Corporate Fraud: Red Flags, Warning Signs, and Effective Methods

Corporate fraud is an illegal offense committed by a business entity or a person in a deceitful manner. It is designed to hide behind legitimate business practices and perpetrate dishonest activity to give an unfair advantage to the person or company engaging in the fraud. The scope of corporate fraud is wide and can include illegal activities such as tax fraud, bribery, accounting fraud, misappropriation of company assets, products or services misrepresentation, and money laundering. It may also include payroll fraud, inventory theft, cash theft, and forgery. When corporate fraud happens, it is either a company acts illegally to enhance its industry reputation or the business is a victim of its own employees' fraudulent or unethical actions.

Unlike most types of fraud, corporate fraud is a white-collar and non-violent crime. However, it does not happen without leaving its victims. In addition, corporate fraud typically occurs within a business environment, while other types of fraud may happen outside a corporate setting or between individuals. Individuals perpetrating corporate fraud are usually executives or employees within a company, particularly targeting business operations and dealings with stakeholders.

What is Corporate Fraud?

Corporate fraud happens when individuals or businesses use dishonest practices to gain unfair advantage. It is a collective of illegal and unethical actions by individuals or companies to deceive others. If perpetrated by persons acting in their capacity as employees of a company, it is most definitely for personal gain, especially to obtain money illegally. When a company commits corporate fraud, it is either for money gain, to damage another entity/business, or to enhance its corporate image deceitfully.

Regardless of a business's size, industry, or the region in which it operates, corporate fraud is a menace for many companies. It is a complex scheme that builds a cloud over the integrity of corporate businesses globally, posing a significant threat to stakeholders and, ultimately, the economy. As a strategy for damaging other entities, corporate fraud can adversely affect industry peers. For instance, disclosing negative information about a peer company within the same industry may ruin its reputation, forcing a lower valuation of that company and reducing its revenues. A company that consistently loses its revenues due to corporate fraud may be driven out of the market. Consequently, investors and business owners may encounter lost economic opportunities or end up losing a fortune.

Types of Corporate Fraud

As the Association of Certified Fraud Examiners (ACFE) reported, businesses lose about 5% of their financial revenue due to fraudulent schemes, including corporate fraud. Corporate fraud can have considerable social and economic impacts on businesses and may ultimately cause them to collapse or go bankrupt. Furthermore, it can distort industry markets by giving corporate fraudsters a competitive advantage, which is likely to drive out legitimate businesses from the economy. Common types of corporate fraud are financial statement fraud, asset misappropriation, cyber fraud, and corruption.

Financial Statement Fraud

Financial statement fraud is the most common type of corporate fraud. It involves manipulating or falsifying important numbers such as revenues, sales, assets, and liabilities. This fraud is usually perpetrated to manipulate stock, defraud investors, or mislead the general public. In most cases, the pressure to outperform other companies in the same sector or match their advantage with other competitors is what leads to the manipulation of financial statements for most businesses.

A notable example of financial statement fraud is the Enron scandal. It is one of the major and notorious cases of corporate fraud. Enron was a big energy company that made several billions in profit while it was in business. However, when the company's revenue began to drop and the business got into a debt crisis, it began manipulating numbers through financial statement fraud to hide the realities. The company eventually went bankrupt as a result of their actions. Consequently, the company's investors and creditors lost billions while thousands of jobs were lost.

WorldCom, an American telecom firm and one of the largest longest-distance providers in the U.S., also perpetrated one of the largest accounting frauds in history. The company got into financial trouble and falsified its books to hide its losses from creditors and investors and look good to the public. Unfortunately, this got out of hand, and the company filed for bankruptcy. Verizon purchased WorldCom's structure once it emerged from bankruptcy.

Asset Misappropriation

Asset misappropriation is also one of the most common corporate frauds, primarily involving the misuse of a company's assets. Accounts that do not add up, missing inventory, sales of proprietary information, and theft of tangible assets by external or internal parties are all examples of asset misappropriation. Asset misappropriation fraud is usually committed by people entrusted with the company's assets, including employees and directors.

Corruption

Corruption is a heinous corporate fraud encompassing various sharp practices, such as embezzlement, illegal gratification, economic extortion, bribery (receiving or offering bribes), getting kickbacks from projects, and receiving or giving anything that can quash a company's integrity. Corruption occurs when an employee or director of a company uses their power or position for illegal business transactions to gain an advantage for themselves or others in exchange for something. It also includes manipulating contracts to favor certain persons over others, aiding and abetting fraud by others, and influencing major business decisions using money.

Cyber Fraud

Cyber fraud involves corporate theft of or unwanted access to a company's sensitive and important information, including money records, customers' data,  and other valuable confidential data/assets. In a typical corporate fraud perpetrated through cyber fraud, a fraudster contacts an employee of a company under false pretenses and gets them to either wire money to their accounts or disclose sensitive information. This fraud happens in stages and may take a while before the hackers finally strike. For instance, they may first steal employees' login information/credentials. Afterward, they may use those credentials to access the company's account and wire funds or access the company's database and steal customers' sensitive data.

Common types of cyber fraud in a business environment include business email compromise, malware deployment, pharming, and phishing. Generally, cyber fraud can lead to a harmed reputation, lost funds, penalties, and even legal issues for companies that fall victim to this type of corporate fraud.

Causes and Risk Factors

Generally, corporate fraud is perpetrated for the same reasons as any other type of fraud scheme. That reason is greed in most cases. For most companies, the perceived need to retain existing investors or attract new ones is what makes them manipulate their financial statements to appear profitable and look good to the public. In other cases, corporate fraud may happen due to senior management's lack of honest leadership. In any case, the causes of corporate fraud are largely categorized as internal factors, external factors, and psychological/organizational factors.

Internal Factors

Several internal factors can be responsible for corporate fraud in a company, including weak internal controls and a lack of leadership and accountability.

Weak Internal Controls

Companies with robust internal control systems and regular audits are less likely to fall victim to corporate fraud. Lack of strong internal controls has contributed to the cause of fraud in many companies. For instance, with poor documentation processes, poor reporting methods, and an unclear separation of employee roles/duties, the likelihood of corporate fraud hitting a business is high.

Internal controls include procedures and policies put in place to ensure the accuracy of financial records, promote operational efficiency, and protect a company's assets. Segregation of responsibilities among employees is also a form of internal control system that can help ensure that no single employee takes control over all aspects of a critical business process. Regular audits are also vital in a company's internal control process to prevent corporate fraud.

Lack of Oversight and Accountability

When a company lacks clear moral direction and oversight, especially from senior management, the business is bound to be hit by corporate fraud. The chances are high that other employees of a company will engage in sharp practices if they are being led by superiors who are not accountable and indulge themselves in actions perceived as corrupt. While almost no employee takes up a job with the intention of committing corporate fraud, the opportunity to commit fraud may suddenly become attractive where there is a clear lack of supervision bundled with other factors.

External Factors

Sometimes, corporate fraud is committed due to external factors that require a company to keep the business going. The most common among these factors are economic pressures and market conditions/competitive pressures.

Economic Pressures

Many cases of corporate fraud in businesses are related to their finances and how to appear profitable to their outside investors and good to the general public. The economic pressures occasioned by the highly competitive global business environment can make a company employ fraudulent accounting schemes to make its business appear more profitable than it really is to attract new investors and retain existing ones. Many companies falsify their books to avoid reputational damage that may accompany a failed operations strategy and to protect businesses from declaring bankruptcy and permanent closure.

Competitive Pressures and Market Conditions

The impact of competitive pressure and market conditions has left many companies struggling to outperform competitors in the same industry amid the global economic downturn. This struggle is primarily to avoid being pushed out of business. As a result of the pressure, a business may attempt to deceive its customers and stakeholders to remain competitive. For instance, a company may decide to produce substandard products and push them into the market at the prevailing market rate. If such products are defective, the company may attempt to hide the dangers associated with using them and still flood the market with them anyway. This often happens with pharmaceutical companies, and it is a typical type of corporate fraud instigated by external pressure, in this case, market conditions and competitive pressure.

Psychological and Organizational Factors

Corporate fraud may occur due to certain psychological factors and organizational structures in a company, particularly about work culture and environment. Generally, employees who are not motivated are, in many cases, encouraged to commit corporate fraud.

Employee Motivations and Rationalizations

Employee motivation, for instance, a promise to pay excessively generous bonuses to anyone who meets or exceeds a demanding target, can be the permission needed for them to commit corporate fraud. Such employees may be tempted to manipulate results to surpass unrealistic job expectations, which is fraudulent. Personal justification for deceitful or unethical actions may also play a part in corporate fraud. For instance, this can happen when an employee tries to explain certain actions to alleviate guilt by saying the company will not notice the loss or that the business can afford it.

Furthermore, employees with financial difficulties or pressures are more likely to commit corporate fraud, especially when they are not well motivated in remuneration. Financial pressures may be a result of an employee living a luxurious lifestyle beyond their means or getting into serious debt from gambling. Sometimes, peer pressure to collaborate in workplace fraud and avoid harassment by colleagues may also cause corporate fraud.

Organizational Culture and Its Role

The links between organizational culture and fraud are not clear-cut or straightforward because the role organizational culture plays in the risk of corporate fraud is often challenging to quantify. However, dysfunction in a company's culture may be the root cause of corporate fraud. Even though no business sets out to establish a dysfunctional organizational culture, somewhere along the line, a company may develop a culture that encourages unethical behaviors among employees. This may indirectly encourage fraudulent activities within the company.

An organization that fails to demonstrate a commitment to attract, train, and retain honest and competent employees may unknowingly build a dysfunctional culture. When this happens, the chances of holding employees accountable for misbehaviors are low, which may encourage them to commit corporate fraud.

Detecting Corporate Fraud

Corporate fraud detection should be a big part of an organization's loss prevention strategy and, sometimes, a part of its compliance management system. Well-executed practical strategies are important in detecting corporate fraud. For instance, conducting regular audits, having strong internal control systems, implementing thorough documentation, encouraging whistleblowing, and using automated fraud detection systems can expose corporate fraud.

Red Flags and Warning Signs

Corporate fraud has several tell-tale signs. Common indicators include the following:

• Employees working excessively and unexplained overtime
• Altered or missing documentation in financial reports
• Considerable unexplained inventory shortages
• Undetailed accounting records or incomplete bookkeeping
• Noticeable employee financial problems
• Unexplained adjustments to financial accounts, for instance, accounts receivables of accounts payable
• Vendors or clients' insistence on dealing with one a particular employee
•  Frequent cash overages/shortages
• Employees providing copies of vendors' invoices rather than original documents
• Employees living large beyond their paychecks

Fraud Detection Methods

The following are some effective corporate fraud detection methods:

• Regular Internal Audits - Performing routine internal audits in areas like product returns, cash, inventory management, and product returns can help detect corporate fraud. Similarly, having external, impartial, and independent persons conduct occasional undisclosed audits, particularly in high-risk departments of a business, cannot be overstated.
• Implementing Strong Internal Control Systems - Implementing internal controls makes it difficult for employees to commit corporate fraud. Where any is being perpetrated, the control systems in place can detect them. For instance, mandatory vacation requirements, separation of financial duties among employees, and 2-factor authentication to access company data can detect fraud in the workplace.
• Using Technology and Data Analytics - Embracing evolving technology can help a business stay abreast of emerging corporate fraud patterns and uncover frauds where they are already happening. Similarly, using predictive data analytics, a concept that uses historical data to forecast future workplace fraud, can help detect corporate fraud. Data analytics has proven particularly useful for e-commerce ventures and financial institutions in identifying and detecting potential fraud early. Furthermore, behavioral analytics, which emphasizes the significance of understanding people's behavior patterns and is powered by machine learning, is pivotal in detecting fraud and responding to suspicious activities in real-time.
• Using AI and ML -Artificial Intelligence (AI) and Machine Learning (ML) are designed with adaptive abilities to learn from ever-evolving corporate fraud patterns. They are particularly effective in identifying and detecting patterns associated with financial fraud.

Whistleblower Programs

Setting up a system for reporting suspicions of fraud, such as a whistleblower program, is an effective way of detecting corporate fraud early and preventing losses. According to reports, at least 43% of uncovered corporate fraud schemes were a result of whistleblower tips. A business may implement a whistleblower program by setting up an anonymous tip line, dedicated email address, or a web form and then inform employees about the reporting mechanisms. One can also be created for vendors, clients, and the general public.

When setting up a whistleblower program, having whistleblower tips go directly to a company's internal auditor, legal department, or external legal counsel for an independent investigation is highly recommended. Generally, tip lines should provide a disclosure policy that describes the rights of the accused, the types of tips accepted, and the protections for the whistleblower. A company's whistleblower program set up for early detection of corporate fraud should offer anonymity to potential reporters. Otherwise, it may not be as effective as desired.

Preventing Corporate Fraud

Unlike corporate fraud detection, which involves monitoring behavior or transactions to identify a fraudulent scheme after it has occurred, prevention involves taking proactive measures to ensure fraud does not happen. Corporate fraud prevention covers the systems, policies, and procedures put in place by a business to check fraudulent activity. While detection primarily deals with existing fraud threats, prevention largely protects against potential threats. Employing the following corporate fraud prevention strategies can help a business avoid or reduce losses.

Establishing Strong Internal Controls

Internal control is a strong corporate fraud prevention measure. It ensures that no one individual has full control over multiple functions in a process. In other words, with an internal control system in place, no single employee of a company can solely execute a transaction from start to finish without input from other employees. The major elements of a robust internal control system include restricted/limited access, leadership commitment to work ethics, and segregation of employees' duties. Having these elements in a business will establish multiple layers of defense against potential external or internal corporate fraud.

However, establishing strong internal controls is not enough. An ongoing evaluation of control systems is another critical element of control systems. A company must ensure that it regularly monitors and reviews its internal controls system as business needs change and the fraud landscape evolves.

Promoting Ethical Culture

Promoting and maintaining an ethical culture is critical in preventing corporate fraud, especially now that the competition within various industries is fierce. Maintaining ethical culture or practices can foster a work environment where employees of a company act with integrity and honesty unwittingly. This plays a major role in ensuring that a business operates with transparency, hence preventing corporate fraud and investors' and shareholders' interests. Furthermore, maintaining a strong ethical culture within a company promotes accountability and compliance with legal and regulatory requirements.

Generally, employees who work in a setting where ethical values are of paramount importance are more likely to report suspicious activities that may lead to corporate fraud. Nevertheless, leadership plays a vital role in promoting a strong ethical culture among employees of any company. When a company's leadership sets the tone by prioritizing ethical conduct, it is a clear statement to employees that fraudulent activities will not be condoned within the organization. In addition, a company's leadership should organize regular ethics training sessions to educate employees on the need to exhibit an ethical culture at all times. During such training sessions, they must ensure that awareness about corporate fraud is raised and stress that exhibiting ethical practices can help prevent fraud.

Regular Audits and Compliance Checks

Among several other things, regular audits and compliance checks can help in preventing corporate fraud. Any company intending to prevent fraud from happening should have an effective compliance team comprising individuals with relevant expertise in legal and compliance functions. Members of that team must be abreast of relevant laws and industry standards that apply to the industry in which the company operates to ensure compliance at all times. The duty of a company's audit team must include reviewing the company's internal policies and procedures. This will help them determine whether the organization aligns with relevant compliance regulations and identify any gaps that may encourage corporate fraud.

To conduct audits and compliance checks, a company's dedicated audit team should determine the scope of the compliance audit - areas and regulations to be assessed. Typically, the scope of a compliance audit should include evaluating controls, observing processes, and interviewing employees. During the audit, the team should collect relevant documentation and data showing the company's compliance efforts to internal policies and industry standards that may help prevent corporate fraud. Areas where non-compliance is observed must be immediately addressed while continuous monitoring for compliance is ensured.

Legal and Regulatory Framework

The legal and regulatory framework surrounding corporate fraud is put in place in response to crises caused by unethical workplace business practices. It helps ensure that a business is in tune with laws, regulations, and other industry standards that impact the company.

Relevant Laws and Regulations

Certain legislations are the driving force behind various initiatives being implemented to prevent or detect corporate fraud. Such laws and regulations include the Sarbanes-Oxley Act, Dodd-Frank Act, and the Foreign Corrupt Practices Act, which are discussed below:

• Sarbanes-Oxley Act (SOX) - This Act was enacted in 2002 to enhance corporate governance and protect investors interests. The law was created following various scandals in the early 2000s, including Enron, where corporate executives filed deceptive financial statements and were passed down by public accounting companies.SOX mandated audit committees and internal control systems for businesses and introduced the need for CEOs and CFOs to certify financial reports. It also established the Public Company Accounting Oversight Board (PCAOB), a non-profit, private sector group to regulate accountants who regulate public companies. Furthermore, SOX made provisions for implementing criminal punishments for persons caught committing corporate fraud.

• Dodd-Frank Wall Street Reform and Consumer Protection Act - This Act was introduced to increase accountability, transparency, and consumer protection in the financial industry. It brought notable regulatory changes to the industry in response to the lax oversight of financial institutions that led to the financial crisis within the industry. The Dodd-Frank Act requires professionals responsible for compliance programs to understand whistleblower protections and consumer protection provisions.

• The Foreign Corrupt Practices Act (FCPA)- The FCPA applies to United States businesses and industries, as well as foreign entities that make debt offerings in the U.S. or are listed in the nation's stock exchanges. It was enacted in 1977 to prevent bribery and corruption in international business dealings/transactions. This Act prompted the establishment of certain robust compliance programs to ensure businesses do not run foul of the law. As part of the provision of the law, organizations must make strict anti-corruption policies, perform due diligence on third parties, and train their employees on compliance with such policies.

The regulatory agencies focused on corporate fraud prevention include the following:

• Federal Bureau of Investigation (FBI) - The FBI is the lead agency investigating corporate fraud, particularly those involving self-dealings by corporate executives and falsification of financial details. Self-dealing includes kickbacks, insider trading, and misuse of corporate assets for personal gain.
• Bureau of Consumer Protection - The Bureau of Consumer Protection is a division of the Federal Trade Commission (FTC) that stops deceptive, unfair, and fraudulent business practices. It gathers reports from consumers, investigates issues, and sues people or companies found to have broken the law.
• The United States Department of Justice (DOJ) - The President's Corporate Fraud Task Force of the U.S. Department of Justice was established in 2002. Its primary duty is to hold individuals or entities involved in corporate fraud responsible for their actions and restore an atmosphere of integrity and accountability within companies across the United States.

Penalties and Legal Consequences

The legal consequences and penalties for corporate fraud range from imprisonment and hefty fines to various other sanctions, depending on the severity of the offense and the circumstances. For instance, under the Sarbanes-Oxley Act, executives of a company risk up to ten years jail term and up to $1 million in fines for deliberately certifying non-compliant financial reports. Individuals or companies found guilty of corporate fraud could be made to refund double the sum of their fraud gains. In some cases, they risk significant damage to their professional or industry reputation. For individuals, a conviction for corporate fraud may eliminate the possibility of seeking meaningful employment opportunities within their industry.

Corporate fraud is a breach of public trust that can greatly erode a company's finances and reputation. It largely involves deceptive practices by organizations or employees to achieve financial gains. Common examples of corporate fraud include corruption, financial statement manipulation, asset misappropriation, cyber fraud, and false expenses. Considering the spate of corporate fraud schemes across different industries, knowing the red flags is key to preventing or detecting them. With strong internal controls, regular internal audits, the use of technology and data analytics, whistle-blower programs, and a strong ethical structure, a company can prevent or detect incidents of corporate fraud. Furthermore, acting quickly when fraud is suspected within an organization is critical in ensuring the protection of the business.