Advances in technology, the pandemic, and even the political environment bring disruptions to an organization’s internal control environment. Leaders must recognize the warning signs of weak controls and take swift action or fraudulent activity can occur under the radar with costly consequences.
According to a recent ACFE Global Fraud Report, a typical fraud case lasts 12 months before detection and can cause a loss of up to $8,300 per month for businesses. Furthermore, the study found that nearly half of reported cases were a result of lack of internal controls or an override of existing controls.
Even if their responsibility isn’t detecting instances of fraud, auditors must understand the warning signs of a defective client control environment to assess the risk that financial statements are misstated. Increased risk means increased procedures and, importantly, alerting a client to concerns of fraud can mitigate the financial impacts to the business.
Unfortunately, fraud actors are becoming more effective in concealing their illegal activity, however, below are the top warning signs of a weak control environment that auditors should be on the lookout for to protect their client’s financial health.
Environmental
Environmental indicators of a poor control environment can range from a poor tone at the top to financial conditions at the company. Does management create a climate of honesty and integrity? If not, employees may take their lead to the detriment of the employer.
Also, employees that feel secure and valued in their roles are more likely to be loyal and dedicated workers, meaning they are less likely to act against their organization for their own financial gain.
Other contributing factors that can weaken controls include a lack of opportunities for advancement and even the political environment. A recent Winthrop University study found a correlation between a high degree of organizational political alignment and the strength of its information and enforcement environment—with more corporate fraud convictions resulting from stronger corporate political connections.
Additionally, the discouragement of the lack of a clear path for professional growth for employees can lead to an increased risk of workers seeking fraudulent gains from the company.
Management
Poor management is one of the top reasons for a weak internal control environment at any given organization. This can include weak oversight, giving employees free reign to act autonomously and, potentially, fraudulently while evading notice.
Poor segregation of duties and lack of clear job descriptions is another risk factor, as structural disorganization can lead to mistakes, security risks and increases in human error.
Lastly, a lack of policy enforcement can embolden employees to act dishonestly. For these reasons, it’s critical that employees are properly trained and expectations are clearly set from the start of the onboarding process and throughout their careers.
Financial Results
While auditing a client’s financial statements, there are a few clear warning signs that fraudulent activity may be occurring somewhere in the organization. Namely, unexplained changes to financial health indicators. These can include changes to revenue, gross profit, and expenses that don’t appear to align with their records or cannot be explained by the reports the company has provided.
A less obvious but equally troubling discrepancy to be aware of is inventory shortages, especially when working with a company that sells a product to consumers or other businesses. You may notice that the recorded inventory does not align with sales or revenue reporting, indicating that there may be an issue like theft that should be noted to the client.
Personal Factors
Whether it is a member of the leadership team or an entry level employee, pivotal personal factors can drastically increase the risk of employees seeking illegal financial gain from their unsuspecting employers.
Often, expensive life changes or habits are the most common gateways to fraudulent acts. These can include a recent health diagnosis, divorce or an addiction related to gambling, shopping, or drug use.
Other potential triggers and/or warning signs to be cognizant of in employees include negativity toward the employer and organization, or a general lack of work life balance without appropriate compensation. Having strong mentorship and management oversight at a company can be effective in mitigating many of these factors.
Unfortunately, these indicators are nuanced, and not as easy to identify as they may seem. To date, only 4% of frauds are detected through financial statement audits. If you suspect that your client is at risk of, or actively experiencing fraud, it’s important to encourage them to launch an investigation and complete an internal controls assessment before financial or legal consequences are incurred.
Karen Webber serves as a Partner in the Advisory & Consulting practice at The Bonadio Group. She is responsible for growing the firm’s fraud and forensic services and solutions practice and brings 14 years of experience in financial exploitation investigations, divorce consulting, and estate litigation support. Webber is the founder of FraudFindr.com, an anti-fraud software that has established an international reputation in the field of financial abuse intervention.
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