Focus on fraud: internal controls, audit policies--and a tough stance--can help deter fraud.

• Author: Stern, Adrian
• Position: FRAUD PREVENTION

Consumer fraud in California amounted to $53 million in 2004, according to the Federal Trade Commission. To stop fraud in its tracks, it's necessary to understand the four general elements that must occur to establish fraud:

* A misrepresentation of material facts;

* Knowledge of the falsity of the representations made with the intent to deceive;

* Reliance by the victim upon the misrepresented facts; and

* Actual injury resulting from the misrepresentation.

Typically, fraud occurs in the shadows. While a bank robber steals with a gun in front of employees and customers, the person who steals by committing fraud generally goes unseen.

Three conditions characterize fraud: incentive or pressure, opportunity and rationalization. Examples of incentive or pressure include greed, living beyond one's means or personal financial losses. Opportunity may be found in acts such as taping passwords to computer monitors or leaving signed checks in unsecured areas. Rationalization is demonstrated by attitudes or comments such as "they owe me" or "they have more than enough money to spare."

INTERNAL CONTROLS

The first line of defense against fraud is a strong system of internal controls. While a lack of internal control does not guarantee fraud will take place, it does open the door a bit wider. If people intent on committing fraud think they may be blocked by strong internal controls, they will be deterred.

Examples of poor internal controls include:

* Lack of segregation of duties, such as an individual making bank deposits, posting them to the accounts receivable system and performing monthly bank reconciliations;

* Poor physical controls over inventory, marketable securities or blank check stock;

* Inadequate documentation and support for cash disbursements;

* Inadequate or obsolete accounting software; and

* Failing to perform independent verification, such as spot checks of physical inventory.

To prevent these failures, companies should conduct periodic risk assessments, lead by either internal or external auditing staff. The assessments should focus on high-risk areas, such as physical controls relating to high-dollar fixed assets, cash, marketable securities, payroll and inventory.

Specific questions should be raised during these assessments: Is there a policy of locking doors and filing cabinets after business hours? Does the company require the use of identification numbers and passwords, which are kept secured and rotated on a regular basis...