What Is Defalcation and How Do You Detect It?

Defalcation is the misappropriation of funds by a person entrusted with them, such as a trustee, executive, or an employee with access to company finances. This act is a breach of fiduciary duty, which is the responsibility to act in another party’s best financial interest, and is considered a form of fraud and embezzlement. The defining characteristic is the perpetrator’s trusted status, which provides the opportunity to commit the financial crime. The act itself can range from simple theft to complex schemes designed to hide the activity over a long period.

Common Defalcation Schemes

One of the most direct forms of asset misappropriation is skimming, which involves stealing cash from an organization before it is recorded. For instance, a cashier might pocket a customer’s payment and discard the sales record. Because the transaction is never entered into the system, tracing the missing funds requires other controls, such as comparing inventory levels to sales data.

A more intricate method is a lapping scheme, which conceals the theft of customer payments. In this scenario, an employee steals a payment from Customer A and does not record it. When a payment arrives from Customer B, the employee applies it to Customer A’s account to avoid a late payment notification. This cycle continues with subsequent payments being misapplied to cover the previous theft, a process that can only be sustained by the constant receipt of new funds.

Fraudulent disbursements occur when an employee causes the company to pay for a fictitious purpose. This can be done through a billing scheme, where the perpetrator creates a “shell” company and submits fake invoices for non-existent goods or services. The employee then approves the payment to the shell entity they control. Employees may also falsify expense reimbursement requests for personal travel or non-existent business meals.

Payroll fraud targets a company’s salary distribution system. A common tactic is creating a “ghost employee,” an individual who is not employed but is listed on the payroll. A dishonest manager could create a fake record and direct the paychecks into an account they control. Another payroll scheme involves inflating the hours worked or the pay rate for oneself or a co-conspirator.

Warning Signs of Potential Misappropriation

Anomalies within an organization’s financial records and operational processes can be early indicators of defalcation. The behavior of the person committing the fraud can also reveal their actions.

Financial Red Flags

These financial indicators can signal that something is wrong:

• Missing documents, such as canceled checks, deposit slips, or vendor invoices.
• An increase in customer complaints about account statements, especially claims of uncredited payments.
• A pattern of duplicate payments made to a single vendor.
• Unusual journal entries made at odd times or by unauthorized individuals.

Behavioral Red Flags

Common behavioral red flags from an employee include:

• Living a lifestyle not supported by their known salary, such as making extravagant purchases.
• An unusual unwillingness to take vacations or sick leave, as they may need to be present to conceal their activities.
• An individual who is overly protective of their work area and resists sharing job duties.

The Role of Financial Audits

A standard financial statement audit, while designed to give an opinion on financial statements, can help detect defalcation. Auditors must assess the risk of material misstatement due to fraud, which leads them to perform specific procedures that may uncover misappropriation. This involves testing the company’s internal controls, which are the policies and procedures designed to prevent fraud. If controls are weak or easily overridden, the risk is higher.

During an audit, professionals perform substantive testing by examining individual transactions and account balances. An auditor might inspect a sample of vendor payments and supporting invoices to ensure they are legitimate. They may also confirm account balances directly with third parties, like customers or banks. Analytical procedures that compare financial data to identify unusual fluctuations can also highlight areas needing investigation.

Financial audits have limitations. An audit provides reasonable, not absolute, assurance that financial statements are free from material misstatement caused by error or fraud. A well-concealed scheme, especially one involving collusion or forgery, may not be detected by standard procedures, so an audit is not a guarantee that all fraud will be discovered.

Initial Investigative Steps

When defalcation is suspected, the first step is a methodical and confidential financial investigation, often led by a forensic accountant or a specialized internal investigator. The primary goal is to uncover facts and quantify the extent of the loss. The first action is to discreetly secure and preserve all relevant financial records, such as bank statements, invoices, and payroll data, to prevent the suspected individual from destroying evidence.

The investigation moves to a detailed analysis of the preserved data, where forensic accountants trace the flow of funds to identify irregularities. This may involve analyzing electronic data for manipulation, reviewing endorsements on canceled checks, or scrutinizing vendor files for fake entities. The objective is to follow the money from its source to its illegitimate destination.

Quantifying the total loss requires a meticulous reconstruction of fraudulent transactions over the entire period the scheme was active. The investigator then prepares a detailed report outlining the scheme’s mechanics, a timeline of events, the individuals involved, and the calculated financial impact. This report focuses on the financial evidence and provides the basis for any subsequent actions.