-offs. Brainstorm ways a fraudster can manipulate records or pilfer inventory for their own personal gain. Annual physical inventory counts by a CPA can identify discrepancies with perpetual inventory records.
Fixed assets. Determine whether the company prepares a detailed fixed asset register and tags high-value assets, such as scanners, printers, phones and computers. Adhering to a routine maintenance schedule can help the borrower track the whereabouts and condition of each item.
Payables. Beware of payable fraud schemes, such as phantom vendors and kickbacks (when vendors overcharge and kick back a portion of the overage to the purchasing agent). Diligent borrowers take steps — such as confirming vendor balances and duplication of duties — to mitigate payable fraud risk.
Improper revenue recognition. Evaluate the company’s policy for recording sales. Some prematurely book sales to boost earnings or delay recognition to minimize taxable income. Also beware of fictitious customers and excessive returns, refunds, discounts and voids.
Lax expense review. Ask how management verifies fees paid for services —rent and professional fees, for example — because there’s no physical evidence of the expenditure, except a contract or invoice. Strong customers also have formal expense report approval procedures, because many first-time fraudsters test the waters with expense report abuse.
Fraud risk profiles identify borrowers’ weaknesses — and expose which areas warrant additional due diligence. Sometimes lenders and borrowers independently rate the company and then compare results. This exercise often serves as a springboard for discussing risks, opportunities and perception gaps with your customers.