How to mitigate against procurement fraud [with examples]

Procurement fraud is a costly and difficult-to-control aspect of the procurement process for businesses of every size. It’s difficult to spot and hard to prove and prosecute. And cases are fraud are on the rise: the Association of Certified Fraud Examiners (ACFE) estimates that up to 5% of purchasing is wasted on fraudulent procurement schemes. 

Government contracts are often susceptible to fraud. In fiscal year 2021 alone, the Department of Justice (DOJ) recovered over $5.6B in funds connected with the False Claim Act (FCA). But private companies should also maintain strict controls to avoid falling victim to these activities. 

This article covers the essential elements of effective fraud protection. We’ll cover the conditions that allow fraud to happen and the common warning signs that it’s occurring. We’ll also discuss best practices for mitigating fraud risk within your procurement function. 

What is procurement fraud?

Procurement fraud occurs when an internal and/or external perpetrator manipulates the purchasing process within an organization. Often, a combination of internal and external parties conspire to create the conditions that lead to procurement fraud schemes.

A typical fraud scenario involves an external vendor receiving business at a price above the standard or base price for products or services. The internal stakeholder who awards this inflated contract receives compensation for their part in the scheme. This may come in cash, tangible gifts, favors, or other advantages offered in return for facilitating the fraud.

Procurement fraud is more likely to occur in situations where there is a high volume of purchasing and a low rate of procurement oversight. Procurement fraud becomes more likely when the internal perpetrator is under financial stress or has personal struggles such as substance or gambling addiction. Sometimes the internal conspirator is dissatisfied with the employer or compensation.

5 primary types of procurement fraud

Not every fraudulent activity involves the exchange of cash. While in some fraud cases, the internal actor seeks compensation, other forms of nepotism and non-compensated fraud are common.

1. Deal fixing with kickback

Collusion for compensation is one of the most common forms of contract fraud. In this scenario, an outside supplier is chosen To provide goods or services for an inflated sum. As compensation for cooperating with bid-rigging, the internal stakeholder receives monetary or non-monetary compensation, also known as a kickback.

2. Conflicts of interest

Conflicts of interest may not involve direct compensation for the procurement scheme. In some cases, the fraud involved setting up friends or family members to perform services regardless of price considerations or performance capability. It’s important to note that simply choosing a friend or family member to perform services for your company is not inherently fraudulent.

If referred through an open bid and evaluation process, with full disclosure of the relationship between stakeholder and supplier, these arrangements are perfectly legal. The element of fraud is introduced through deception or omission of facts.

3. Sham company payments

Falsified payments to shell companies is a less-common form of fraud. It’s only feasible in situations where little or no procurement oversight exists. For instance, if an organization does not perform invoice reconciliation or invoice matching to its purchase requisitions and purchase orders, this leaves room for so-called “fake company” fraud. This fraud scenario usually involves smaller recurring amounts of payment spread out over a more extended period to avoid detection through accounting audits.

4. Inflation or under-delivery

Another common form of fraud is price-fixing or manipulating the quantity of goods received after the sourcing process. This may involve product substitution, performing below contract specifications, or overpricing an invoice for the materials received. In this case, the internal conspirator typically receives outside compensation as payment for facilitating the deal at a higher price.

5. Falsified statements

Not all forms of procurement fraud follow a deal and kick back format. In some cases where contracts must follow supplier-specific guidelines - for instance, when a government procurement project requires a small or medium business (SMB) supplier - Making false statements about supplier designation or certification can be considered fraud. Another example of this would be excepting conventionally grown food under an organic heading when it has not received organic certification.

How to spot procurement fraud when it happens

Budgetary controls are one of the most critical elements in preventing your company from becoming a victim of procurement fraud. Regular accounting audits by independent third-party‘s are often instrumental in avoiding costly procurement schemes.

Larger companies are at more risk for this type of fraud specifically because they deal in higher volume, often employ many SaaS software suppliers, and therefore have more opportunities for quantity or quality of goods to fall through the cracks. Despite this, small business owners should use the same vigilance in dealing with fraud. 

Having a solid understanding of your procurement process is one component of mitigating the opportunity for fraud. Another is to develop an awareness of employees in your company who are involved with purchasing or sourcing materials and services. As with most forms of budgetary control, an ounce of prevention is worth a pound of cure. Many times, in the absence of solid budgetary control, procurement fraud goes unnoticed.

Common warning signs to investigate:

Suspect employee behavior: It’s impossible to discern fraud strictly by scrutinizing employees. However, be aware of any changes in the material wealth of employees involved with purchasing and procurement. Sudden or substantial changes (for instance, an employee driving a new car well beyond their means) and other irregularities may provide clues about known or suspected fraud.

Unusual bid activity: Any anomalies in the bidding process or RFP/RFQ response activity outside the norm may warrant scrutiny. Pay attention to instances where buyers or procurement stakeholders express disproportionate interest or support for a specific vendor. Look for instances where a subcontract or third party delivers goods contracted through a bid process without prior agreement. 

Materials or service fluctuations: Keeping a close eye on the quality and inventory levels of materials deliveries can help spot procurement fraud due to under-delivery or invoice inflation. Strong budgetary controls that involve three-way matching and materials receipt processes can head off instances of this type of fraud.

Invoice discrepancies: Any instances where materials and invoice data do not reconcile should be investigated. Keep a close eye on vendor payments and tie these payments back to specific projects or purchases every time.

How to handle a violation of a procurement policy

When a procurement fraud incident happens, there is limited recourse for remediation. Procurement fraud is distressing because it involves internal actors and external suppliers.

Developing a fraud response policy with well-defined action plans and stakeholders is essential for recovering from a fraud incident and reducing its likelihood in the future.

In general, a fraud response process should include the following:

• A list of internal stakeholders to be notified upon discovery of a fraud incident. This may include human resources, legal, audit, or security teams.
• A communication plan for internal and external channels of communication. This may include a public relations representative to handle media or public comments.
• A plan to communicate to high-level decision-makers such as board members, auditors, regulators, investors, etc.
• An audit process to establish the particulars and extent of the fraud and its participants.  

5 ways to mitigate against procurement fraud at your company

Use these techniques to reduce the likelihood of fraud in your procurement process:

1. Enhance procurement training

Educating your procurement and finance staff about the mechanics and frequency of procurement fraud can help them better understand how it occurs and remain vigilant against potential incidents. In addition, consider vetting and evaluating procurement hires with a lens on the potential for fraud. By enhancing the hiring process, companies may avoid fraud before it occurs.

2. Establish approval controls

Strict procurement controls are one of the best defenses against incidents of fraud. Establish a documented and repeatable procurement process with built-in checks and controls to spot abnormalities in the supply chain or accounting process. Understand standard pricing and maintain updated price lists where possible. With many eyes on each purchase, the ability to perpetrate fraud under the radar is significantly reduced.

3. Establish preferred vendors

Develop and adhere to a strict policy of using pre-evaluated and authorized suppliers. By following a stringent due diligence process and developing a highly selective supplier list, the likelihood of fraudulent activities from unknown suppliers is reduced.

4. Conduct regular internal audits

Regular internal audits (whether conducted by company stakeholders or outside parties) are a key element in reducing incidents and the likelihood of fraud. Employing high-visibility auditors with a forensic approach to accounting will increase the likelihood of finding fraud while deterring bad actors from attempting it.

5. Create a whistleblower policy

It’s crucial to empower your internal staff with the tools and reassurance to report potentially fraudulent activity. In some respects, procurement fraud is a symptom of a dysfunctional corporate culture. Healthy cultures with open communication can highlight discrepancies and enhance fraud prevention.

How Vendr prevents fraud by streamlining your procurement functions

Automating your procurement process with a procurement software system can help organizations address and reduce the likelihood of fraud.

Vendr’s supplier management capabilities create a well-controlled system, including:

• Automated approval workflows for purchases.
• Dynamic spending controls and contract management.
• Invoice approval, three-way matching, and integrated payment.
• Access to pricing data to ensure quality and standard, fair pricing.

These and other procurement management features create better budgetary control and visibility to reduce risk and fraud.