Uncovering the Fraud Triangle and Other Misconduct

By PAUL REYES, CPA BEDERSON LLP; MATTHEW SCHWARTZ, CPA/ CFF, CFE, CIRA; and TIMOTHY KING, CPA/CFF, CFE - BEDERSON LLP

Accountants are relied upon to uncover fraud across a number of disciplines, including, audit, attorney trust accounting and bankruptcy. Here are some of the warning signs as well as tips for preventing fraud.

AUDIT From an auditor’s point of view, fraud risk is a major factor. It affects every stage of the audit, from planning to performance and, finally, completion. Three factors, commonly referred to as the “fraud triangle,” can lead to fraudulent acts within an organization: Pressure, opportunity and rationalization.

* Pressure is represented by a financial or emotional force that pushes one toward fraud. This may be difficult for the organization to foresee, as an employee’s personal finances and motivations cannot easily be ascertained. Knowing about employees can help reduce this vulnerability to fraud. For example, background checks can be run on new employees. It is also important to make sure vacation time is taken annually. When an employee does not take time off, it is possible they are doing so to enable the concealment of fraud.

* Opportunity is an ability to execute a plan to commit fraud without getting caught. Maintaining good internal controls can mitigate this factor. Segregation of duties, (e.g., not having the same employee handle the processing of receipts from customers and the authority to approve write-offs or managing petty cash and recording the transactions in the accounting system) is imperative. Additionally, restricting access to certain financial data and closely watching bank account activity for suspicious transactions is paramount to limiting opportunities to commit fraud.

* Rationalization is a personal justification for the dishonest actions. An employee who feels underappreciated or undercompensated can be motivated to commit fraud. Combined with opportunity, this factor can be one of the most compelling. Like pressure, rationalization can be difficult to see coming. But fraud committed by long-term employees who do not receive the desired acknowledgement, advancement or monetary compensation happens more frequently than an employer might expect.

Understanding how fraud can occur is important. The fraud triangle can be a valuable tool in detecting it if it does exist and preventing it in the future.

ATTORNEY TRUST ACCOUNTS

Accountants are rarely asked to be involved in their attorney clients’ trust accounts until there is a problem — and that problem is often an ethics complaint, either from a client or the New Jersey Office of Attorney Ethics. Either way, an ethics complaint is a claim that an attorney has misappropriated client funds and thus violated both the New Jersey Rules of Professional Conduct and Court Rules. In other words, it’s a claim that the attorney has committed fraud.

Any attorney who faces such a complaint should immediately seek competent representation. However, having good accounting practices will go a long way in successfully responding to any such claim.

Both attorneys and accountants who do any work for attorneys should be familiar with Court Rule 1:21-6, which is available at njcourts.gov/notices/ioltarules.pdf. This rule requires any attorney licensed in New Jersey to keep track of all client funds separately. This does not mean that all client funds must be in separate bank accounts, only that they be tracked individually, like an accounts payable sub-ledger. In addition, no client funds can be overdrawn. For example, if an attorney deposits $10,000 on behalf of Client A, disbursements on behalf of Client A cannot be more than $10,000, even if the attorney’s trust account has additional funds. Further, the $10,000 disbursed can only be from cleared funds. Therefore, checks cannot go out the same day the deposit is made. The one exception is if the deposited funds are bank checks. In addition, the account must be reconciled at least monthly.

Although there are more rules, following the above will go a long way to demonstrating proper record keeping.

Practice tip for attorneys: ask your accountant to periodically analyze your trust account to make sure you are following proper procedures.

Practice tip for accountants: if your attorney-client does not ask, suggest it would be in their best interest for you to provide such a periodic analysis.

BANKRUPTCY

There are many types of bankruptcy fraud. One of the most common types is fraudulent conveyance. To overly simplify, a fraudulent conveyance is a transfer of the debtor’s assets made to a third party in order to place them beyond the creditors’ reach.

Under Section 548 of the Bankruptcy Code, a trustee may recover any transfer of funds or property that took place within two years of the filing of the petition while the company was insolvent, which was not made for reasonably equivalent value that was made to an insider.

One way to identify such a transaction is to review the company’s records for large payments and investigate the backup documents and other information to determine if a possible action exists.

Finding that company payments were made to a personal credit card is a sure red flag. It is not uncommon for a review of statements to reveal that items such as luxury cars and expensive jewelry were paid by the company. In most of these situations, the threat of a lawsuit will result in settlement.

When frauds take place that do not involve a diversion of funds, they are usually difficult to uncover and even more difficult to prove. Here’s a real-life example: A company’s principals take enormous funds which are not reflected as compensation. To hide the problem, they overstate the company’s inventory by several million dollars. At one point, the bank demands audited financial statements. The principals devise a scheme where they count all the inventory in their large warehouse under the supervision of a CPA firm in late December and then move all the inventory to their stores and count it a second time. The scheme worked for a couple of years until the CFO, a co-conspirator, died suddenly. When the principals were questioned, they claimed that they went into their warehouse on Dec. 30 and discovered that all the inventory had been stolen. Then the company filed bankruptcy.

Paul Reyes, CPA, is a supervisor of accounting and auditing at Bederson LLP. He is a member of the NJCPA and can be reached at preyes@bederson.com. Matthew Schwartz, CPA/CFF, CFE, CIRA, and Timothy King, CPA/CFF, CFE, are the co-managing partners of the insolvency and litigation services department at Bederson LLP. They are both members of the NJCPA and can be reached at matthew.schwartz@bederson.com and tking@ bederson.com, respectively.