Procurement Fraud Definition and Prevention

CFO’s of growing companies often worry about compliance and preventing fraud. Preventing procurement fraud might not be the top priority for many growing companies, but it certainly should be top of mind.

Procurement controls are a must to prevent fraud. If you think that Company is immune to these problems, then think again.

If you don’t have strong Procurement cost controls, it is not a question of if; it is a question of when Procurement fraud would happen—assuming that you can discover that in time.

Robust procurement controls help prevent Procurement fraud and help a company with raising external funding.

This article will cover the exact steps a Company CFO or the Procurement officer can take to prevent procurement fraud.

First, click on the link below to download the free Procurement fraud checklist.

Then identify the top two things that can help you to prevent fraud.

Procurement Fraud and Company’s Evolution

Stage 1: Startup

In the beginning, there is the founding team and 1-2 people. There is a limited procurement activity, especially if you are a services company.

Procurement is a synonym for owners of the Company going to Costco or Sam’s Club and purchasing all they need to run the business. Very limited procurement, owners controlling all purchases, no possibility of procurement fraud.

Stage 2: Growth

A company typically has under 50 employees; purchasing activity now involves buying office supplies, capital equipment, IT hardware and software, and other maintenance supplies.

Most of the companies generally have an office manager responsible for purchasing all items the Company needs.

Purchasing is as simple as sending an email to the office manager. She takes care of purchasing them and the whole process, including paying the vendors using a company credit card.

Stage 3: Scale

In this stage, the Company is in growth mode; you are hiring as fast as possible 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.

1. The focus in this stage is primarily hiring more sales and marketing staff, expanding production capabilities.
2. Most of your employees have credit cards for small purchases, meals, travel & expenses. This requires you to have a person in accounting to match receipts to the purchases and ensure that there is no misuse of the card.
3. You probably have grown to multiple locations.

If you are a CFO/COO or CEO of a company in stage 3, you should be thinking about procurement fraud prevention.

We are not suggesting that you should not trust your employees, but you should be considering implementing measures to prevent procurement fraud.

Having solid controls and controls enforcement is the key to preventing procurement fraud in your organization.

Click here to schedule a demo and see for yourself how ProcureDesk helps you implement and track procurement compliance and prevent procurement fraud.

What is Procurement Fraud?

Let’s first define what procurement fraud is. 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.”

In simple words, it is a kickback to the buyer from the supplier for selecting the supplier’s bid and which might not be in the Company’s best interest.

The scope of procurement fraud is not limited to supplier and buyer’s collusion, but it is a recurring theme in Procurement.

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) than at later stages like vendor performance and delivery.

Procurement Fraud Triangle

Why does fraud happen? There could be multiple reasons, but these three tenants of fraud can capture any act of fraud.

As per ACFE (Associations of Certified Fraud Examiners), the fraud triangle consists of

1. Perceived financial need

Financial need is the motivation or the reason behind the fraud. Examples include financial debt, gambling, or other short-term needs that an individual cannot 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 understands the controls well, they can quickly identify opportunities for committing fraud.

Lack of procurement controls also offers an opportunity for fraud.

3. Rationalization

This stage involves an individual who is planning to commit fraud to rationalize their actions. For example, the amount is so tiny 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 that doesn’t meet the quality requirements.

In return, the buyer receives a kickback. It is widespread, especially in companies with no well-defined sourcing process, or the Procurement is decentralized to the individual location or departments.

Company Controller could limit the impact of such procurement fraud in specific locations.

Still, it could have a devastating impact on your product reputation if you land up buying inferior raw materials, leading 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, 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 that Company’s name.

The payments are generally small enough not to raise any alarm, but this can cause severe damage to your Company over time.

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, it is easy for that individual to commit fraud.

3. Conflict of interest

Even if you have tighter controls and well-defined processes, the chances are that fraud can happen in the form of a conflict of interest.

You would often see this even in companies with well-established processes.

The individual is responsible for purchasing selecting a vendor who is related to them in some fashion.

There is nothing wrong with that if you have conducted a bid process, the selected supplier meets all your qualification criteria, and the individual responsible for purchasing has 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.

If your sales team is colluding with buyers of your customers and giving a kickback to buyers.

In 2010, HP paid $55M to settle allegations that it paid money to individuals to win US government contracts. So, it would help if you were looking at preventing procurement fraud and how not to engage in such practices with your customers.

4. Inflated Invoices

Another example of procurement fraud is the overinflated invoices from the suppliers.

This is generally done systematically by the suppliers so that Finance can’t detect fraud easily.

For example, the unit price is over the purchase order unit price by a few cents.

Imagine, if the vendors submit a high volume of invoices, these cents quickly add to thousands of dollars in a few years.

 

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.

However, one should always start with strong procurement controls.

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, and conflict of interest. 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 expected consequences, including termination, which should 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.

1. 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; a senior manager can approve up to $10,000, and so on.

A purchasing system can easily implement purchasing controls and automate the basic purchasing process.

2. All invoices should have a pre-authorized purchase order; if that is not in place, Company’s Controller should do a proper investigation to understand the gaps in the process and how to fill those gaps.

3. For purchases that are happening through credit cards, a valid receipt and justification are required to approve the expense, including proper business approval.
However, having controls doesn’t prevent procurement fraud, but you also need to have an internal audit department auditing purchases regularly.

The 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.

In that case, focus on automating the controls so that you can 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 control 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 solid 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.
The procurement department manages the 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 for Buyer/Supplier collusion

I am not suggesting that you have a full-time investigator watching every action of your employees.

But be watchful of lifestyle changes.

The extravagant personal spending of people involved in purchasing could be a sign that something is not correct.

They could have hit the jackpot, and in that case, they might not need the job after all!

Ricky D. Sluder, a certified fraud examiner, offers a helpful tip about reviewing social media accounts; for example, if a procurement officer is making $60,000 a year posts pictures 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, they can offer the following benefits

1. An electronic system for creating purchase orders ensures that all orders are approved at the right authorization levels.
2. The ability of end-users to create a receipt for purchases ensures that employees purchased the item, and it is not a fraudulent purchase order.
3. Automatically matching a purchase order with receipt and invoice (also called 3-way match) ensures that you are paying for the same items purchased and delivered.
4. Complete visibility into Spend, the data is in one place, and any decent purchasing system can run reports and provide historical purchasing information.

 

Conclusion

As the adage goes, “Prevention is better than cure.”
The best step forward is to put together preventive controls that can prevent procurement fraud from happening.
Some of you might say that we are small enough to have any fraud.

Still, it is easier to implement basic controls when your organization is small vs. when it has grown up to 100 employees and multiple locations.

Also, keep in mind that you don’t overburden your employees with much control, implement sufficient but lean controls.

Automated purchasing systems can help in simplifying the implementation of such controls and provide better spend visibility.