Sunday, April 21, 2013

Keeping Your Business Safe From Fraud

clip_image002This article was written by Mike Capsuto, SCORE Orange County Business Mentor

Fraud is the crime of obtaining money or some other benefit by deliberate deception. Fraud ranges from corruption, misappropriation of company assets, to falsifying financial statements.

Small businesses are particularly vulnerable to fraud. Management's primary focus on sales and profits leaves them with little time for being involved in day to day operations. Furthermore, most small businesses are developed around a concept of a "trusted family" of employees. Placing trusted employees in positions without proper monitoring does not seem to be an unreasonable staffing approach to owners of a small businesses.

According to the Association of Certified Fraud Examiners (ACFE) 2012 Report to the Nations, of the 1,388 cases studied, small businesses had the highest reported frequency of fraud at 31.8%. Compare this to businesses with 100 to 999 employees, 19.5%; 1,000 to 9,999 employees; 28.1%; and 10,000 plus employees, 20.6 %. Estimated median loss from fraud for small businesses with less than 100 employees was $147,000. The median time before fraud was discovered was 18 months.

The frequency of fraud for small businesses is likely higher. Many incidents are not reported. Common reasons are: the individual involved was a relative, a long time “trusted” employee, an owner, the fear of bad publicity, or lack of time to pursue the perpetrator.

The following are the most common fraud schemes according to the ACFE report along with examples. The percentage is the frequency of reported cases in each of the categories committed in businesses of less than 100 employees.

1. Billing (32.2%):

  •   Employee creates a fictitious company and bills employer for nonexistent services.

2. Corruption (27.9%): Corruption is further categorized:

  • Conflict of Interest: An employee owns an undisclosed interest in a supplier. The employee negotiates a contract between his employer and the supplier, purchasing materials at an inflated price.
  • Bribery: An employee processes a supplier's invoices with inflated prices. In return the employee receives a percentage of the price as a kickback.
  • Illegal Gratuities: An official negotiates an agreement with a contractor, and in appreciation the contractor provides the official with an expensive gift such as a free vacation.
  • Extortion: An employee refuses to purchase goods or services from a vendor unless the vendor hires one of the employee’s relatives.

3. Check Tampering (22.4%):

  • Employee steals blank company checks, makes them out to himself/herself or an accomplice.

4. Skimming (20.7%):

  •       Employee accepts payment from a customer but does not record the sale.

5. Expense Reimbursement (17.2%).

  • Employee files a fraudulent expense report, claiming business travel, hotels and meals.

6. Cash Larceny (16.6%):

  • Employee steals cash and checks from daily receipts before they can be deposited in the bank.

7. Payroll (14.2%):

  • Employee claims overtime for fictitious hours.

The majority of frauds (64%) are committed by non-management employees. But frauds committed by managers or executives are three-and-a-half times more costly. The greater the management role, the more they are entrusted with company assets. Most people who committed fraud were first-time offenders. Only 3% of perpetrators had been convicted of a previous crime involving fraud.

Three factors that must be present for a person to commit fraud.

1. Pressure - Common pressures are:

  • Unable to pay personal bills.
  • Desire to obtain luxury items.
  • Drug, alcohol or gambling addiction.

2. Rationalization - Rationalizations may include,

  • I’ll pay the money back.
  • They will never miss the funds.
  • They don’t pay me enough.

3. Opportunity - The person committing the fraud sees an internal weakness and begins the fraud with a small amount of money. If no one notices, the amount will usually grow larger.

Discovery usually comes from:

  • Tips or by accident.
  • The perpetrator gets greedy and creates suspicion.
  • After the individual has absconded with the funds and can no longer be located.

The Small Business Administration (SBA) website ( has published six tips for preventing and managing employee fraud which should serve as a guideline for all employers.

1. Use Pre-Employment Background Checks

The first step to preventing fraudulent employee behavior is to make the right hiring decision. Basic pre-employment background checks are a good business practice especially for those employees who will be handling cash, high-value merchandise, or have access to sensitive customer or financial data. outlines the types of information that you can use as part of a pre-employment check. However, always consult with an attorney. Laws vary from state to state.

2. Check Candidate References

Few employers check candidate references' assuming that a reference will never be anything but glowing. However, it’s good practice to check references' particularly those of former employers or supervisors. If your candidate has a history of fraudulent behavior then you will want to know about it, before you hand them a job offer.

3. Proactively Communicate Conduct Guidelines

Every business needs an employee code of ethics and conduct. While it won't prevent criminal or fraudulent behavior, the standards it outlines will set a clear benchmark for employee behavior and guidelines on how to do business based on a series of principles that promote ethical and lawful conduct. The code of conduct should be documented and agreed to by all employees. Then, revisit the code each year and be sure to add any new considerations that may have materialized - for example, if you do business with certain suppliers, contractors, or government agencies who require you and your employers to agree to new codes of conduct as part of your business relationship.

4. Don't be Afraid to Audit

As a rule of thumb, identify high risk areas for your business and audit for violations on a 6-12 month basis - these could include business expense reports, cash and sales reconciliation, vacation and sick day reports, violations of email/social media or Web-use policies.

5. Recognize the Signs

Some potential red flags to look out for include:

  • Not taking vacations - many violations are discovered while the perpetrator is on vacation
  • Being overly-protective or exclusive about their workspace
  • Prefers to be unsupervised by working after hours or taking work home
  • Financial records sometimes disappearing
  • Unexplained debt
  • Unexpected change in behavior

6. Set the Right Management Tone

One of the best techniques for preventing and combating employee theft or fraud is to create and communicate a business climate that shows that you take it seriously. Here are some simple steps:

  • Reconcile statements on regular basis for fraudulent activity
  • Hold regular one-on-one review meetings with employees
  • Offer to assist employees who are experiencing stress or difficult times
  • Encourage open-door policies giving employees the opportunity to speak freely and share their concerns about potential violations.
  • Create strong internal controls.
  • Require employees to take vacations..
  • Treat unusual transactions with suspicion.
  • Trust your instincts.

Whether you are a large or small business, management must take aggressive actions against the conditions that perpetrate fraud with a clear plan of internal control that limits the opportunity for fraud and minimizes the impact when fraud does occur. Most accounting firms will help set up a reasonable system of controls. But at their core, fraud involves a violation of trust. It is this violation, that makes such crimes so harmful, perhaps even more than the resulting financial loss.