What Is Vendor Fraud? Types & Prevention Tips

The main challenge is finding a way to uncover vendor fraud since fraudulent acts are performed with the intent to conceal them. Businesses with weak or missing internal controls are at a high risk of this type of fraud. In this article, we’ll talk about the different kinds of vendor fraud and give you some tips on how to prevent them.

Types of Vendor Fraud

Vendor and procurement fraud—a type of fraud related to the purchase of goods from vendors—remains a persistent problem among businesses, accounting for 55% of reported fraud cases. Fraud in the workplace is prevalent, and most are perpetrated internally and in connivance with vendors. Moreover, 48% of occupational fraud is due to corruption, with a median loss of $200,000.

Given that fraud in the workplace can cost your business a lot of money, knowing the common vendor fraud schemes can help you catch fraudsters even before they steal from you.

Invoice Fraud

Invoice fraud is a type of fraud wherein invoices are intentionally falsified or altered to take advantage of weak internal controls. It occurs in the following circumstances:

• Employees intentionally alter vendor invoices or craft fake vendor invoices
• Employees with access to vendor records create a fake vendor and bill the company for non-existent products and services
• Vendors intentionally over-inflate prices, charge items not delivered or performed, or charge hidden fees, hoping that buyers won’t catch these small changes
• Vendors intentionally reduce the quantity of goods delivered, which is easily perpetrated for large-volume, low-value items, and if the buyer doesn’t count the goods received
• Several employees collude to create fake invoices and accounting documents

The best way to prevent and detect invoice fraud is to have strong internal controls. Before paying an invoice, it must go through a series of approvals to verify if all contents in the vendor invoice are legitimate. You must also perform three-way matching to detect inconsistencies between different source documents.

Corruption Through Bribery and Kickbacks

In the context of vendor fraud, corruption exists when employees receive bribes and kickbacks from vendors in exchange for securing contracts or manipulating prices. The complicit employee acts as an advocate of the vendor, almost always recommending the vendor be the primary or sole supplier. In exchange, the vendor will give them gifts or a cut of the final contract price.

Corruption can also occur when an employee has a personal connection to a vendor, such as owning the vendor’s business or being related to the vendor (e.g., the vendor is the employee’s spouse). This instance creates a conflict of interest, which can be exploited if not addressed.

Fighting workplace corruption can be difficult, especially if it involves high-ranking officials. Here are some ways that can reduce or discourage workplace corruption:

• Rotate employees
• Conduct employee lifestyle checks
• Establish a culture of honesty and integrity (i.e., “the tone at the top”)
• Conduct regular risk assessments to spot vulnerabilities within the company’s systems processes
• Enhance due diligence procedures in screening vendors

Vendor Misrepresentation

Vendor misrepresentation occurs when vendors claim to have certifications and qualifications that they don’t actually possess. Some vendors use this deceitful tactic to get new clients, and—if you’re not careful—you might fall for the vendor’s sweet talk and too-good-to-be-true promises.

The best way to prevent this type of vendor fraud is to conduct a thorough vendor fraud risk assessment that’ll ask for the following information:

• Company background information
• Latest W-9 form
• Most recent audited financial documents, if available
• Permits, licenses, and certifications
• Portfolio of products, clients, and past projects

Counterfeit Goods

Supplying counterfeit goods is also a type of vendor fraud. The best way to detect counterfeit goods is to inspect the goods upon arrival.

• Check the label and packaging: Errors in spelling, font style, logos, or formatting may indicate that the goods are counterfeit. You have to be meticulous to spot these errors. Besides that, you should know what the original goods look like to spot counterfeit goods.
• Ask for serial numbers or authenticity codes: Some manufacturers include authenticity codes, legitimacy seals, and serial numbers to protect their goods from being pirated. You can verify these codes and numbers via the manufacturer’s website. If the serial number or authenticity code can’t be verified, that’s a red flag.
• Check the price: Some vendors sell their products for less than the market price. If a seller gives you a huge discount of 50% off the market price, you must be skeptical about the offer. Original goods are expensive because of how they’re manufactured. So, put yourself in the manufacturer’s shoes: Would you sell your product at half its original price while knowing how expensive it is to produce one unit?

Collusive Bid Rigging

Bid rigging occurs when two or more vendors collude to manipulate the bidding process.

• Vendors agree on a fixed price range so that there will be significant differences in bid prices.
• Vendors take turns winning contracts in a rotation-based bidding system. In this scheme, some vendors will bid at intentionally high prices or ask for terms and conditions that they know won’t be accepted, making it easier for their designated vendor to win the contract.
• The winning vendor subcontracts some of the work to other vendors as a reward for participating in the bid-rigging scheme.

However, it’s also possible that bid rigging is between an employee and the vendor. The employee will feed the vendor inside information so that the vendor will know what the company is looking for. This way, the vendor can bid according to the company’s preferences, which can lead them to win the contract. In exchange, the employee will receive a cut from the winner.

To prevent bid rigging, businesses should establish clear and strict procedures for bidders. Publicizing bids promotes transparency and encourages small supplies to join bids. You may also let bidders sign an anti-collusion clause so that they’ll be aware of the legal ramifications of bid rigging.

Tips for Vendor Fraud Prevention

Anyone can be a victim of fraud, especially if the fraudster knows they can exploit you. The best course of action is to implement preventive measures to keep fraudsters at bay.

Screen Vendors Carefully

Vendor screening can help you pick vendors who are reliable, capable of meeting your needs, and true to their businesses. Here are some things that you need to do during vendor screening:

• Establish criteria: Determine what you’re looking for in a vendor such as technical expertise, experience with different clients, certifications, and product quality.
• Meet the vendors personally: Meet the vendors in person so that you can get to know the people you’ll be working with. You can also use this opportunity to ask additional questions that come to mind.
• Gather information: Send a Request for Information (RFI) to your shortlisted vendors. The RFI must provide all the information you need to determine whether the vendor can satisfy your needs. There are also procurement websites that publish RFIs like the SAP Business Network.
• Conduct background checks: Access public records to check if the vendor has been associated with past litigations or ongoing cases. You may also check business information platforms such as Dun & Bradstreet and Lexis Nexis to look for relevant company information.

Train Employees on Fraud Awareness and Detection

Conducting fraud awareness training is a good step to equip your employees with the necessary skills to detect and spot fraud. Fraud detection can be hard since fraud is intended to be concealed. However, there will always be loopholes that can help uncover it.

As a business, you may do the following to enhance fraud awareness and detection:

• Attend regular seminars and workshops for the latest fraud tactics and schemes.
• Use scenario-based approaches in illustrating different fraud schemes.
• Encourage employees to take courses relating to fraud.
• Require employees at the frontline of fraud detection to undergo certification training.
• Establish a whistleblower program to encourage employees to report fraudulent activities within the business.

Employ Strict Control Over Vendor Records

Having a vendor master file (VMF) helps you prevent vendor fraud because it is the source of truth for all vendor information. It contains all the information about the vendor, their preferred payment methods, and other important documents.

The integrity of the VMF must be maintained at all times by only allowing one person to make changes in the file. Hence, proper segregation of accounting duties must exist to mitigate the risk of vendor fraud.

The person responsible for maintaining the VMF must not handle the following duties concurrently:

• Collecting payments from vendors
• Reviewing and approving invoices from vendors
• Coordinating with vendors regarding purchase orders

Rotate Employees Regularly

Employee rotation (also called job rotation) is a strategy that moves employees to different positions and departments within the company. Its main goal is to expand their skill sets and enhance their overall experience, and it’s also one way of reducing the risk of corruption and collusion in the business.

However, it’s important to ensure that the rotation process is not perceived as an implication of potential fraud. Exercise caution and address any concerns carefully to avoid misunderstandings or regrets.

Here are some tips for implementing an employee rotation program:

• Determine which positions you want to rotate regularly.
• Identify the participants in the rotation (e.g., those who have been with the company for at least six months or those who have been handling the position for at least a year).
• Set the frequency of rotation (e.g., monthly, quarterly, semi-annually, or annually). Note that frequent rotation might disrupt efficiency, especially if the next person to handle a position is inexperienced.
• Communicate the rotation program to all concerned employees several months in advance so that everyone can process the upcoming change.

Implement Strong Internal Controls

Nothing beats strong internal controls. However, collusion and connivance can beat that, especially if it involves high-level positions. Regardless, establishing a good internal control system can reduce the risk of vendor fraud. By implementing multi-level approvals, you can easily spot fraudulent invoices and prevent them from being paid.

Implementing a good internal control system alongside rotating employees can prevent employee collusion, as rotations can uncover fraud. Once the next person takes over, they might discover some discrepancies and sound the alarm when they spot evidence of fraud, which makes it almost impossible to commit fraud without being caught sooner or later.

Consider A/P and Payments Automation

Automation can deter fraud most of the time because it reduces human intervention. Payment automation lets you pay vendors without manually transferring funds to their bank accounts. With payment automation software, payments can be automatically charged to your bank account or credit card.

However, having automated systems doesn’t make your business fraud-proof. Using A/P software can help you process all vendor invoices and payments in one place and enable multi-level approval workflows.

By using approval workflows and access controls, all vendor invoices go through a process of review and approval. Employees with access to the A/P software can also have different access controls to limit their access to certain features.

Pay Vendors Electronically

Physical cash flow in the business is another temptation for theft and fraud. Employees with direct access to cash might be tempted to steal small amounts or perform cash skimming when there are no surveillance cameras in place.

By paying via wire transfer or credit card, you reduce the risk of cash theft and reduce fraud risk because there’s no physical cash involved. As long as you send the payment confirmation notification to the vendor, you’re good to go.

Moreover, electronic transactions always leave a trail. It’s easier to track electronic transactions than those paid in cash. By simply not recording the payment, fraudsters can easily steal cash when they get the right opportunity.

Conduct Employee Lifestyle Checks

Another fraud red flag is sudden changes in the employee’s lifestyle, such as living beyond their means or income level. In the Occupation Fraud 2024 report, 39% of perpetrators lived beyond their means. Signs of lifestyle changes include

• Expensive housing and luxury cars
• Costly vacations
• Luxury items and accessories
• High credit card debt

For example, a person earning $75,000 may be living beyond their means if they rent a $ 5,000-a-month apartment, rent a luxury car at $1,000 monthly, and go on lavish vacations and cruises frequently. When conducting a lifestyle check, evaluate how the employee is financing these expenses. If the employee’s reason is valid (e.g., being born to a rich family), then there’s no reason to suspect fraud.

Frequently Asked Questions (FAQs)

How to mitigate vendor fraud?

What is an example of procurement fraud?

Bottom Line

Vendor fraud is not an impossible occurrence. Anyone can be a victim of vendor fraud, especially if proper internal controls are absent. The only way to mitigate vendor fraud is to implement strong controls in the business and establish a culture of honesty and trust.