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.   

There's a Whale in the Fish Tank!

While no one can put a number to the JP Morgan trading problem yet, in the vocabulary of auditors, the results likely will be material.  Using the word material in this context means that it would influence the decisions of folks relying on the financial statements.   Coming in the midst of efforts to improve both regulatory and financial controls for banks, it points out how much work remains to be done on the topic of appropriate risk management and reporting.

 It strains credibility that the bank’s CEO started to realize they had a problem when he read about the “London Whale” on the front page of the Wall Street Journal.  The trade was executed as part of what was supposed to be the bank’s risk management strategy.  If there’s a whale in your fish tank it shouldn’t take a third party to make you notice. 

While JP Morgan messed up in many ways here, you have to give them credit for keeping the conversation focused on how risky and complex the trade was.  No one can dispute that the speed and complexity of global financial transactions make them difficult to manage.  However, this focus misses the point that the bank is supposed to have internal control infrastructure that doesn’t allow them to get into a place where they make trades that have indeterminate impact.  

Anyone who has worked in a big organization knows that risk culture doesn’t change quickly in either direction.  There must be senior people at the bank today who didn’t have to read the Wall Street Journal to find out there was a problem.  Apparently the Treasurer’s position at the bank wasn’t filled during the time much of the controversial trading was going on.  However, before he left the bank, the person in the role apparently was concerned.  This is someone who was reporting the bank’s CFO.  GMI, an independent corporate ratings agency gave JP Morgan Chase an “F” for corporate governance policies in advance of the loss being made public.  This grade is typically given to less than 5% of the companies they rate.  GMI also ranked JP Morgan’s financial statements lower than 92% of comparable firms in terms of accounting and governance risk. 

Group On auditors’ found the company had a material weakness in its internal controls.  The tools are available today to highlight when controls don’t appear to be in good condition.  An error of the scale that occurred at JP Morgan Chase should not happen in an effective internal control environment.  It is hard to believe the deterioration of these controls happened suddenly since the last audit report.

Social Fraud

Thought I’d take a break from tax topics to talk about a growing area of employee fraud --  social media related fraud.  A new survey by Robert Half shows that internal auditors at large companies list this subject as their top concern.  Worse yet, this topic gets priority based on a  combination of high inherent risk for fraud combined with an acknowledgement that companies aren’t paying attention to how and when social media is actually being utilized.

Not only are companies not aware of what is going on, the Robert Half report goes on to say that a set of best practices for monitoring social media use by employees doesn’t appear to exist.  Conversely, statistics indicate that best practices for circumventing company security to use social media are commonplace – a 2010 Trend Micro survey shows one in ten employees say they do this regularly.  In the same survey, half of the users said they disclosed confidential company information through a social media outlet.  The survey also showed unauthorized use of social media growing.  Interestingly, when Trend Micro talked about the impact of this with large companies, what they found was an increased incidence of fraud related to security breakdowns that weren’t intentional on the part of the original offender.  Apparently criminals target social media interactions associated with corporate computers to gain access to data that allows them to commit crimes against the organization.

This isn’t just a big business problem.  Small companies should confront this aggressively as soon as possible.   As with every other type of fraud prevention, you start with defining what the problem looks like for your company.  The next step is to engage your staff by making the risks clear to them.  A Globe Scan survey done last year showed 87% of employees thought they should be allowed to use social media at work.  Explaining why it’s a fraud related problem is a good starting point for limiting use.  You’ll also want to engage the people responsible for your tech security to get protection.  Presumably this will create a toolkit for working with employees to discuss acceptable and nonacceptable use of cloud and social media applications. 

Gartner consulting says by 2014 one in five people will use social media to the full exclusion of e-mail for communications.  That means you can’t eliminate the problem, you can just manage the risk. Starting sooner is your best bet for financial fraud prevention.

Caveat Emptor -- Buyer Beware

As I can tell you from up close exposure, the tax code doesn’t get simpler each year.  If you are seeking out help with this project it is important to be careful.  The IRS (which right now is not on my list of favorite things!) did put out a helpful list of warning signs that the person who is offering tax assistance may not be legit. 

• No Preparer Tax identification number
  • In addition to a CPA license, I need to pay for one of these too.  At this point, they’re pretty easy to get, so a fraudster who doesn’t even bother to get one is both a lawbreaker and lazy.
• Not giving you a copy of the tax return to sign
  • You are responsible for what goes on the return, not your preparer.  Make sure you are familiar with what is on it.  Telling the IRS I didn’t look at my return will not help you avoid penalties.
• Promises related to refunds
  • No one should prepare taxes based on a percentage of your refund or promise you a bigger refund.  The only reason you get a big refund is that you overpaid your taxes during the year.  What you want in terms of tax preparation help is someone who helps you plan so you don’t give the IRS your money interest free for a year. 
• Tells you it’s OK to put false information on your tax return
  • The IRS doesn’t fight fair to begin with.  Don’t give them ammunition to put into the gun.  Be honest, and work with someone who can help you pay less in tax.  Tax avoidance is legal and encouraged.  Tax evasion is expensive and can involve jail time.

  

From my reading on this topic I would add a note to be skeptical of deductions that seem too good to be true.  Deductions and credits are usually designed so the more they could help you, the less they actually do.  An example of this kind of “advice” is a deduction of all your expenses – including personal items – because you have a home based business.  First of all you can’t take personal expenses for a business. Also, deductions for businesses get limited based on how much you invested in the business in the first place.  This is a perfect illustration of how the complexity of the system makes it easier to victimize people. 

While I’m not a fan of having to pay taxes, it is something to take seriously.  When the IRS decides you’ve done something wrong (even if you haven’t) it’s an enormous hassle.  If you’re going to spend time and money on tax preparation, it’s worth an extra amount of due diligence to think about what credentials your helper really has. 

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….