Thieving Thoughts

Recently I’ve worked with a number of clients who were the victims of employee theft.  While I like to emphasize prevention, this is so commonplace that it’s also worth visiting what to do if (when?) it happens to you.   Employee fraud is a huge problem, and in difficult economic times it’s not on the decline. In retailing alone, employee theft accounts for almost 44% of total losses.  That’s about 10% less than what stores lose to shoplifting.  Guess which one is easier to do?

Loss of property to theft is generally tax deductible.  As with everything else involving taxes, you have to be prepared in case the deduction is challenged.  For a theft loss to be deducted the event that caused you to lose property or money has to be illegal in your state.  A conviction is not required. The IRS is pretty broad in its definition of theft including:  blackmail, embezzlement, extortion, kidnapping and fraud on their list.  Employee fraud and theft usually qualifies.

In a rare show of common sense, you can deduct the theft loss in the year it is discovered, which doesn’t have to be the year in which it occurred.  However, you have to be prepared to prove that the property was yours, when you discovered it was lost, and that you didn’t just lose track of whatever went missing.  Also, if you are eligible for an insurance claim, or have some other possible means of recovery you need to do that first.  You can’t deduct the loss until it’s completely clear how much you have lost and that it’s permanent.

Other things to keep in mind are that inventory loss can be managed on your tax return by either raising the cost of goods sold or reducing the value of your inventory.  You don’t need to file a special form for either method.  Also, if you lose money on a stock due to accounting fraud or other malfeasance on the part of that company, that’s considered a capital loss instead of a theft loss.  Finally, if you’re the victim of a Ponzi scheme, your ability to deduct the loss is constrained by whether the transaction was part of your trade of business (in that case you’re fine) or a personal loss (this is worse).  If it's personal, you won’t get everything back, and you’ll probably want to hire an accountant to figure out how to calculate the deduction.

On that cheery note I’ll go back to tracking the Frankenstorm headed our way. Hopefully my next topic won’t be about deducting casualty losses.   

Fraud and the IRS

While we’re all still smarting from paying taxes, it’s tough to hear that the IRS is having more fraud problems.  The Treasury Inspector General is complaining that the IRS still hasn’t addressed enforcement issues  in the whistle blower program that were discovered in 2009.  The issues are not small, ranging from poor controls in safeguarding data, poor processing and lack of timeliness in addressing tax fraud. One example is that IRS employees aren’t required to note the date of a claim.  Needless to say that’s pretty critical in terms of tax payments.  Tax payers who don’t file timely have to pay stiff penalties.  The IRS also recently won in Tax Court on the issue of being able to take any refunds due to offset taxes owed from prior periods.   Why not apply some of their own standards to themselves?

On a happier note, in light of concerns about government employees not behaving in exemplary fashion when they’re out of the office, the IRS has reportedly nixed out of town training conferences.  While more training is clearly needed, it sounds like it is simple enough to be done inside the Beltway. 

The other fraud problem that refuses to go away, is the ongoing issue of taxpayer identity theft.  Someone who has stolen your social security number files a tax return in your name that gives them a refund. The IRS only finds out that it wasn’t really you is when you file the legitimate tax return.  Needless to say untangling the ensuing mess is horrible.   The service is reportedly putting more resources against this problem, but they are not winning the battle.  A key fact to remember is that the IRS only uses snail mail to send notices.  You will never hear about a legitimate audit, refund or data request form the IRS via e-mail.  The service also doesn’t use social media sites.

Give or Take $600MM

I spent most of last week in audit training classes.  It’s no secret that the nuts and bolts of audit work are not exciting.  Unfortunately, the relevance of the task at hand was in the news.  I agree with  Lynne Turner, former head accountant at the SEC, on the missing money at MF Global.

 "It's like it just vanished into thin air and the fact that people today can't tell us where the $600 million went is not a good sign. The fact that they were held in custodial accounts that someone should have been on top of only further complicates the issue and makes it even more concerning."

Whether it was for meeting margin calls or going to a personal account in the Cayman Islands is still TBD, but that’s where the boring work that I was studying  is really important.  It may not be material for a new TV series, (CPA: Miami ??) but trained forensic accountants are the best chance for finding the needle in the haystack.

It’s important to note here that in a forensic engagement, where the task is finding the missing $600 million, the work is structured to find the needle.  However, in an audit, that level of detail work would cost too much money.  So the guys at PwC were just looking for potential misstatements that are material.  In accounting, something is material if it would cause a user of the financial statements to make a different decision about the company. 

In this case, MF Global had structured the sovereign debt deal so they could, in compliance with accounting rules, move the debt off their balance sheet.  Would investors have made a different decision if the debt were sitting in the liabilities section of the financial statements?  We’ll never know that, but FINRA regulators did find the accompanying disclosure of “off balance sheet arrangements and risk” inadequate. (My word, not theirs – I didn’t read the FINRA notice.) So with full disclosure it could have been just “caveat emptor” to investors.  You have to wonder about the judgment call to do a deal of that size and expect no one would care about the detail of a massive increase in leverage. 

Of course, the guiding light of that judgment was Jon Corzine.  One thing that’s always discussed in audit classes is how the person who is least likely to commit fraud is the one the auditors should be most worried about.   While Corzine doesn’t have the kind of financial motivation that say a bookkeeper has, clearly he sanctioned decisions that can only be described as rationalizing illegal behavior.  The fraud triangle is motivation, rationalization and opportunity.  Corzine had all three.  Who knows, this could be material for the first episode of CPA & Order….    

Avoiding the Fraud Triangle

The Treasury Department requires virtually all businesses that provide financial services to the public to file”Suspicious Activity Reports” when they see financial transactions that might indicate malfeasance.  This monitoring requirement used to be focused primarily on banks, but as part of the USA Patriot Act it was expanded to get a broader view of the financial system.   Apparently this expansion was worthwhile as the latest “SAR Review” released by the Financial Crimes Enforcement Network shows quite an uptick in this type of suspicious behavior.

Despite -- or maybe because of -- the focus on following the money to stop terrorism, questionable activities associated with terrorist financing were the topic of 30% more filings than last year.  Money laundering filings went up in 2010, after a decline the year before.  (Apparently even criminals had a tough time with the recession).  Interestingly depository institutions actually reported a year over year decline in suspicious activity.  The growth is in the “shadow banking” world that includes credit unions and money services businesses.  Of those, Gaming Establishments increased their filings by 16% and Card Clubs increased 180%.

All of this serves as a reminder that the technology allowing more transactions to happen more easily is also fertile ground for criminals.  This isn’t just a big business problem.  Ironically, according to the Association of Certified Fraud Examiners  per employee losses from fraud are 100 times greater for small businesses than those for larger companies.  The Association cites 3 areas where small businesses make themselves especially vulnerable:  inadequate screening of new employees, not using financial controls to contain fraud, and allowing employees to conduct transactions that make it easy to commit fraud.  The fraud triangle is built on a base of incentive and rationalization.  All it takes is opportunity to commit the crime.  If employers make it easy, it’s more likely to happen. 

Global Fraud Update

As depressing as recent economic statistics may be, new fraud findings are worse.  The fourth annual Kroll Global Fraud Report finds more than a quarter of global companies experienced some form of information theft or fraud within the last 12 months.  Information theft is higher than average in the US, despite the region’s relatively safe environment compared to emerging markets.  87% of companies in North America indicated some level of fraud had impacted them, and two-thirds of those surveyed believe their exposure to fraud has been increased in the past year.  The main reason they cite is increasingly complex technology required to do business. 

 CFOzone.com highlights that physical theft is down for 2010 worldwide, while data theft increased by 52%.  They point out that "only" 27% of companies experienced a data loss, but 80% reported some sort of attack or problems related to data management. 

 Larger companies indicated they might curtail global expansion as a way of reducing their fraud risk.  While that’s a defensible strategy, it was a shock for me to see that despite these really high growth rates in fraud activity, the amount of money these same companies are spending on fraud prevention has declined year-over-year. The response varied by industry type.  (See Kroll's graphic summary below).

I’m the first one to say that you can’t confuse correlation with causality, but this one seems like it’s obvious there’s a connection.  Information fraud can be costly to companies in terms of both the actual loss and the loss of confidence that customers develop based on the incident.  Retreat isn't the answer, even in tough economic times.  Consistent investment in fraud prevention has to be the winner every time.