If you look at the progression of any company from startup stage to a well-established company, there is a common theme on how the procurement process evolves over time. Preventing procurement fraud is not a priority for most of the small to mid-size companies, let’s look at the evolution of the company and when preventing procurement fraud should become a priority.
Procurement Fraud and Company Size
Stage 1: In the beginning, there is the founding team and 1-2 people. There is limited procurement activity, especially if you are a services company. Procurement is a synonym to owners of the company going to Costco or Sam’s Club and purchasing all that they need to run the business. Very limited procurement, owners controlling all purchases, no possibility of procurement fraud.
Stage2: In this stage, a Company typically have under 50 employees, purchasing activity now involves buying office supplies, capital equipment, IT hardware and software and other maintenance supplies. Most of the companies have generally an office manager responsible for purchasing all items company needs. Purchasing is as simple as sending an email to the office manager and she takes care of purchasing them and the whole process including paying the vendors using a company credit card.
Stage 3: In this stage, the Company is in growth mode, you are hiring as fast as you can and opening new offices. You probably have an accounting/ERP system at this time to handle your books and handling other business processes like creating sales orders, managing customer billing and paying vendors.
- The focus in this stage is primarily hiring more sales and marketing staff, expanding production capabilities.
- Most of your employees have credit cards which they use for small purchases, meals, travel & expenses. This requires you to have a person in accounting to match receipts to the purchases and ensuring that there is no misuse of the card.
- You probably have grown to multiple locations.
If you are a CFO/COO or CEO of a company which is in stage 3, you should be thinking about procurement fraud prevention. I am not saying that you should not trust your employees but you should be considering implementing measures to prevent procurement fraud.
What is Procurement Fraud?
Let’s first define what is procurement fraud. As per Wikipedia –“Procurement fraud can be defined as dishonestly obtaining an advantage, avoiding an obligation or causing a loss to public property or various means during procurement process by public servants, contractors or any other person involved in the procurement.”
It is simpler words, it is a kickback to the buyer from the supplier for selecting the suppliers bid and which might not be in the best interest of the company. The scope of procurement fraud is not limited to certain categories or companies but it is a widespread issue.
As per consulting firm PricewaterhouseCoopers Global economic survey, 2014 twenty-nine percent (29%) of global organizations had experienced procurement fraud. Procurement fraud is common at the beginning of the procurement process (vendor selection stage) then the later stages like vendor performance and delivery.
Procurement Fraud Triangle
Why does fraud happen? There could be multiple reasons but any action of fraud can be captured by these three tenants of fraud. As per ACFE (Associations of Certified Fraud Examiners), the fraud triangle consists of
1. Perceived financial need: This is the motivation or the reason behind the fraud. Examples include – Financial Debt, gambling or other short-term needs which an individual is not able to fulfill with the current income source.
2. Perceived opportunity: The second side of any fraud is an opportunity for someone to commit fraud. For example, if the person committing the fraud understand the controls well or lack of controls in the purchasing process, they can easily identify opportunities for committing fraud.
3. Rationalization: This stage involves an individual planning to commit the fraud to rationalize his or her actions. For example, the amount is so small that it will not affect the organization or no one will notice such a small change. Others rationalize by relating to the situation they are in and rationalizing in their mind that the situation is temporary and the fraud is one time and will never happen again. I think you can say the same for gamblers, it always starts with a small bet.
Procurement Fraud Examples – Types of Procurement Fraud
Following are some of the common examples of procurement fraud
1. Employees colluding with suppliers
As per cporising.com, this is the most common example of procurement fraud. In this case, employees responsible for purchasing a product or service collude with a supplier to purchase a product at a higher cost or a cheaper product which doesn’t meet the quality requirements.
In return, the buyer receives a kickback. It is very common especially in companies where there is no well-defined sourcing process or the procurement is decentralized to the individual location or departments. The impact of such procurement fraud could be limited in certain locations, but it could have a devastating impact on your product reputation if you land up buying inferior raw materials which leads to a poor-quality product for your customers.
2. Fraudulent companies’ set up by employees:
Though this is not the most common example of procurement fraud, but this might cost you the most. In this type of fraud, few employees may collude to form a fraudulent company and then keep on issuing payment in the name of that company.
The payments are generally small enough that it doesn’t raise any alarm but over a period of time, this can cause serious damage to your company. There are multiple reasons this could happen – first, the company doesn’t have a purchase order process so they don’t match invoices against purchase orders before the payment, second, if an individual manages the entire process from purchase to payment then it is easy for that individual to commit such fraud.
3. Conflict of interest
Even if you have tighter controls and well-defined processes, chances are that fraud can happen in the form of conflict of interest. You would often see this even in companies with well-established processes. The individual responsible for purchasing select a vendor who is related to him/her in some fashion. There is nothing wrong with that if you have conducted a bid process, the selected supplier meet all your qualification criteria and the individual responsible for purchasing have declared the conflict of interest. Unfortunately, that is not always the case.
Procurement fraud impacts your procurement process integrity. But the reverse of this is also true, which means if your sales team is colluding with buyers of your customers and giving a kickback to buyers. In 2010, HP paid $55 M to settle allegations that it paid money to individuals to win US government contracts. So, you should be looking at preventing procurement fraud but also looking at how not to engage in such practices with your customers.
How to prevent Procurement Fraud
There are multiple ways to prevent fraud, some are basics common sense approach and some needs investments in system and processes from companies to detect and prevent fraud.
1. Educating Employees and Suppliers
The first and foremost step towards procurement fraud prevention is the education of employees about your procurement practices including your bid process, how you select vendors, conflict of interest etc. The same is true for your suppliers, create a supplier code of conduct and ensure that suppliers have read and acknowledged it. It is not a full proof process but it will at-least inform employees of what is expected and what are the consequences including termination, that should take prevent conflict of interest cases.
2. Purchasing controls and auditing of purchasing controls
Having proper controls helps in the prevention of procurement fraud. Following are some examples of purchasing controls you should have in place.
- All purchase requisitions should be authorized and approved by the authorized individual in the organization. Based on the transaction amount, the approval should come from different individuals. For example, a manager can approve only up to $5,000, Sr. Manager can approve up to $10,000 etc. A purchasing system can easily implement purchasing controls and automate the basic purchasing process.
- All invoices should have a pre-authorized purchase order, if that is not in place proper investigation should be done to understand the gaps in the process and how to fill those gaps.
- For purchases, which are happening through credit cards, a valid receipt and justification are required to approve expense, including a proper business approval.
However, just having controls doesn’t prevent procurement fraud but you also need to have an internal audit department auditing purchases on a regular basis. Audit department should be randomly select purchasing transactions and ensuring that there are no gaps in the implementation of the control.
If you are like many mid-market companies, you probably don’t have the luxury of an audit department, if that is the case, focus on automating the controls as much as possible so that you minimize the chances of procurement fraud, we will talk about procurement control automation in a later section.
3. Segregation of duty
Ensure that duties are segregated and that the same individual doesn’t have control over the entire purchasing process. In other words, a single individual shouldn’t be able to create purchase orders, key in invoices and issue payments. Even if you have tighter controls, segregation of duty minimizes the chances of procurement fraud.
An ideal case is that there are two different departments handling purchase orders and invoices, procurement department managing purchase order process and accounts payable managing invoice capture and issuing payment. If you don’t have dedicated resources, employees requesting purchases can handle issuing purchase orders directly but Accounts payable can only handle invoices.
4. Be Watchful
I am not suggesting that you have full-time investigator watching every action of your employees but being watchful of changes in lifestyle, the extravagant personal spending of people responsible for purchasing could be a sign that something is not right or they hit a jackpot and in that case, they might not need the job after all!
Ricky D. Sluder a certified fraud examiner offers a useful tip about reviewing social media accounts, for example, if a procurement officer making $60,000 a year posts picture of extravagant purchases on social media, that could be a sign that something is not right.
5. Automation of control
Automation not only helps with productivity improvements; it also helps with fraud prevention. Automated purchasing systems have many benefits but from a procurement fraud perspective, it can offer the following benefits
- An electronic system for creating purchase orders ensures that all orders are approved at the right authorization levels.
- The ability for end users to create a receipt for purchases ensures that there is a proof that the item was purchased and this is not a fraudulent purchase order.
- Automatically matching a purchase order with receipt and invoice (also called 3-way match) ensures that you are paying for the same items which were purchased and delivered.
- Complete visibility into spend, the data is at one place and any decent purchasing system can run reports and provide historical purchasing information.
When it comes to procurement fraud, the best step forward is to put together preventive controls which can prevent the procurement fraud from happening. As the adage goes “Prevention is better than cure”.
Some of you might say that we are small enough to have any kind of fraud, but it is easier to implement basic controls when your organization is small vs when your organization has grown up to 100 of employees and multiple locations. Also, keep in mind that you don’t overburden your employees with a lot of control, implement sufficient but lean controls. Automated purchasing systems can help in simplifying the implementation of such controls and provides better spend visibility.
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