With losses due to fraud increasing, companies should begin to consider ways to protect against misappropriation of assets. According to a 2018 report from the Association of Certified Fraud Examiners, the typical organization loses 5% of its annual revenue to fraud. Further,  23% of cases involving employee fraud result in a loss of at least $1 million, ACFE said.

Interestingly, while management’s implementation of appropriate internal controls can mitigate against the risk of fraud occurring, they may not be able to prevent or detect fraud in cases of employee collusion. Because of this risk, companies should consider obtaining “fidelity insurance” to protect against employee-related fraud.

This article discusses the scope of fidelity insurance policy coverage, the types of employee fraud, and procedures a company should follow if there is a suspicion of employee fraud.

Fidelity Insurance

Fidelity insurance covers incurred losses or damages due to acts of employee fraud. These can include the misappropriation of company cash, inventory, and long-term assets and misuse of corporate credit cards.

Harry Steinmetz

It is essential to understand that while losses related to tangible property are often subject to coverage under these policies, the policies do not cover damages associated with potential income that could have been earned on the stolen assets.

A common misconception with fidelity insurance is that revenue associated with the inability to collect interest on cash stolen (or the loss in margin due to inventory theft) is subject to coverage under the policy. In fact, it is not.

Depending on the underlying policy, the insurance is intended to cover the intrinsic value of the assets (cash, inventory, and other property).

Although each policy is unique to the insured, losses incurred from accounting errors or mistakes are not covered by the policy. The insured must have suffered losses directly related to fraud or theft perpetrated by an employee.

To support the claims, the insured must demonstrate a pattern of transactions that appear to not comply with the insured’s policies and procedures, or that are unusual in nature. Moreover, among other things, there must be proof of intent, via the production of misleading documentation and other methods of concealment.

Types of Employee Fraud

There are many ways in which an employee(s) can commit fraud, of which asset misappropriation is the most common. The following are three major types of asset misappropriation:

Cash Receipts

Fraud related to misappropriation of cash receipts falls into two distinct categories. Depending on the timing, cash fraud can be categorized as either skimming or larceny.

Nicole Lu Chen

Skimming is a type of “off-the-books” theft, as the perpetrator steals cash before it can be recorded in the accounting system. Skimming is often difficult to detect, as there is no direct audit trail obtainable from the books of the account. Employees who are in a position to receive payments can easily skim cash if there are no effective internal controls to mitigate against it.

One of the most common skimming schemes is when goods or services are sold to a customer, and an employee is able to collect and keep the customer’s payment without  the sale being recorded. Loss of gross margin and inventory shortages are indicators that this problem exists.

Larceny is the theft of assets already recorded in the company’s accounting system. The perpetrator may steal money directly from a cash register after the processing of sales transactions, or misappropriating physical customer checks and recording the cash receipts. From an audit trail perspective, larceny can be detected with effective internal controls.

Fraudulent Disbursements

Perpetrators will make distributions of company funds to either themselves or to third parties colluding with, controlled by, or related to the employee.The three most common fraudulent disbursement scams are billing, payroll, and expense reimbursement fraud.

In billing fraud, the perpetrator creates fraudulent invoices and processes them through the accounts payable system. The perp may also make personal purchases on company-issued credit or debit cards, or through company bank accounts through wire transfers.

In payroll fraud, the perpetrator often falsifies payroll documents to cause the company to process payroll disbursements to non-employees.

The most common type of payroll fraud involves ghost employees — people who don’t work for the company but are included in payroll cost. The non-employee can be either a fictitious person or a real one who’s not a bona fide employee. In other cases, the perpetrator creates a ghost employee with a name very similar to that of an actual employee and cashes the check themselves.

In expense reimbursement fraud, the perpetrator can manipulate reimbursement reports to obtain reimbursement for non-business disbursements. The perpetrator can also mischaracterize expenses by overstating costs and creating fictitious or altered invoices for purchases.

Inventory and Other Asset Misappropriation

The most common schemes under this fraud category involve purchasing and receiving inventory. The perpetrator can falsify the records of incoming shipments by agreeing that the quantity received matches the shipping documents and then stealing inventory. While this shortage is identifiable once a physical inventory is taken, it may be difficult to identify how the shortage occurred and who is responsible.

Another way employees can commit fraud by theft of inventory is to  falsify sales and inventory-shipping documents, deliver the inventory to either themself or a third-party, and record a provision for uncollectible accounts receivable.

What to Do if You Suspect Employee Fraud

We typically recommend the following if you suspect employee fraud:

Consult with Professionals

The most critical step to recover your loss is to consult with your lawyer and with a professional experienced in detecting and determining employee fraud, such as a forensic accountant.

Retaining a forensic accountant early on will mitigate against increased losses, and if fraud is caught early it can minimize the destruction of supporting documentation evidencing the fraud. Having a forensic accountant involved in the process also aids in the preparation of a fidelity claim with the insurance provider.

Review Internal Controls, Including Safeguarding of Documents

It is also essential to obtain all documentation evidencing the fraud, as it will provide a paper trail enabling a forensic accountant to reverse engineer the magnitude of the fraud.

You should document the name and employment details of the alleged perpetrators, the details of fraud incidents, and police involvement (if any). Forensic accountants will use the documentation to develop a timeline of events, gain an understanding of how the employee perpetrated the fraud, identify the extent of the losses suffered, determine how the employee ultimately concealed the fraud, and the status of the assets stolen.

Commence an Investigation

It is vital to retain professionals to assist in conducting a formal investigation. Engaging a forensic accountant and lawyer can help with the direction of the investigation, the identification of key individuals involved, obtaining relevant documentation, and preparing an expert report that can serve as evidence in a court of law.

Whom Should You Notify?

If your organization has fidelity insurance coverage, be sure to notify your insurance provider to ensure that a Proof of Loss and Claim is appropriately filed within the timeline specified in the policy. A forensic accountant with experience in fidelity insurance claims can help you with the claim.

If criminal charges are pressed against the perpetrator, law enforcement should be involved as early as possible.

Harry Steinmetz is partner-in-charge of New York forensic, litigation, and valuation services at audit firm Friedman LLP. He is also partner-in-charge of transaction advisory services at the firm and a Certified Fraud Examiner. Nicole Lu Chen is a manager at Friedman.

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