Nonprofit Blog

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Tuesday, December 6, 2011

Issues & Insights: Nonprofits More Susceptible to Fraud for a Variety of Reasons

Posted by Paul O'Grady

Got an employee who never takes a vacation? Does your controller always bring you invoices to sign at the end of the day on Fridays as you’re preparing to leave? Are your financial statements and bank reconciliations perpetually late? If so, you and your organization could be the victims of fraud. In the following article, Armanino McKenna Partners Jeff Stegner and Paul O’Grady discuss how to recognize the signs of fraud and how you’re organization can greatly reduce its risk of fraud with just a few simple organizational and process changes.

In its bi-annual Report to the Nation, the Association of Certified Fraud Examiners captures nationwide data from police, court and insurance records and delivers the scary results: fraud continues to be rampant and widespread, touching all business categories and industries. In fact, organizations on average lose 5 percent of their annual revenue to occupational fraud perpetrated by employees. Additionally, financial statement audits are attributed with discovering 7% of fraudulent activity.

Nonprofit organizations, in particular, are susceptible to fraud. At a recent webinar conducted by Armanino McKenna on occupational fraud in nonprofits, 63 percent of attendees who responded to a polling question said that their organizations had experienced fraud in the past.

Jeff Stegner, an Armanino McKenna Partner and expert in fraud investigation and forensic accounting, says this isn’t surprising. “In many cases, nonprofits are more exposed to misappropriation of assets, goods and cash,” Stegner says. “With the current poor economy, the tendency to rationalize stealing and to give way to feelings of entitlement among employees increases. If you combine that with inadequate internal controls, you create an environment that is ripe for fraudulent activity.”

The mechanisms for perpetrating fraud are legion: check tampering, falsification of time sheets and expense reimbursements, skimming of cash, and even the creation of fictitious vendors and “ghost” employees set up to receive stolen funds, are all examples of occupational fraud that is experienced by nonprofit organizations.

There are three conditions that must be present for fraud to occur in nonprofits:

Pressure – Problems at home, expensive tastes, medical bills, and addictions experienced by individuals within your workforce create personal financial pressure that is difficult for some employees to resist. Generally an unshareable financial need.

Opportunity – Individuals who have the authority to conduct transactions on behalf of your organization and who are feeling “pressure” are more likely to commit fraud.

Rationalization – Employees who feel pressured and who have access to funds or bill paying rationalize their stealing. In nonprofits, where budgets are often tight and compensation may be frozen for extended periods, employees who would otherwise be ethical can get on the slippery slope of rationalization where they convince themselves they are “borrowing” money and intend to pay it back, but never do.

Two of these conditions, pressure and rationalization, are beyond the control of senior management or boards of directors because they can’t be easily detected. Even when they are, senior managers don’t often view them as warning signs of fraud.

“Often, the guy who never takes a vacation is viewed as having a strong work ethic, or as a beneficent control freak,” Stegner says. “But I can’t tell you how many fraud cases have surfaced when the hard working employee finally does take a vacation. The fact it, that employee is often perpetrating a fraud that he or she knows will be discovered if they are not there to keep the cover up going.”

Despite these hidden problems over which management has little control, the third condition, opportunity, can be taken away or greatly reduced, thus providing greater security for your nonprofit organization.

“You can make it nearly impossible to commit occupational fraud by implementing strong, but simple controls,” says Paul O’Grady, an Armanino McKenna Partner who leads the firm’s nonprofit audit practice. “These don’t usually require a big commitment of either time or money.”

O’Grady gives a few enterprise wide examples:

Create an anonymous whistleblower or tip system – If you have an employee Intranet website, you can implement a section where personnel who suspect or observe fraud can anonymously feed tips to your human resources or executive team. The employee could opt in or out of revealing their identity through the page and the program should include rewards for employees who tip management off to the problems.

Conduct surprise audits – Ask your internal or external auditors to conduct surprise audits of specific departments or operations and rotate the audits through an annual cycle.

Implement a policy of mandatory vacations – Insist that all employees take vacations. This can be driven through a “use it or lose it” vacation policy, or a simple directive from management. Vacationing regularly also has been proven to have beneficial effects on overall productivity.

Make job rotation routine – Cross training and job rotation are excellent ways to both increase fraud detection (as employees with fresh eyes come into a new job they are more likely to spot issues) and to strengthen your overall organization.

Build an ethical culture – A company either flourishes, or rots, based on the tone set by its CEO and senior management team. If a company expects to maintain a good reputation and wants to be perceived as transparent and trustworthy, you can’t have a CEO known for questionable business and personal behavior. On the other hand, a CEO known for both business acumen and ethical behavior sets a very positive tone that is always well received by employees and the marketplace.

In addition to enterprise wide initiatives, both O’Grady and Stegner say there are numerous financial controls that can be implemented that remove the opportunity to commit fraud. Some of these include:

  • Encourage all employees to take direct deposits.
  • Review detailed payroll reports on a regular basis.
  • Reconcile bank statements promptly.
  • Insist on original receipts for all out of pocket expense reimbursements.
  • Segregate accounting from cash receipts reporting.
  • Ensure the monthly close happens at the end of each month.
  • Regularly review accounts payable and vendor listings.
  • Employ your auditors to look at financial processes and test transactions following a downsizing (downsizings where employees are laid off often reveal previous fraudulent activity).
  • Do not allow a single employee to perform multiple financial tasks such as signing checks, authorizing disbursements, recording transactions and reconciling bank statements.

With times being difficult right now, Stegner says that for nonprofits, it is more important than ever to create a strong culture of ethics and to implement even stronger financial controls. He sums it up this way: “Trust, but verify.”

If you need additional information regarding this article, contact Jeff Stegner or Paul O’Grady at 925.790.2600.

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