Accounts Payable Fraud: Identification & Prevention Guide

To safeguard an organization’s financial health and security, businesses, regardless of size, must remain vigilant over their financial transactions and adopt strategies to thwart and manage fraudulent activities. Ignoring this could expose them to the considerable threat of accounts payable fraud, potentially causing irreparable harm to their reputation and inflicting substantial costs detrimental to their financial stability.

What Does Accounts Payable Fraud Entail?

Accounts payable fraud is a prevalent form of deception that impacts a company’s accounts payable department—the unit tasked with remunerating suppliers and other business partners. It can be perpetrated by internal employees, external vendors, or a collusion between the two. Increasingly, this fraud also involves outside parties exploiting access to the company’s accounts payable systems.

The repercussions of fraud are severe for any business. According to the Association of Certified Fraud Examiners (ACFE), an average organization forfeits 5% of its annual revenue to fraudulent activities, with a median loss amounting to $125,000. Disturbingly, these deceptive practices often go undetected for roughly 14 months, causing an average monthly loss of $8,300.

How is Accounts Payable Fraud Executed?

Under the classification system of the Association of Certified Fraud Examiners (ACFE), accounts payable fraud is categorized as an “asset misappropriation”, which is amongst the most frequent types of occupational fraud.

This form of fraud primarily involves unauthorized disbursements, the most common manifestations being billing schemes, check tampering, and expense reimbursement manipulations.

In a billing scheme, an employee might establish a fictitious company and submit counterfeit invoices for payment. This type of fraud is more easily executed when the invoices are for intangible services, such as consultancy work. Check tampering involves an employee illicitly obtaining and forging company checks, keeping the cash for personal gain. Vendors, too, can perpetrate fraud by intentionally overcharging or invoicing multiple times for services, thereby collecting unearned revenue.

Accounts payable fraud may also stem from external perpetrators seeking access to a company’s bank accounts. This is often done through phishing schemes where the fraudster impersonates a key vendor and sends bogus invoices. Opening these invoices can provide the scammer access to the company’s financial systems.

Five Warning Signs of AP Fraud

Whistleblowers are the primary source of fraud detection in a significant majority of organizations, as revealed by an ACFE study. Internal audits and management reviews are the second and third most prevalent detection methods. However, ACFE suggests that proactive monitoring, robust IT controls, and regular account reconciliations can halve the duration of undetected fraud.

Here are some key areas recommended by the ACFE to scrutinize for potential red flags:

1. Invoices: Invoices sharing an address with an employee, listing only a P.O. Box number, or featuring even-numbered totals raise suspicion. The absence of crucial details like a tax ID number or a purchase order (PO) number is another telltale sign of potential fraud.
2. Vendor Master File: Regularly examine the vendor master file for a high number of inactive or duplicate suppliers. Look out for repetitive contracts awarded to the same suppliers or large, unexpected contracts granted to new vendors. Also, be alert for invoices that don’t align with the address on the vendor master file.
3. Checks: Missing checks or irregularities in signatures could be indicative of check fraud.
4. External Complaints: Complaints from suppliers about delayed or non-payment when your records suggest you’ve already settled the invoices might signal a problem.
5. Employee Behavior: According to ACFE studies, 85% of fraud cases exhibited at least one behavioral red flag. Common warning signs include employees living beyond their means, facing financial difficulties, fostering unusually close relationships with vendors or customers, or showing reluctance to delegate duties.

Six Predominant Types of AP Fraud

1. Billing Schemes: As per ACFE’s 2020 study, billing schemes were the most frequently observed type of fraud in accounting departments. These schemes can be executed in several ways, including:
   • Establishing a fictitious company to generate fraudulent invoices and cash checks, with invoices for intangible services being the most common due to the lack of physical inventory to verify.
   • Orchestrating pass-through schemes, where an employee, who has the authority to approve invoices and authorize payments, sets up a shell company that purchases items from another supplier, increases their price, and sells them back to the business. The profit margin is pocketed by the employee.
   • Producing invoices from inactive suppliers listed in the vendor master file and issuing checks to vendors with whom the company no longer transacts.
2. Check Fraud: The AFP’s 2020 Payments Fraud and Control Survey indicated that check fraud was the most prevalent type of fraudulent activity. Here, employees forge or steal company checks and deposit them into their personal accounts. To cover their tracks, they typically manipulate the accounting system’s code.
3. ACH Fraud: As more businesses migrate to ACH payments, this area has increasingly become a hotbed for fraudulent activity. Cybercriminals often target ACH payments by accessing the system through compromised business email accounts. These bad actors generally send an invoice that appears to originate from a supplier, but once the link or file is clicked, the attacker gains system access, enabling them to pilfer valuable data. ACH fraud can also occur when an employee misuses their employer’s account information to open a personal credit card.
4. Expense Report/Reimbursement Fraud: This type of fraud commonly involves forged receipts, double expensing by employees who shared meals or traveled together, non-qualifying transportation and entertainment expenses, claiming maximum expense amounts that don’t require a receipt, or inflated mileage claims.
5. Kickback Schemes: In such a scheme, employees collude with suppliers for personal gain. Typically, the supplier overbills an invoice, the AP clerk issues the check, and the extra funds are split between them.
6. Conflict of Interest: Often, kickback schemes stem from conflicts of interest, which can arise if an organization member has familial ties with a supplier or receives substantial gifts from them. These conflicts can be detrimental when someone exploits their professional or official role for personal or corporate benefits.

Understanding Benford’s Law

Benford’s Law, often applied in fraud detection, pertains to the expected frequency of leading digits in a set of naturally occurring numbers. According to this principle, the digit 1 will be the leading number 30.1% of the time, whereas the digit 2 will lead 17.6% of the time. Each subsequent numeral, from 3 through 9, appears as the first digit with diminishing frequency.

Fraud examiners leverage Benford’s Law to verify the authenticity of datasets, such as clusters of payment amounts. For instance, if the distribution of first digits in 100 line items on an employee’s expense report deviates markedly from the distribution predicted by Benford’s Law, it can trigger suspicions of possible forgery in the expense reports.

Investigating Fraud

To detect and investigate accounts payable (AP) fraud executed by employees, vendors, or external entities, it’s crucial to establish audit trails, segregate duties, and integrate with procurement systems. Below are the fundamental steps to follow.

Detecting Fraud in Your AP Department Whistleblowers, especially in smaller companies, are often the first to raise an alarm about potential fraud. It’s essential for your company to have procedures that not only encourage whistleblowers to speak up but also ensure their protection once they do so. The ACFE report shows a growing preference among whistleblowers to communicate via email or web form. They are also inclined to report fraud to their immediate supervisor, making it critical for managers to be adequately trained and informed on handling such disclosures.

Regular audits and managerial reviews are the second and third most common methods of fraud detection in organizations. Implementing best practices, such as meticulous examination of bank statements, vigilant monitoring for duplicate payments, and frequent scrutiny of vendor master files to safeguard against invoices from dormant suppliers, is highly recommended.

Handling Detected AP Fraud The ACFE study showed that when an organization confirmed an employee’s fraudulent activity, 80% of the offending employees faced some form of internal disciplinary action. Employees were more likely to be terminated for fraud than managers or executives. While 59% of businesses reported these cases to law enforcement, only a smaller portion resulted in criminal convictions or civil judgments.

10 Essential Tips for Preventing and Detecting AP Fraud

Given that most organizations don’t recover losses resulting from fraud, prevention is paramount.

Here’s how you can prevent accounts payable fraud:

1. Be Vigilant: Regular audits, close KPI monitoring, and promptly checking bank statements are essential, along with being alert to potential red flags.
2. Establish Reporting Channels: Set up a tip line or other reporting avenues for employees to confidentially report fraudulent activities. Develop robust guidelines to protect whistleblowers.
3. Background Checks: Thoroughly vet all employees, including reference checks, to mitigate risk.
4. Enforce a Code of Ethics: Create a comprehensible code of ethics reflecting your industry and corporate culture. It should define policies dealing with conflicts of interest.
5. Implement Reimbursement Policies: Enforce clear guidelines for expense reimbursement, upheld at the highest organizational levels.
6. Define and Segregate Roles: Divide responsibilities to minimize risk – the employee issuing checks should differ from the one signing them or reconciling bank accounts.
7. Educate on Cyber Threats: Train employees to recognize and react appropriately to phishing attempts and other potential cyber threats.
8. Verify Invoice Changes: Develop policies requiring proper verification of any modifications to existing invoices, banking information, or contact details.
9. Maintain Vendor Master File: Regularly update the vendor master file to keep all vendor information up-to-date.
10. Automate AP Process: Implement an automated AP system to enhance security and reinforce role segregation.

Leverage AP Automation for Fraud Protection

By automating the Accounts Payable (AP) process, businesses can create robust audit trails, segregate duties, and integrate with procurement systems, facilitating compliance with purchasing policies and enabling three-way matching. An AP automation system can automatically flag potential outliers as fraudulent and convert data into insightful reports, highlighting changes in spending.

Most accounting software can automate a significant portion of AP tasks, thereby providing the above-mentioned safeguards. Such technology makes fraud more challenging to commit while also increasing the likelihood of swift detection if attempted fraud occurs.

Considering the potential financial losses and reputation damage from AP fraud, addressing this issue may seem overwhelming. However, preventative measures are critical. Systems capable of identifying, discouraging, and effectively responding to fraudulent actions can significantly protect a company’s integrity and future success. By understanding different fraud types and maintaining a proactive stance, businesses can both prevent and mitigate the damaging effects of such crimes.

Frequently Asked Questions on Accounts Payable Fraud

How is the cost of accounts payable fraud determined?

No universal formula exists to calculate the financial impact of AP fraud, as it significantly varies among different organizations. Typically, fraud goes unnoticed for about 14 months and costs companies approximately 5% of their annual revenue. Employing tools like Benford’s Law, tracking missing checks, and examining vendor complaints or invoices missing crucial details are effective methods for detecting fraud and estimating financial loss.

What preventive measures can be taken against accounts payable fraud?

The key to combating AP fraud is vigilance: closely monitoring transactions and financial statements for irregularities. Additionally, fostering a trustworthy work environment that encourages employees to report fraudulent behaviors is crucial. Other measures include clear role definitions to segregate financial duties, frequent updates to vendor information, and robust internal controls requiring adequate verification for financial statement alterations.

What are common examples of accounts payable abuse?

Typical abuses in the accounts payable process include billing schemes, check fraud, ACH fraud, expense report and reimbursement fraud, kickback schemes, and conflicts of interest.

How can one identify a fraudulent vendor?

Fraudulent vendors often send invoices missing key information, rendering them untraceable. A vendor master file filled with inactive or duplicated suppliers receiving unexpectedly large contracts can also be a red flag. Additional signs include employees living beyond their means without clear reasons, missing checks or inconsistent signatures, and complaints from suppliers about late or non-payment despite records showing completed payments.

Source