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January 16th, 2020


Fraud: “It Will Never Happen Here, We Have Good People”

Barbara Uggen-Davis, CPA, CMA, Chief Financial Officer

There is a common misconception among small business owners that fraud and theft only happen in large companies. The truth is, small businesses are at the greatest risk of both internal and external fraud. The following are just some of the fraud risk factors for small businesses.

  • Employees often wear many hats and take on responsibilities outside of their core competencies.
  • There are generally too few staff members to allow for adequate segregation of duties.
  • Employees can fall prey to external fraud due to lack of experience.
  • Inadequate checks and balances can set up a situation where internal fraud can occur because a trusted employee simply has too much access and not enough oversight.

Take, for example, the case of “Donna” who worked as an Office Manager for a small shipping company. Donna was a hard-working, trusted team member. She handled the bookkeeping, billing, purchasing and kept the office running smoothly. She was well-liked and always friendly.  Donna rarely took vacation. She always took care of everything herself and never asked for help. When Donna did finally take a vacation, it was discovered that she had embezzled in excess of $30,000 over the previous year. Donna seemed like the perfect employee, so how could this happen? Like many small business employees, Donna had been given too much access and inadequate supervision and oversight.

Criminologist, Donald R. Cressey, developed the “Fraud Triangle” to describe the conditions that increase the potential for fraud. The fraud triangle consists of Incentive, Rationalization, and Opportunity. Incentive may be financial pressures such as debt, gambling, unexpected healthcare costs etc. Incentive may also be emotional, sometimes stemming from jealousy of others financial status or resentment about workplace issues.

Rationalization is the individual’s internal thoughts about the fraud and how they justify it as acceptable against their own moral code. They may consider a theft to be temporary and intend to repay it later. They may also feel that they deserve the money as compensation for a perceived unfairness.

When hiring, always conduct criminal background checks and credit reports for admin and accounting staff. A bad credit report can indicate a greater risk for fraud due to external financial pressures on the employee. But remember, a clean record doesn’t guarantee anything, nor does high debt always lead to fraud. Fraud, once discovered, is often unprosecuted, leaving the perpetrator free to commit fraud repeatedly at multiple employers. Look for high job turnover on an applicant’s resume as a potential indicator of fraud risk.

As a leader, you can be on the lookout for employees who exhibit signs of Incentive or Rationalization, but the biggest thing you can do to prevent fraud is to address the third leg of the triangle – Opportunity. Opportunity is the specific circumstances that allow fraud to take place. Opportunities for fraud include weak internal controls, inadequate accounting policies, and a “poor tone at the top” which includes leadership’s integrity and demonstration of ethical behavior.

“Nothing will completely eliminate the risk of fraud, but solid business practices can go a long way in creating an environment where fraud is less likely to occur.”

You can reduce the opportunity of fraud by implementing adequate segregation of duties, supervision, strict adherence to good financial control policies, and routine internal audits. Nothing will completely eliminate the risk of fraud, but solid business practices can go a long way in creating an environment where fraud is less likely to occur.

No matter how trustworthy the employee, adequate oversight of the accounting function is critical. The person responsible for entering data into the accounting system should not have financial approval authority. The person who signs the checks shouldn’t be the person preparing them or entering them on the books. Someone who is not responsible for bookkeeping should reconcile the bank statements.  This separation of duties helps mitigate some of the risk factors related to opportunity for fraud.

Let’s go back to Donna. When Donna needed to buy supplies, her supervisor would give her signed, blank checks. Donna would then go to the store and return with the supplies. She would pay for the supplies using her own money and then write a check to “cash” for a larger amount and kept the difference. When the bank statement arrived, Donna would reconcile the bank statement herself and destroy the actual checks written to cash. (This occurred back when banks still mailed the original checks with the statements.)

Donna had incentive. She was recently married and was pressured by her new husband to commit the fraud. She felt trapped by her husband’s demands and rationalized that no one would notice.  Her husband helped her rationalization by telling her the company was underpaying her and that she deserved the money.

The company could have prevented the fraud by reducing the opportunity. In this case, having someone other than Donna reconcile the bank statements and match the purchase receipts to the checks would have alerted the company that something was wrong. Had these procedures been in place, Donna would have been far less likely to attempt the fraud in the first place.

Internal financial audits should be conducted routinely.  It can be as simple as having a supervisor or third-party review the payment registers for the previous month and compare them to the supporting documentation. In Donna’s case, it was a review of a single transaction with suspicious supporting documentation that raised the red flag to initiate the investigation.

An outside accounting service can be a great resource in fraud prevention and detection. Have an audit done of your financial control procedures to identify and mitigate weaknesses.  If you have a small staff, you can leverage an outside accounting service to perform bank reconciliations and payment reviews to help mitigate risk.

If you do discover fraud, turn it over to the police and prosecute. Not only will it help you potentially recover some of the loss, but it may also help prevent the next employer from becoming a victim.  Donna was arrested, prosecuted, convicted and ordered to make restitution.  In court, Donna said her husband taught her how to perpetrate the fraud.  Even though he had been caught several times, no employer had ever prosecuted.

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