Article by Ari Kashton, CA•IFA/CBV, CFE, DIFA
Are fraud hotlines worth it?
The Association of Certified Fraud Examiners' (ACFE) is an enthusiastic supporter of fraud hotlines. Their research indicates that frauds are most frequently detected by investigating tips and fraud hotlines are, effectively, institutionalized tip-collecting mechanisms.
THE LOGIC OF FRAUD HOTLINES - TIPS ARE THE MOST COMMON FRAUD DETECTION METHOD
The ACFE has collected a plethora of data to support its belief in the benefits of fraud hotlines. The ACFE's 2010 Global Fraud Study, the Report to the Nations on Occupational Fraud and Abuse finds that, "Tips were by far the most common [fraud] detection method ..., catching nearly three times as many occupational frauds as any other form of detection." This finding is consistent with every ACFE Global Fraud Study since 2002 - when the ACFE began collecting fraud hotline data.
Based on the results of the ACFE's 2010 Global Fraud Study, tips led to the discovery of about 40% of detected frauds. Comparatively, management reviews and internal audits detected 15% and 14% respectively. Interestingly, 8% of frauds were discovered by accident, while external audits only discovered 5% of the frauds. (Don't bank on external auditors to find fraud!) Other internal processes which discovered frauds included account reconciliations (6%), document examination (5%) and monitoring (3%). In addition, rarer methods for discovering fraud were police notification (2%), perpetrator confession (1%) and information technology controls (1%).
Given that tips were the catalyst for 40% of the detected frauds, one can understand the ACFE's enthusiastic support of fraud hotlines.
THE FINANCIAL CASE FOR FRAUD HOTLINES
The ACFE survey's participants estimated that the typical institution (corporate, not-for-profit or government agency) loses the equivalent of approximately 5% of revenue to fraud. For example, a company with $10 million in annual sales is estimated to lose $500,000 a year to fraud. Similarly, a city with $10 billion in annual revenue (like Toronto) is estimated to lose $500 million a year to fraud. Whether or not the 5% estimate is universally applicable is debatable; however, it is evident that financial losses due to fraud are believed to be quite significant.
Given the significance of the potential financial losses from fraud as well as the effectiveness of tips in discovering fraud, the ACFE's studies suggest that a fraud hotline should be a financial priority for most commercial, not-for profit and government agencies.
RISKS OF NOT HAVING A FRAUD HOTLINE - THE ENRON EXPERIENCE
Consider the Enron collapse of December 2001. Enron did not have a fraud hotline. Enron's stock collapsed as internal financial fraud became evident. Shareholders lost approximately $11 billion. Some propose that the financial problems at Enron commenced as early as 1986 when Enron suffered a long succession of business failures. Others note the change from business failures to outright fraud may have commenced around 1996 when Enron's Chief Financial Officer, Andrew Fastow, (with the tacit approval of Enron's auditors) began hiding Enron's growing debts in off-book entities. During this period some Enron employees had either direct knowledge or deep suspicions about Enron's financial problems, but Enron had no formal reporting process. No one officially came forward until August 2001, when Sherron Watkins, a Vice-President for Corporate Development, (at great personal risk to herself) sent an anonymous letter to Enron's Chief Executive Officer, Ken Lay, outlining some of Enron's questionable accounting practices. However, by then the financial damage had been done. Enron went bankrupt within three months.
FRAUD HOTLINES COME OF AGE
Companies, not-for-profits and government agencies, with foresight and/or experience, are recognizing the benefits of implementing fraud hotlines. For example, in 2001 the City of Toronto discovered that it had paid a company $85 million to lease computers. Unfortunately, City Council had only approved an expense of $43 million. Subsequent to this $42 million fraud, in 2002, the City of Toronto became the first municipality in Canada to implement a fraud hotline.
FRAUD HOTLINE BASICS
Aside from phones, hotlines can also collect information via internet forms, e-mail and/or regular mail. In addition to fraud, some hotlines capture additional information covering areas such as harassment, employee complaints, discrimination, violence, etc.
In all cases hotlines involve establishing a formalized information collection, reporting and issue disposition system. Underpinning the system are operational, communication and investigation protocols. Other fundamental components include the creation of a governing fraud policy, standardization of information collection/reporting forms and the establishment of secure, high level, and independent reporting lines. Effective hotlines create a cradle to grave record for the disposition of each issue.
THE ADVANTAGES OF FRAUD HOTLINES
Some of the more notable advantages of a fraud hotline include:
- Increased detection of internal and external fraud;
- Increased recovery of fraudulent losses;
- Increased detection of internal control weaknesses;
- Increased prevention of fraud (through the increased perception of detection);
- Centralized fraud reporting and investigation co-ordination;
- Increased communication and operational improvements;
- Increased employee moral;
- Positive effects related to internal and external public relations;
- Positive recognition of ethical and effective governance;
- Proactive compliance with institution charters, fraud policies and governing laws.
THE DARK SIDE OF FRAUD HOTLINES – THE MADOFF EXPERIENCE
Notwithstanding the benefits of fraud hotlines, there are potential risks to consider. For example, the Securities and Exchange Commission (SEC) – one of the world's most feared regulators - has a long experience handling fraud tips. Notwithstanding the SEC's experience and reputation, from the spring of 2000 to Bernie Madoff's financial implosion in December 2008, Harry Markopolos contacted the SEC no less than five times with increasingly poignant financial evidence that Madoff's investment activities were a fraud. Despite eight examinations, the SEC failed to find Madoff's fraud. Pundits estimate Madoff investors lost $65 billion.
FRAUD HOTLINES - DISADVANTAGES/CONCERNS
Potential disadvantages and/or concerns related to fraud hotlines include the following:
- Potential costs associated with fielding all calls:
- Call volume;
- Seriousness of issue (nuisance, venting calls);
- Legitimacy of issue (vexatious, slanderous calls);
- Materiality of issue (petty calls);
- Potential errors in process and/or judgments relating to:
- Assessing the issues;
- Collecting additional information;
- Communication of the issues;
- Investigation of the claims;
- Investigation management and reporting;
- Potential costs associated with investigating all calls;
- Investigations/follow-up difficulties regarding anonymous callers;
- Corporate culture / work environment issues (potential Big Brother stigma);
- Potential lawsuits related to investigations;
- Potential repercussions of failed investigations;
- Data security issues;
- Privacy issues;
- Whistleblower protection concerns (if the tipster is not anonymous).
FRAUD HOTLINES - CONCLUDING THOUGHTS
The ACFE estimates that companies and government entities with fraud hotlines cut their fraud losses by approximately 50%. However, the ACFE also notes that many individual fraud examiners question the effectiveness of some fraud hotlines. These examiners note that many "fraud calls" may not be fraud related and or may lack sufficient information to investigate the issues.
Ultimately, the effectiveness of a fraud hotline depends upon the people involved. It starts with proactive and enthusiastic support from top-management, appropriate funding, experienced staffing (at all levels of the hotline: information collection, assessment, investigation, management and reporting), continuous internal fraud education and continuous fraud line awareness marketing.
In conclusion, fraud hotlines must be intelligently implemented, actively monitored and diligently maintained to realize the expected benefits.
ABOUT THE AUTHOR
Ari Kashton, CA•IFA/CBV, CFE, DIFA
Ari Kashton is a Senior Manager in Soberman LLP's Business Valuation and Litigation Support Group. Ari enjoys assisting his clients by preparing and presenting financial analyses, quantifications and reports, both forensic and transactional, amongst a host of other responsibilities.
Ari has expertise in business and securities valuation, intellectual property and intangible asset valuation, investigative and forensic accounting; financial litigation accounting, acquisition due diligence, damage quantification, financial model and transfer pricing.
Ari also enjoys writing articles, academic papers and presentations, many of which are now published works. Ari speaks regularly in his areas of expertise and has presented to government officials, industry and professionals associations.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.