What's the price tag?

Fraud examiners can help their organizations measure the economic effects of fraud and thereby aid management to more accurately assess and adjust prevention and detection efforts.

The Enron fraud of 2001 caused its bankruptcy, the wipeout of $78 billion in stock market value and the collapse of the professional services firm, Arthur Andersen, according to The 10 Biggest Frauds in Recent U.S. History, Forbes magazine. And when the Qwest Communications accounting fraud came to light, its stock dropped from a trading high of $64 in 2000 to less than $1 in 2002, according to the Forbes article. Investors recouped pennies on the dollar for their losses.

Fraud is expensive in so many ways. It decimates retirement accounts, ruins reputations and inflicts mental anguish. Businesses, owners and investors lose billions from the theft of cash and other assets, devaluation and lost economic opportunities.

Businesses need to measure the negative economic impacts of fraudulent activities to determine sustained losses and to assess the degree to which management must adjust internal control environments for improved fraud prevention. Unfortunately, fraud examiners sometimes face difficulties in accurately and completely measuring these negative economic impacts.

This article focuses on 1) some of the challenges fraud examiners confront in measuring the economic impacts of fraud and 2) approaches and benchmarks fraud examiners should consider when measuring the economic impacts of fraud.

CHALLENGES IN MEASURING THE ECONOMIC IMPACTS OF FRAUD

Several factors associated with fraudulent activity create challenges in quantifying the economic impacts of fraud. For example:

• The fraudulent activity occurs over an extended period of time. The ACFE's 2014 Report to the Nations on Occupational Fraud and Abuse reported that the median duration for fraud cases reported, from commencement to detection, was 18 months. Such extended periods can potentially increase the magnitude of economic harm and the perpetrator's concealment activities.
• The extent to which fraud is concealed. In many instances, the more elaborate the cover-up the more difficult it might be to accurately measure the economic impact of the fraudulent activity.
• The extent to which upper management and/or ownership is involved in the fraudulent activity. According to the Report to the Nations, page 41, a "strong correlation [exists] between a fraudster's level of authority and the financial impact of the fraud."
• The collusive nature of the fraudulent activity. Collusion creates significant difficulty in investigating the extent of the fraud and, thus, might complicate the measurement of the economic impact, according to the AICPA's AU Section 230 Due Professional Care in the Performance of Work, paragraph 12. Collusion additionally tends to increase the economic harm to an organization, according to the Report to the Nations, page 46.
• "Tip of the iceberg" effect. This factor involves being able to easily measure direct losses from fraudulent activity that are plainly visible but also might involve a huge mass of hidden harm that isn't plainly visible, according to the Report to the Nations, page 8.
• The type of harm suffered can be difficult, or even impossible, to accurately measure. For example, if a fraud is highly publicized it's extremely difficult if not impossible to measure the impact the fraud might have on current and future profits of a company.
• The industry in which a company operates affects the degree of harm an organization experiences. For example, Arthur Andersen was a worldwide professional services firm in the accounting and consulting industry with billions of dollars in revenue. Because of activities related to Enron and the U.S. government's obstruction of justice indictment in 2002, the firm's reputation suffered greatly and it basically went out of business thereafter.
• Time pressures and cost constraints affecting the investigation. Fraud examiners occasionally might be limited by cost and time constraints to accurately and completely measure the full impact of a fraud.

CALCULATION APPROACHES AND BENCHMARKS

"Cash is king"

Of course, schemes vary depending on pressures and opportunities, but most individuals perpetrating fraud focus their efforts on enriching themselves through the theft of cash. Given this focus, along with the fraudster's deliberate concealment of the crime in company accounting records, it's often best to focus on cash as the starting point when investigating and measuring losses suffered from fraudulent activity.

For example, 4NExchange, LLC, was a multimillion-dollar Ponzi scheme operating in the state of Utah from 1999 through mid-2002. The U.S. Securities and Exchange Commission shut down company operations and, as part of the process of investigating and measuring investor losses, hired my former firm. By focusing on the cash flow, our investigation allowed us to:

• Prove that 4NExchange, LLC, derived almost all of its "profits" by taking money from one investor and paying promised returns to other investors (the essence of a Ponzi scheme).
• Quantify the net amounts individual victims/investors in the scheme either benefited from or lost in making their investments.
• Measure the overall net damages, which proved to be important to both the civil and criminal actions brought against the perpetrators.
• Identify additional schemes and entities to which investor money flowed. This last area was of importance in identifying potential sources of recovery.

In another case, focusing on the cash proved most beneficial in measuring investor losses suffered because of the embezzlement of funds from a water rights company. The business activity of the company was to collect investor money and to buy and sell local water rights. The appointed manager of the water rights company inappropriately removed funds to make personal investments, reimburse personal expenses and supplement his salary.

The investigative approach involved recreating the cash flow of the company. Focusing on the cash flow as the starting point allowed us to accurately measure the overall investor losses suffered from the manager's embezzlement activities and to aid investors in recouping losses through the litigation process.

Accrual accounting

In certain schemes, the fraud examiner has to focus primarily on accrual accounting (e.g. financial statement fraud). This requires the fraud examiner to have a thorough understanding of accrual accounting to properly measure the impact of the fraud on company profits. For example, in cases involving revenue recognition the fraud examiner investigates instances of the early booking of and/or the overstatement of revenue as compared to the guidance set forth by Generally Accepted Accounting Principles (GAAP).

The fraud examiner might then be charged with measuring the extent to which profits were overstated due to any fraudulent revenue recognition activities. The fraud examiner performs this calculation by preparing two sets of financials — one that shows the profits with the overstated revenue and another without the overstated revenue. The difference in the two sets of financials shows the extent to which profits have been overstated.

Opportunity cost

Many companies are also impacted through lost economic opportunities because of fraud. Examples include missed investments (e.g. interest income, new business opportunities and others), the need for cash infusions by company owners, additional expenses paid due to late payments incurred because of a lack of funds, etc.

Lost economic opportunities in this area might be more difficult to measure because the calculation involves focusing on what might have been instead of what actually happened. Companies, however, should consider and even quantify the lost economic opportunities so a true picture of losses suffered can be determined.

In the water rights embezzlement case above, the manager invested approximately $1.6 million of investor funds in related-party entities instead of in legitimate investment opportunities. Had the manager acted in line with his contractual responsibilities, investors potentially could have received substantial returns to their investments.

Sometimes, employees fraudulently take funds from their employers and then attempt to rectify the situation secretly by partially paying back a portion of the funds they originally stole. (In fact, these partial payments, in some instances, lengthen the period of the fraud because of the perpetrator's eased conscience and the positive effect these partial payments might have on the perpetrator's ability to rationalize the fraud.)

In the meantime, with amounts still owed to the company, some owners and investors are forced to make cash infusions into their companies not knowing that the shortage of cash occurred because of the fraudulent acts of their employees.

Tip of the iceberg

In many cases involving fraud, the original discovery of a problem, or the red flags that triggered an investigation, might in fact be symptoms of a much larger problem. For example, in investigating the 4NExchange LLC, Ponzi scheme, fraud examiners determined that the perpetrators used investor funds in a prime bank scheme and in another investment-related scam in a neighboring state. Fraud examiners can only accurately and completely measure the economic impact of fraudulent activity in which we've found additional fraud was discovered only after completion of the entire investigation.

Impact of time and cost constraints

In some instances, fraud examiners are limited by time and/or cost constraints, which forces them to cut short completion of a full-scale examination of a much larger problem. Despite these limitations, fraud examiners should communicate to their organizations any measures of economic harm obtained from their limited examinations.

Also, it might make sense for a fraud examiner to estimate any economic harm suffered from the fraudulent activity that he or she wasn't able to fully investigate because of the constraints. This might be possible through educated estimates developed from the limited examination. For example, the fraud examiner might have noticed certain patterns that allow him or her to reasonably estimate the additional harm.

Benchmarks

A fraud examiner might find it useful to utilize fraud benchmarks typical of the alleged fraudulent activity being investigated. The following sources are illustrative of benchmark information that might be useful to fraud examiners:

• The Report to the Nations provides valuable benchmark information associated with fraud. For example, the report provides median statistics, measures of effectiveness for various fraud-fighting internal controls, conclusory language that might be valuable to fraud examiners as they formulate their investigation plans, etc. The ACFE additionally provides other information that might provide valuable benchmarks to fraud examiners.
• Certain industries measure (with varying degrees of success) frauds specific to their services and products. For example, the National Insurance Crime Bureau (NICB) is a not-for-profit organization that focuses on fighting insurance fraud. As part of its services, the NICB's data analytics department focuses on providing crime-trend analyses and studies on insurance fraud topics that might aid fraud examiners in insurance-related fraud issues.
• Governmental agencies provide national and local statistics. For example, the FBI provides multiple reports and publications on specific types of white-collar crime. A state government might have agency benchmark information on consumer fraud or health care fraud.
• Some professional services firms such as Ernst and Young publish fraud survey reports that might provide useful benchmarks.
• Other fraud examiners might offer invaluable information based on their own experiences and research. Stay connected with your colleagues so they can strengthen your abilities to better serve your organizations and clients.

CALCULATING THE PRICE TAG

Fraudulent activity, of course, has a negative economic impact on businesses. Properly trained fraud examiners are in prime positions to aid companies in measuring this economic impact. Fraud examiners measuring the negative economic effects of fraudulent activity help their organizations recoup losses and determine the extent to which management needs to change control environments to prevent any further fraudulent activities.

Jared A. Funk, CFE, CPA, CGMA, is the managing consultant for the Berkeley Research Group in Salt Lake City, Utah.

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