July 2003

The Benefits of a Fraud Hotline

By Thomas A. Buckhoff, PhD, CFE, CPA

Bill Blake” was terminated by his employer, a retail grocery business, for unsatisfactory job performance evaluations. Finding himself out of a job and in need of money, Bill decided to retaliate against his former employer. Having worked in accounts payable, he knew that the company did not have adequate controls over that area. He created a fictitious vendor named “Tri-State Trucking” and, using an Excel spreadsheet, created and submitted Tri-State Trucking invoices to his former employer for services that were never rendered. The accounts payable department approved the invoices, and checks were made out and sent to Tri-State Trucking’s post office box address. After stealing $1.8 million over five years, Bill bragged about his ongoing fraud scheme to a stranger in a bar. The next morning the stranger called Bill’s former employer and alerted them to the scheme. Bill was ultimately convicted of fraud and sentenced to five years in prison.

“Pete Raymond” was the president and CEO of a medium-sized business specializing in data processing. The company’s board of directors did not create and enforce adequate internal controls to monitor Raymond’s activities, an oversight common to many corporate boards. Pete exploited this lack of oversight and embezzled more than $800,000 from his employer via a variety of disbursement schemes. After years of getting away with hundreds of thousands of dollars, Pete became reckless and sloppy in executing his schemes. For example, some of the invoices submitted by fictitious vendors created by Raymond were simply handwritten by him on blank sheets of paper. Eventually, the increasingly large amounts of cash being diverted to Raymond created cash flow problems for the company, which prompted a forensic examination of the company’s finances. When questioned about the suspicious handwritten invoices, Raymond’s secretary acknowledged that she knew that the invoices had been created by Raymond and that such conduct constituted “impropriety” on the part of the CEO. Because the perpetrator was the president and CEO, Raymond’s secretary said she didn’t know who to tell about the fraudulent invoices. The company did not have an anonymous “hotline” for reporting this type of behavior.

The Problem

The two actual cases summarized above highlight the increasingly serious problem of fraud in the workplace. The Association of Certified Fraud Examiners (ACFE) defines fraud as the use of one’s occupation for personal gain through the deliberate misuse or theft of the victim organization’s resources or assets. According to the ACFE’s Wells Report (2002), fraud cost organizations $600 billion per year, or about 6% of gross revenues. Consistent with the cases cited earlier, the report also indicates that:

In the aftermath of numerous corporate scandals, organizations are now expected to be more active in developing and maintaining effective fraud detection and prevention programs. According to the Federal Sentencing Guidelines, organizations can be liable for the unethical or illegal conduct of their employees. In 2001, the U.S. Sentencing Commission ordered 186 organizations to pay fines averaging $2.2 million each for the unethical or illegal conduct of their employees. Unfortunately, none of the organizations received a reduction in fines for having in place an “effective program to prevent and detect violations of law.” The Sarbanes-Oxley Act of 2002 requires public companies to establish procedures for the “receipt, retention, and treatment of complaints” received by the organization regarding accounting, internal controls, and auditing. Violations of these new regulations can result in penalties of fines and up to 10 years imprisonment.

In summary, the costs associated with the failure to prevent fraud come in several forms: 1) losses resulting directly from the fraud scheme itself, 2) fines imposed by regulatory bodies and the courts, 3) lawsuits initiated by a variety of stakeholders, and 4) higher insurance premiums. Organizations without effective fraud detection and prevention programs will eventually follow the paths of Enron, WorldCom, and Arthur Andersen into bankruptcy and extinction.

The Solution

Since most frauds are known to others, organizations must facilitate the transfer of this information from those who have it to those who need it. A fraud hotline can provide the following benefits: First, and most obvious, it can effectively uncover fraudulent activity. Fraud losses tend to increase over time, so early detection is important. Indeed, the 2002 Wells Report found that organizations with fraud hotlines cut their fraud losses by 50% per scheme. Second, the most effective way to prevent fraud is to instill a “perception of detection” in the minds of potential perpetrators. Few people will commit fraud if they think they will be caught. Well-publicized fraud hotlines strengthen the perception of detection and let employees know that fraud will not be tolerated. Third, a hotline can also be used to report incidences of unsafe working conditions, workplace violence, harassment, or other serious issues, thereby reducing expenses resulting from shortages, fines, workers’ compensation claims, lawsuits, negative publicity, and lower productivity. Finally, a hotline can help satisfy the Sarbanes-Oxley Act’s new requirement that organizations establish procedures for the “receipt, retention, and treatment of complaints.” In addition, federal fines resulting from the unethical or illegal acts of employees can be significantly reduced if the offending organization has in place an “effective program to prevent and detect violations of law.” Hotlines are an integral part of an effective prevention and detection program.

Several factors are critical to the effectiveness of fraud hotlines. First, they should be available around the clock. Employees typically will not call during work hours to report on coworkers or bosses. Hotline studies indicate that over 40% of calls are made at night or on weekends. If no one answers the call, many times the employee won’t call back. Second, to preserve confidentiality and to protect the caller from possible retaliation, the caller must be allowed to remain anonymous. Third, since anyone within the organization could be involved in the fraudulent activity, the hotline must be maintained by a third-party provider. The hotline provider should have trained professionals who can listen effectively, ask relevant questions, document the contents of the call, and quickly convey the information back to the organization. Finally, employees need to know that the hotline is available and know why they should use it. Promotional materials such as posters, signs, and brochures will help educate employees about company policies, procedures, expectations, and commitment to a fraud-free, employee-friendly work environment.

In summary, fraud hotlines can reduce losses resulting from fraud, negative publicity, and poor workplace morale. They improve employee morale and loyalty by empowering employees to speak up and make a difference. Effective hotlines promote a desirable work environment that, in turn, can enhance the organization’s ability to attract and retain quality employees. In an environment of declining ethical values, hotlines are a necessity for organizations wanting to remain competitive.

Robert H. Colson, PhD, CPA
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