Factoring and invoice discounting facilities release hundreds of millions of pounds every year in prepayments on invoices that are due to be paid in the future. The risk for invoice finance companies is that an invoice is not paid. In the case of non-recourse factoring, it is the invoice finance company that is left with the often-arduous and expensive task of chasing up the debtor to get their money back. Invoice fraud is a significant threat to the financial viability of factoring firms. In an earlier post we examined the various types of invoice fraud perpetrated. In this post we look at the various ways invoice fraud can be identified and stopped before criminals flee with the money.
Pre-Meditated Invoice Fraud
Although the rarest type of invoice fraud, pre-meditated fraud is the costliest for factoring firms. It is when a company is set up with the intention of committing fraud by obtaining prepayments on invoices that they intend to steal. The first line of defence against this type of fraud is the initial meeting that the factoring firm has with its potential new client. This process is called the survey.
The survey involves a visit by an invoice financier from a factoring firm to the premises of the prospective client. The visit is to understand the business of their possible new client and to give an opinion about what type of financing is most suitable for that company. The survey will include assessments about the financial stability of the company, the asset strength of the company (especially the unpaid invoices), and the integrity of the directors and staff of the company.
The team for a survey will include both those who check the books and trading history of the company applying for invoice finance, as well those who run background checks on the directors and owners. They will also contact customers to check that the balances on outstanding debts tally with the books shown in the survey.
If a potential client for factoring clears the survey stage, then the ‘take on’ stage is initiated. This is when the accounts team of the company meets the financier’s team. There is a run through of how the invoice finance facility works. At the same time, outstanding paperwork is signed and the sales ledger is handed over to the invoice financier. At this stage fintech is integrated into the system of the client, if any is being used.
Debtor Balance Verification
The survey and the take on give the factoring firm a clear idea about the business of their new client, the personalities involved, the product sold and the state of the business as revealed by the accounts. This is the first stage of checks to try and spot any anomalies that might suggest invoice fraud is a possibility.
However, the debtor balance verification process gives more certain data on the new client. This is when the sales ledger is dissected and all outstanding invoices are checked with the customers of the company being onboarded for factoring. Occurrences that will trigger suspicion of fraud are:
- Only mobile numbers available for debtors;
- A debtor verification check that is too good. An unusually quick response from debtors, as well as an unusually high percentage of debtor responses suggests the possibility of collusion between the new client and its customers; and
- If there are too many blanks drawn when looking into the credit worthiness of the debtors.
Spotting Invoice Fraud Once the Factoring Facility is Operational
Once the new client has passed the survey and take on stages and the debtors have been investigated, the factoring and invoice discounting can commence. Now money is changing hands and invoice fraud can be committed. There are a number of ‘red flags’ for the financier’s team to keep a look out for.
Too Large Invoices
As mentioned in the companion article to this, the costliest fraud is the pre-mediated fraud where the client company raises a large fresh-air invoice for prepayment. The intention is to abscond with the prepayment. To prevent this, AI and computer learning tools can analyse the accounts and set parameters for the range of invoice amounts that the new client company usually deals with. Anything outside of these parameters needs further investigation.
Increasing Turnover
It is the dream of all directors and owners that turnover increases. However, it can be an indicator that invoice fraud is being committed. The audited accounts from the client need to be matched with the data regarding the level of sales assigned to the financier working for the factoring firm. The increased sales and cash take should match (taking into account the delays of 30, 60 or 90 days for invoices to be paid as well as credit notes). If cash collections don’t show the same rise as sales, then something is off.
Similarly, if an unusually large number of sales are covered with credit notes, then further investigation is required. If fresh-air invoicing has been committed then the best way to continue trading beyond the first fresh-air invoice is to raise a credit note to delay paying back the illegally obtained money.
Low Cash Collections
As alluded to above, if there is a large gap between sales and the cash take then invoice fraud may be systematically being employed to defraud the factoring firm. One common cause of this discrepancy is that debtors are making payments to a different bank account then the one assigned by the invoice financier for factoring and invoice discounting. Under a disclosed factoring agreement all debtors are given Notice of Assignment that their debt is being handled by a third-party factoring firm. The invoice will include details of which account should be used to transfer money. If the money does not go to the account controlled by the invoice financier, then they have the legal right to sue for a second payment.
Banking cash that belongs to the invoice financier is a serious breach of trust. The survey stage will have included the client signing a ‘trust clause’ in the financing agreement which allows the factoring firm to take legal action against anyone (employee or director) who misappropriates debtor receipts.
Use of Credit Notes
Credit notes are intended to deal with situations where the buyer queries the quality or quantity of goods or services provided. Since they regularly purchase from the same source, they are happy to receive credit rather than their money back.
However, the use of credit notes is also key to many acts of fraud, as the credit note is a substitute for cash that clears the transaction off the sales ledger of the supplier. If the credit note is to cover a fresh-air invoice then it has no legal basis.
A credit note can be used to delay the discovery of a fresh-air invoice. Another criminal permutation is for the client company to delay the reporting of a credit note for a genuine transaction in order to keep factoring funding levels higher than if the credit note had been promptly reported to the invoice financier.
All things being equal, the level of cash being substituted for credit notes in the client’s accounts should remain roughly the same. Sudden increases or decreases in the percentage of credit notes used in turnover needs to be explained. An unexplained jump or fall in the frequency and volume of credit notes is a clear indicator that fraud could be the real reason for the anomaly.
Disputes
Another indicator that all might not be right with the client is to take note of disputes. The invoice financier will be in regular contact with the debtors in their factoring facility. If there is a growing number of disputes about invoices (perhaps they are fresh-air invoices) and credit notes (perhaps the client is withholding credit notes from the financier) then the financier will be prompted to investigate further for possible fraud.
Days Sales Outstanding
An increase in Days Sales Outstanding or DSO can also be indicative of a company struggling with its finances and finding ‘creative’ ways to improve the books. This will typically be raising credit notes against fresh-air invoices just before the invoice financier flags the outstanding invoice for further attention. Another reason for a growing DSO is that money is being banked to another account not controlled by the invoice financier. The other possibility is that the client has changed the sales ledger to re-age invoices to make them seem more recent than they really are.
Factoring vs Invoice Discounting
The two main differences between factoring and invoice discounting pertinent to this topic is that with invoice discounting batches of unpaid invoices are sold for prepayment, and that the debtor payment should go into a trust account controlled by the invoice financier. It is easier to hide a fresh-air invoice in a batch with other legitimate invoices. Secondly, the client can request of debtors that payments be sent to the company account not the account set aside for invoice discounting. And thirdly, there is more scope for re-aging invoices, again hidden in a batch of legitimate invoices. For these three reasons invoice discounting is more prone to abuse by invoice fraud.
In contrast under a factoring agreement the invoice financier is in constant contact with debtors. They hold a mirror copy of the sales ledger which is updated in real time rather than periodically under an invoice discounting system. Moreover, the invoice financier takes over credit control in a factoring facility meaning their eyes are always on such indicators such as disputes, credit notes and low cash collections to outstanding invoice ratios. And lastly, under a factoring agreement the factoring firm effectively buys unpaid invoices and when the debtor pays the money goes straight to the factoring firm. There can be no confusion of sending money to the wrong account.
In Summary
The process of spotting fraudulent invoices begins when a factoring firm is approached for invoice finance. Due diligence during the survey and the initial take-on can raise red flags that the customer is untrustworthy.
If these two stages are cleared, there is then debtor balance verification that checks the books of debtors against the sales ledger of the potential client. This process also does credit checks and background checks on suppliers to make sure they are legitimate and financially sound. This stage provides another level of protection against future invoice fraud.
Once the invoice financier is in place and the invoice finance facility is up and running, then the best way to guard against fraud is to keep a close eye on such things as credit notes, DSO, disputes, and cash collection levels.
The inherent differences between factoring and invoice discounting are such that it leaves more opportunity for a client to make discrepancies in reporting that if found can be put down to ‘errors’ – the money was accidently sent to the wrong account, the invoice was mistakenly re-aged to appear younger than it really was. If these ‘errors’ happen frequently, then it is likely that these were not errors but deliberate attempts at invoice fraud.
As more and more factoring firms set up their own platforms to automate invoice finance, the more machine learning and AI will come to the fore as the most effective tools in spotting unusual behaviour and invoice discrepancies.
