In the modern globalized economy, organizations are becoming highly dependent on third-party vendors, contractors, and suppliers to operate their businesses. Although outsourcing provides flexibility and cost reductions, it also introduces one major and not so well-known risk, which is vendor fraud.
Fake invoices, shell companies, and/or collusion among employees and vendors are just some ways through which vendor fraud can result in a significant loss of money, reputation, and/or legal issues. Learning about the ways to prevent fraud committed by vendors, red flags, and adequate procedures of vendor due diligence is of utmost importance to uphold operational integrity.
So what is Vendor Fraud?
Vendor fraud takes place when a vendor, either alone or in conspiracy with internal employees, knowingly defrauds a company of personal or financial assets. Some of the ways in which fraud can be committed are:
- Overcharging or double billing
- Charging goods or services that have not been supplied
- False vendors that are made by internal employees.
- Kickbacks or bribes given to have contracts approved
- Marked-up prices or replacement with lower-quality goods
Such frauds may remain undetected over a long time particularly in those organizations with weak internal controls or where there are a large number of vendors.
Popular Vendor Frauds
Being aware of the principal types of vendor fraud may assist in identifying it early:
False Invoicing
The vendors present bills of services not provided or exaggerate the price of goods supplied.
Phantom Vendors
In one scheme, fraudsters make false vendor registrations and direct payment to personal or off-book bank accounts.
Product Substitution
Providing products of lesser quality or that do not meet the requirements and charging top-quality products.
Duplicate Payments
Sending an invoice more than once and taking advantage of weak payment verification procedures.
Conspiracy with Employees
Fraudulent vendor transactions are authorized by internal personnel either through bribes or kickbacks.
Dangers and Penalties
The consequences of not taking adequate measures in preventing fraud by vendors are wide:
Financial Losses: Even minor cases of fraud, when repeated, can consume large amounts of money in the long run.
Legal Penalties: Vendor fraud can also initiate regulatory breaches and lead to lawsuits or penalties.
Operational Disruption: Conflicts with suppliers or investigations may stop the supply chains and impact the service of the customers.
Reputational Loss: A firm that is publicized as having inadequate controls to prevent fraud might find its clients, shareholders and regulating agencies losing confidence in it.
Vendor Fraud Red Flags of Vendor Fraud
The detection of fraud early is central to its prevention. Be alert to the following danger signals:
- Invoices containing round figures or generic descriptions
- Employees and vendors that use the same address or bank account.
- Vendors that have little or no online presence being used repeatedly
- Vendor info (address, contact info, ownership) changes frequently.
- Vendor audits or due diligence processes being resisted by employees
- Vendor payments that are increasingly going outside of normal approval processes.
These are the indicators that need to be investigated and should cause a reevaluation of the internal controls.
Vendor Fraud Prevention Solutions and Best Practices
Exposure can be minimised through effective fraud risk management framework. Best practices in vendor fraud prevention include:
1. Vendor Due Diligence
Vendor onboarding is a pre-requisite that should be done thoroughly. An appropriate vendor due diligence procedure involves:
- Confirming the legality, registration and tax identification of the vendor
- Checking company ownership, directors and beneficial owners
- Inquiry about previous litigation, regulatory fines, or bankruptcy.
- Verifying addresses and functional establishments
- Watchlist and blacklist screening comparisons
This is a process that not only checks on legitimacy but also checks on vendors who should be compliant with regulatory requirements.
2. Screening and Monitoring of Vendors
Vendor screening cannot and should not end with their onboarding. Monitoring on a regular basis assists in detecting changes that can give rise to risk. This includes:
- Tracking of performance and delivery trends of vendors
- Periodic re-screening of vendors or upon contract renewal
- Monitoring ownership or location changes.
- Looking at invoice patterns to identify abnormalities
- An effective Know Your Vendor (KYV) program provides additional safeguards.
3. Segregation of Duties
Make sure that no one employee possesses the end-to-end authority to select vendors, make purchases and approve payments. Segregation minimizes collusion and unauthorized frauds internally.
4. Automated Invoice Matching
Put in place purchase order, invoice and delivery receipt matching systems that automatically flag any discrepancies prior to making a payment.
5. Vendor Audits
Undertake random planned vendor audits, particularly those vendors with high volume/ high value contracts. Independent audits enhance transparency and provide a deterrent against fraud.
6. Whistleblower Channels and Employee Training
Train employees on ways of identifying and reporting fraud by vendors. Whistleblowing is promoted through confidential reporting systems, where the whistleblowers are not afraid of retaliation.
Final Thoughts
Due to the increased reliance on third-party relationships as a part of business operations, vendor fraud prevention strategies are also increasing in importance. The fraudsters have also become very sophisticated and it is therefore very necessary that businesses take a proactive approach by integrating effective internal controls with enhanced due diligence practices.
Organizations can safeguard themselves against financial loss and ensure they maintain the confidence of stakeholders by investing in vendor due diligence, having proper Know Your Vendor practices, and being vigilant to red flags. In the era of reputation and compliance being everything, avoiding fraud committed by vendors is not merely a priority, but a necessity.
