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Fraud or Incompetence? How to Tell the Difference

Misstatements and omissions of significant information could be the result of either fraud or incompetence. Unfortunately, it is often difficult to tell the difference.

Incompetence is ineptitude and lack of ability, while fraud is intentional deception for financial or personal gain. Knowing which has occurred is important because there are paths toward recovering what was lost when fraud has occurred. Two similar situations in which retail companies experienced significant inventory shrinkage show the difficulty in distinguishing between fraud and incompetence.

A chain of home improvement centers consistently reported strong gross margins, but its physical inventory counts repeatedly showed large and worsening shrinkages. The problem persisted even as the company’s loss prevention department and internal auditors implemented preventive and detective measures to find the source of the suspected inventory theft. However, the problem was eventually traced to clerks in the merchandise buying department who did not understand the vagaries of retail accounting. They were incorrectly entering list prices into the accounting system instead of the company’s actual selling prices, which resulted in grossly overstated book inventory figures. A case of suspected fraud turned out to be incompetence instead.

A smaller retail company that sold baby furniture also consistently reported strong gross margins but experienced major inventory shrinkages. The company’s outside CPA firm attributed the inventory problems to errors made by an accounts payable supervisor whom the accountants considered to be incompetent. When the company went bankrupt, however, the accounts payable supervisor was found to have been involved in a significant long-term embezzlement scheme. The auditors agreed to pay a large settlement in a malpractice case brought against them to recover the losses. What they had perceived as a case of incompetence was, in reality, fraud.

As these examples illustrate, distinguishing between fraud and incompetence is often difficult for even highly trained professionals. What steps can be taken to diagnose whether incompetence or fraud is the challenge? A cursory examination of a company’s accounting records is a good starting point and may reveal errors and inconsistencies that include the following:

  • An insufficient audit trail, including unsupported balances or transactions, or missing support or documents

  • Transactions that were not recorded in a complete, timely, or proper manner

  • Inconsistencies or significant unexplained items in account reconciliations, financial ratios, or other performance measurements

  • Missing inventory, cash, or other physical assets

  • Unrecorded assets or liabilities, and/or misstatements of revenues or expenses

  • Commingling of personal and business assets and transactions, or of other assets that should have been kept separate

The distinction between fraud and incompetence can be especially difficult to discern as a company becomes less and less solvent. In the later stages of insolvency, a company is usually in chaos. As chronic shortages of cash and materials conflict with constant customer emergencies, management may resort to “robbing Peter to pay Paul” just to keep business flowing on a day-to-day basis. Companies often “play the float,” trying to forestall more customers and employees from fleeing.

The typical stressed out manager in such a scenario has difficulty setting boundaries between his business and personal lives, works all hours under tight financial constraints, and considers keeping track of what’s going on to be less important than reacting to creditors in the moment. When there are poor audit trails, misstated balances, and no money, evaluating whether there was fraud or incompetence is not a straightforward process.

At the start of an investigation, all anyone knows for sure is that there is just not enough money to satisfy all the promises that were made. Most regular JCR readers have seen enough incompetency to know what that looks like, but creditors who have payments at risk often cannot believe that they would have made such a bad credit decision. Therefore, they suspect they must have been defrauded.

The Fraud Triangle

Fraud is often perpetrated by someone the victim trusts. It is committed by someone victims may least expect; otherwise, their guard may have been up, and they would have protected themselves better. The most devastating frauds, both monetarily and emotionally, are perpetrated by people who “were like family.”

In many cases, a reliable way to determine whether fraud has occurred or the actors were simply incompetent is to review the situation through the perspective of Donald Cressey’s “fraud triangle,” which states that the three necessary conditions for fraud to occur are a perceived unsharable financial need (motivation), opportunity, and rationalization.

The motivation to commit fraud often stems from debt problems brought about by lifestyle excesses or an overdeveloped sense of entitlement. Sometimes the motivation is psychological, as some people are driven to prove how much more clever they are than everyone else and feel that the way to do this is to deceive those they’ve tricked into trusting them.

Being motivated to commit fraud is common; having the opportunity to act on that inclination is less so. Factors that can create opportunities for fraudsters to act include poor internal controls, an inability by management to judge performance or a lax attitude toward poor performance, a lack of access to information, incapacity or apathy toward maintaining good business practices, and lack of an audit trail. While it is sometimes difficult to tell whether the environment caused the trouble or the trouble caused the environment, troubled companies tend to minimize the value of internal controls and adherence to plans, which makes them potential breeding grounds for fraud.


 

When a fraudster suffers no repercussions, it becomes difficult to resist “free money,” and small thefts become larger and occur at ever-increasing rates.

 


What probably figures most prominently into creating opportunity for a potential fraudster is the level of trust he or she enjoys. There is no single template for fraud or specific personality traits that apply to those who commit these crimes. A report published by KPMG says that people who commit fraud are typically experienced employees who collude with others inside and outside their organization. Fraudsters usually hold managerial or senior executive positions and have no history of criminal activity. They tend to be highly respected and almost always appear trustworthy.

Rationalization is the third leg of the fraud triangle. Many people have both motive and opportunity, but do not commit fraud because they cannot justify doing so to themselves. Nobody likes a poor self-image, even fraudsters. That’s why those who commit fraud tend to blame others for their actions. They rationalize that they had a pressing need through no fault of their own, that they were underappreciated, that the tax system transfers their hard-earned money to the less worthy, or that their victims deserved it. Just as debtors often blame their secured creditor for “entrapping” them in onerous deals with unmeetable covenants, as if the lender forced them to borrow money they couldn’t possibly repay, fraudsters often blame others for “making” them steal from a company.

When employees see their boss mistreat employees, creditors, or even customers, it may embolden them to mistreat their boss. In one case, the sale of a company exposed two long-term frauds—a smaller fraud in which one partner was cheating the other, and a much larger fraud in which the bookkeeper emulated her boss and embezzled a much larger amount from the two partners. Many employees who are caught stealing blame it on a need to get their “fair share” from an abusive employer. Likewise, those who see their lenders or vendors as adversaries are much more likely to defraud them.

Investigators’ Toolbox

Incompetence usually occurs at a constant rate, while fraud tends to build over time. Most frauds start small, many of them by accident—the perpetrator forgets to make a deposit or record a sale, prepares a check incorrectly, makes a minor adjustment to a covenant calculation, uses the company card for a personal expense, etc. In other instances, fraudsters start small, probing to see if they are detected. When nobody notices the initial shortfall, they become emboldened to reach for more and more. When a fraudster suffers no repercussions, it becomes difficult to resist “free money,” and small thefts become larger and occur at ever-increasing rates.

The following are helpful for discerning the difference between unintentional incompetence and malicious fraud:

  • Experience with both competent and incompetent accountants. Familiarity with both types is helpful for understanding differences in their thought patterns. Fraudulent accountants try to hide what they’ve done; incompetent accountants often try to hide what they don’t know. Incompetents make errors in all kinds of accounts, while fraudsters’ activities tend to be focused in narrow areas where activity is harder to verify, such as cash transactions, off-books activity, or judgment accounts, such as reserves, valuations, and accruals.

  • An understanding of a fraudster’s mindset and the context in which it operates. Publicly held companies are more likely to overstate income and assets; privately held companies are more likely to try to hide income and assets from creditors, spouses, taxing authorities, partners, etc. Entrepreneurs often don’t pay enough attention to accounting, and their systems may be sloppy enough to appear fraudulent, which makes understanding the business owner’s personality important in determining intent and rationalization.

  • Enough business experience to recognize when relationships, procedures, or events do not make sense. Examples include sales on commission reports that differ from the sales reported to the bank, lifestyles that cannot be supported on a person’s salary or the income reported on their tax returns, excessive numbers of transactions with related companies, lack of an audit trail on transactions that should be simple to account for, and employees lacking the credentials and experience to satisfy their job descriptions.

  • Familiarity with accounting systems. Understanding the weak points and detection tools of various accounting systems, what types of mistakes users typically make with them, and how to coax useful information from them are important skills. In QuickBooks, for example, reports can be modified to disclose both the person who made an accounting entry and the exact date and time it was made, which can be useful in determining whether an inaccurate entry was a contemporaneous error or an after-the-fact cover-up.

  • The ability to spot patterns and inconsistencies. Incompetents are often uniformly sloppy, while fraudsters are regularly meticulous about every detail with one or two out-of-character exceptions, such as a single missing vendor file or a couple missing canceled checks. When a painstakingly thorough person loses something or makes a mistake, that isolated instance could have much more significance than the daily errors their incompetent peer commits.

Knowledgeable professionals with experience in forensic accounting and fraud investigations develop some rules of thumb for determining whether a subject is incompetent or dishonest.

For example, incompetents generally don’t like to talk to investigators. Fraudsters, on the other hand, love to show how clever they are and will often talk in extensive detail about almost anything imaginable. However, they become inexplicably vague or uninformed when the area in which the fraud occurred comes up in conversation. With these individuals, it’s best to focus on the few areas they try to skim over.

In many cases, fraudsters feign incompetence when they realize they are being investigated; they claim limited knowledge of the situation and blame themselves for being oblivious to whatever mistakes or schemes others were committing in their midst. True incompetents, on the other hand, are tremendously fearful of being judged as inept by others—or even of admitting to themselves that they may have made catastrophic mistakes and misjudgments.

Fraudsters typically appear at ease when they are being investigated, because they don’t believe they’ll be caught. They also expect that if their misdeeds do come to light, they can talk their way out of any trouble. They are often glad to volunteer to help an investigator find the “real culprit.” Incompetents, in contrast, are often openly hostile to any investigation. They tend not to volunteer information and to answer questions as sparingly as possible. Their attitude seems to be: “Don’t bother me. Just do what you have to and then leave.”

When a good-natured guy wants to buy an investigator a drink while he explains how incompetent or in over his head he was, the investigator should start trying to determine what the person stole and how he did it. That kind of behavior contrasts starkly with that typical of incompetents, who, though they may feel vaguely uneasy, don’t recognize their inadequacies and can only offer a blank stare in response to a question for which a fraudster would have a rehearsed, ready answer.

Compared to both fraudsters and competent employees, incompetents tend to be more secretive, less action-oriented, overly sensitive, less able to meet deadlines, more focused on small tasks to the detriment of the big picture, and enamored more with procedures than with results. Incompetents are usually more negative and impulsive, and they give up easily (they often stack all the things they can’t do in piles). They are less productive than average but try to make up for it by working more hours than normal.

An experienced tax attorney usually can accurately gauge somebody’s personality just by looking at the person’s tax return—where and how they invest, their proclivity for debt, whether they are savers or spenders, how successful they are, etc. Likewise, an experienced forensic accountant can often discern the personality and proclivities of people who prepared the financial information being reviewed. Combining that ability with observations of people to see how they interact with their work, with each other, and with the investigator provides powerful insights for discerning whether the lack of clarity in an insolvent situation is due to fraud or incompetence.

Michael Goldman

Michael Goldman

KCP Advisory Group LLC

Michael Goldman is a senior managing director of KCP Advisory Group LLC. He has been qualified in both state and federal courts as an expert witness in cases involving fraud, solvency, fairness, commercial damages, marital dissolutions, valuation issues, professional malpractice, and bankruptcy issues. He is a CPA, has an MBA, and holds CVA, CFE, and CFF certifications. Previously, Goldman was a professor at the Lake Forest Graduate School of Management and designed courses in the school’s corporate education division.

Topics: 
Fraud
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