Preventing Financial Fraud – Ensure your organisation is protected

Raghunath. T, Director


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    According to the Federal Trade Commission (FTC), in 2019 a reported $1.9 billion was lost to financial fraud, and that represented an increase of over 15% from the previous year. However, not all financial fraud involves companies losing money in an immediately quantifiable manner. Often, the fraud centers around deception that results in a slow drain of funds or drop in profitability that can span several years. Regardless of the immediate or long-term effect, it’s important to know how to pinpoint—and stop—financial fraud before it affects your bottom line.

    Evolution and Types of Financial Fraud

    The most common types of financial fraud involve inflating earnings through various means. The objective is to keep specific groups of stakeholders happy. This often includes private investors, the stock market, or people or organisations holding the company’s debt. There are several ways this kind of fraud is levied, but some of the most common include:

    • Extending the period of depreciation to delay when the depreciation gets factored into the company’s accounts. Many assets depreciate, steadily, year-to-year. If a valuable asset’s depreciation is left off the books for an extra year or so, stakeholders can be fooled into thinking the company’s financial performance is more valuable than it actually is.
    • Hiding liabilities by shifting debt from the main company to a special purpose entity. This kind of fraud involves creating or maintaining a separate company that the main company can shovel off its debt to. The entity’s balance sheet reflects the debt that used to be on the main company’s records.
    • Recognising revenue early while delaying the recognition of expenses Some companies will enter their revenue but leave out the funds they spent to make that money until a later date. When both are, eventually, included, the books balance true. But before then, it looks like the company’s revenue to expense ratio is a lot higher than it actually is.
    • Incorrect capitalisation of expenses When a company capitalises something, they categorise it as an asset instead of an expense. As a result, it shows up on the balance sheet instead of the income statement, which accounts for expenses. If an investor or other stakeholder were to ask to see the income statement, this potentially sizeable expense wouldn’t be factored in, artificially inflating the company’s performance.
    • Factoring in non-existent inventory to fraudulently reduce the cost of goods sold (COGS). The lower your cost of goods sold, the more efficient your company’s production system looks. To calculate COGS, the Initial inventory is added to Purchases made during the period and the period ending inventory is deducted. So, if a company pretends that they have more inventory at the end of the period, their COGS is lower, making them look better to investors.

    Cases of Financial Fraud

    The history of financial fraud is long and complex, but here are some of the more notable examples.

    One of the largest and the most high profile frauds was that of Enron.

    Enron, which was once a poster boy of Wall Street, was found to have engaged in serious  fraudulent activity which involved keeping large debts off the balance sheets. While the high stock prices did arouse suspicions, it was eventually an internal whistleblower’s revelations that  led to the downfall of the organization. The scandal ended up costing shareholders around $74 billion and resulted in the creation of the Sarbanes-Oxley Act of 2002.

    In 2016, the car manufacturer Volkswagen was embroiled in a scandal that ended in a settlement estimated to be in excess of $25 billion. This was not a direct financial fraud, but nevertheless, one that had serious financial consequences . In order to avoid failing to meet emission standards set by  authorities in the US and other markets, Volkswagen installed software in their vehicles that enabled them to fool emissions testers. Thus, vehicles tended to show far lesser emission levels than actual and were considered roadworthy. Once the cover-up was unearthed, it led to a recall of almost 500,000 vehicles and led to serious financial and reputational losses for the company.

    Other cases like the Lehmann Brothers scandal that triggered the economic recession in 2008, the Wells Fargo scandal and Bernie Madoff’s outrageous Ponzi scheme were also noteworthy, but the unfortunate situation is that despite all efforts from authorities across the world, there are still several cases which continue until this day.

    The most high profile case in recent times was that of the German financial services company Wirecard.

    The Wirecard scandal has been dubbed the “Enron of Germany.” The payment provider falsified their books by reporting money that simply did not exist, executing a fraud that spanned the globe. They owed creditors nearly $4 billion. While the CEO was arrested, their COO, who was considered to be a key figure in this scandal, is still missing at the time of writing this article.

    The Next Big Bubble—Cryptocurrency Fraud

    Cryptocurrencies have reached a total market capitalisation of $600 billion. This is only a small fraction of fiat currencies worldwide, which are valued at around $36.8 trillion, but this doesn’t minimize the potential for cryptos to be exploited by fraudulent actors. There are several reasons why fraudsters may soon target cryptocurrencies.

    No Sovereign Backing

    The value of a currency is driven by the financial health of the body that issues it. For example, the US dollar has more value than the Jamaican dollar, primarily because the US economy is more stable and powerful. The value of each currency is relative, and a country’s gross domestic product (GDP), exports, imports, and other factors all affect how much their money is worth in comparison to those of other nations.

    While Bitcoin does have the likes of Elon Musk endorsing it, there is no sovereign backing for the currency. Therefore, the only thing anchoring their value is the speculation of investors. Without verifiable financial fundamentals, fraudulent actors could swing the value of cryptos without being checked by a regulatory body.


    Bitcoin, which comprises 66% of the total cryptocurrency market cap, went from being valued at $1 to $32 per coin in just three months. Fast-forward to the time of writing, and a single bitcoin is worth over $40,000. However, this is more than 10 times what it was in December 2018 when it dropped to around $3,400.

    The meteoric rise and falls experienced by cryptocurrencies have created an atmosphere where large fluctuations are the norm rather than the exception. Sudden dips or drops in value hardly raise an eyebrow, leaving open the possibility for widespread valuation fraud.

    Lack of Clarity

    There’s a cloud of confusion around how cryptocurrencies work, as well as their vulnerabilities. As a result, many seasoned finance professionals and institutions have warned investors to steer clear of cryptos.

    Cryptocurrency infrastructure depends on people using computers to solve mathematical problems, called hashes, on a register called the blockchain. While blockchain infrastructure itself does a good job of rebuffing hackers, the anonymity cryptos provide, as well as the lack of financial oversight, provides fertile ground for fraud.

    How Can Organisations Ensure That Financial Frauds Are Better Prevented?

    The good news is that financial fraud can be prevented. There are several steps companies can take to prevent fraud from impacting their organisation, its partners, and customers.

    Study the Governance Mechanisms

    The governance infrastructure of a company can form the foundation of a fraud-prevention strategy. This would necessitate strong governance mechanisms at the board level, including the board’s constitution. A thorough examination and evaluation of the constitution is best performed by external experts with the various tasks involved given to separate committees.

    It’s also important to delegate authorities effectively, making sure the right people are in charge of examining the most fraud-sensitive areas of the organisation. One way to make these authorities’ jobs easier is to implement whistle-blower policies that provide protection for those that speak up when they see something wrong.

    To prevent fraud before it takes root, it’s important to perform due diligence on customers and suppliers. In addition, at times, employees also have to be investigated to mitigate the risks posed by internal vulnerabilities. This can be done by limiting the tenure of people in key positions, as well as re-examining the rights of people who have access to sensitive systems.

    Audit Environment

    A healthy audit environment sets the stage for a more thorough and transparent audit procedure. This requires clear and independent external and internal audit charters. In addition, there needs to be open communication between external and internal auditors, including those on audit committees. At times, the roles of audit committee members should be re-evaluated to ensure the integrity of the process.

    Stakeholder Relationships

    Certain stakeholders are naturally more compelled to attempt fraud than others. Here are some questions to ask to make sure your company is remaining vigilant:

    • Are there instances of exceptionally favourable or unfavourable financial terms with banks?
    • Are there suppliers who appear to be getting exceptionally large shares of the business or are paid far higher than market rates?
    • Are there customers who appear to be getting significantly more favourable prices and terms than others?

    These kinds of questions can help identify those who may be more likely to levy fraud against your company. Digging into the answers can help you stay a step ahead.

    Business Model and Sector Performance

    While there are always outliers, in most cases, a company’s performance should be similar to others within its sector. This is typically true because they often have similar target customers and deal with the same, or parallel, micro- and macro-economic factors. Therefore, it’s prudent to raise questions such as:

    • Is the business model clear and sustainable?
    • Is the auditor able to visualise what this company would look like financially in the next 5 or 10 years?
    • Is the company reporting earnings significantly more than its peers? If so, is there a clear competitive advantage that it has that justifies this earning?

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