Case study: Retailer implements internal controls for fraud prevention
To illustrate the importance of implementing fraud prevention controls, let’s consider a simple real-world example. One of the areas where fraud occurs frequently is in expense reimbursement. In this example, a large retail company in the US had a policy of automatically approving expense reports submitted by its top executives. These reports frequently exceeded $5,000 per month and, during international travel, sometimes reached as high as $20,000 – without undergoing any formal review or verification.
Each year, the company conducted annual internal audits to identify inappropriate expenses, which were frequently uncovered due to weak internal controls. Although executives were asked to repay the questionable amounts, no further action was taken. Eventually, one executive was discovered to have submitted fraudulent reimbursement claims. In response, the company replaced its reactive audit approach with proactive internal controls designed to prevent fraud from occurring in the first place.
The preventive controls implemented included:
- Requiring preauthorization for expenses exceeding a specified threshold.
- Setting dollar limits for different expense categories.
- Mandating original itemized receipts, invoices, and proof of payment for all claims.
- Prohibiting any executive, including the CEO, from approving their own expenses.
- Periodically rotating approvers to reduce the risk of collusion.
- Providing quarterly reports of executive expenses to the audit committee.
By implementing these new internal controls, the company successfully eliminated the opportunity for fraud to occur by proactively addressing vulnerabilities before they could be exploited.
Modern prevention measures for external fraud
Advances in technology have changed how we understand and approach fraud and we must think beyond the traditional fraud triangle. Although it remains relevant, it no longer captures the full picture. Today, we must consider external influences such as societal pressures, global cultural and ethical differences, and the technical capabilities to execute a fraud scheme. These additional factors are especially critical when evaluating external fraud risks. The fraud triangle was originally developed with the assumption that fraud is typically committed by trusted insiders with access to an organization’s resources.
Today, the risk of fraud from external parties is constantly increasing. Some may commit fraud simply to test system vulnerabilities, while others, such as state-sponsored groups, may target organizations with the intent to extort, often aiming to exploit cybersecurity insurance coverage.
The rapid pace of technological advancement necessitates the implementation of additional fraud prevention controls, such as:
- Cybersecurity enhancements: Measures such as multi-factor authentication (MFA), encryption, intrusion detection systems, and regular vulnerability assessments to safeguard systems and data.
- Data analytics: Proactive monitoring and analysis to detect anomalies in payment patterns, vendor behavior, or system activity logs.
- Zero trust security: A model that enforces strict identity verification and access authorization for every request, regardless of whether the user is inside or outside the network perimeter.
Even with additional controls in place, organizations are now facing threats from fraudsters using artificial intelligence (AI) to execute fraud schemes that would have otherwise been beyond their ability. AI is being used to create fake documents, profiles, voices, images, and videos to deceive employees into providing sensitive information. As cyber fraud threats continue to evolve, organizations must implement new and adaptive controls to effectively prevent emerging risks.
Internal audit’s role in fraud prevention
Internal audit plays an important role in an organization’s fraud prevention efforts by serving both as a deterrent to potential fraudulent behavior and as an independent evaluator of the effectiveness of management controls. While the primary responsibility for preventing and detecting fraud rests with management, internal audit provides independent assurance that the controls and processes in place are robust enough to mitigate fraud risks. Through systematic evaluation of internal controls, auditors help ensure that key policies such as segregation of duties, access restrictions, and approval hierarchies are appropriately designed and operating effectively. This proactive assessment not only reinforces the overall control environment but also plays a critical role in minimizing opportunities for fraud to occur.
A key element of internal audit’s contribution to fraud prevention is its ability to identify areas most vulnerable to fraud through comprehensive risk assessments and testing. Auditors analyze processes, financial transactions, and organizational structures to pinpoint where fraud risks are highest and determine whether existing controls adequately address those risks. This focus allows the organization to prioritize resources and remediate control weaknesses before they can be exploited. Additionally, internal auditors often deploy data analytics and continuous monitoring techniques to detect red flags such as unusual transactions, duplicate payments, or patterns that deviate from normal business operations. Early detection through audit activities enables organizations to respond promptly to suspicious behavior and limit potential damage.
Beyond the technical aspects of evaluating and monitoring controls, internal audit plays a vital role in shaping an organization’s culture of integrity and accountability. By fostering ethical behavior, verifying that policies are clearly communicated, and ensuring the effectiveness of whistleblower mechanisms, auditors help reinforce the organization’s commitment to a zero-tolerance stance on fraud. This cultural reinforcement not only deters unethical behavior but also empowers employees to report any irregularities they encounter.
Finally, internal audit acts as a trusted advisor to both management and the board of directors by delivering independent assessments of the strength of anti-fraud controls and the overall effectiveness of the organization’s fraud risk management framework. By sharing insights on emerging fraud trends and lessons learned from past incidents, auditors help ensure that anti-fraud strategies evolve alongside the organization’s operations and the broader threat landscape. In essence, internal audit’s role not only bolsters an organization’s defenses against fraud but also reinforces stakeholder confidence in its governance and ethical standards.