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Inside Job

Monday, July 12, 2010
How To Protect Your Company From Fraud And Embezzlement

By Don Sadler


The greatest business risk many owners face may be standing right in front of them: employee fraud and embezzlement.


Unfortunately, this risk is often magnified during times of economic uncertainty, when employees may be facing extreme financial strain of their own.


“No way, not at my company!” you might respond. “My employees would never steal from me.”


But, the fact is that employee fraud is much more common than most owners realize.


In a report published in 2009 titled “Occupational Fraud: A Study of the Impact of an Economic Recession,” the Association of Certified Fraud Examiners concluded that financial pressures during the economic crisis have clearly led to an increase in instances of fraud. More than half (55 percent) of the certified fraud examiners surveyed said they believe the level of fraud slightly or significantly increased in the prior year.


The numbers reflecting the financial impact of employee fraud are staggering. In its most recent “Report to the Nation on Occupational Fraud and Abuse” (2008), the ACFE estimated that organizations in the U.S. lose 7 percent of their annual revenue to fraud, which projects to an aggregate $994 billion a year.


Small firms are especially vulnerable. While the median loss among all companies was $175,000, it was $200,000 among small businesses—enough to virtually wipe out many small firms.


“The message to corporate America is simple: Desperate people do desperate things,” says ACFE President James D. Ratley. “In a good economy, most people would never think of committing fraud against their employer. But organizations must be especially vigilant now by ensuring that proper fraud prevention procedures are in place.”


The Fraud Triangle


Bert Davis Jr., a certified public accountant, certified fraud examiner and partner in the Greensboro, N.C., office of the accounting firm Gilliam Coble and Moser LLP, says the best way to understand fraud and embezzlement is to envision a “fraud triangle.”


“There are three main things usually necessary in order for fraud to occur: pressure, rationalization and opportunity,” he explains.


Not surprisingly, nearly half of the respondents (49 percent) to the ACFE survey attributed the recent rise in fraud to increased financial pressure, while only 27 percent attributed it to more opportunities to commit fraud and 23 percent to more rationalization on the part of employees.


“While employers have no control over the financial pressures their employees may be facing or their ability to rationalize stealing, they can control whether employees have opportunities to commit fraud,” says Davis. “And this starts by implementing sound internal controls.”


By this, Davis means ensuring a high level of management oversight of your company’s finances, as well as adequate segregation of financial duties among employees.


“With the troubled economy, many small businesses have had to cut back on staff, which by its nature reduces oversight,” says Davis. “Not watching bank balances carefully and allowing employees to use company credit cards are easy ways to lose oversight, and easy ways for employees to steal.”


Segregation of duties simply means that at least two employees should fill out deposit slips, make deposits and enter them in the ledger, and reconcile the bank statement each month. If this isn’t practical for a very small business, the owner should personally oversee these functions.


Davis tells the sad story of a small-business owner who didn’t follow either of these rules and lost nearly $50,000 over a 14-month period as a result.


“His ‘trusted’ employee received all payments from customers, recorded them in the ledger, prepared the deposits and took them to the bank. Meanwhile, the owner provided little to no oversight. The employee deposited checks but she stole all the cash and did some accounting tricks to cover it up.”


The fraud was only discovered when another employee noticed that cash was still in the drawer when the thief returned from the bank—she had forgotten to put it in her purse. Ironically, experts say that simple mistakes like this are how most fraud schemes are uncovered.


“It’s easy to think this was possible because the business was small and unsophisticated, but most frauds are amazingly simple,” says Davis. “The size of the business is irrelevant. The biggest deterrent to internal fraud is letting employees know that someone is looking over their shoulder.”


Fraud prevention starts by setting the right tone at the top of your organization, says C. Patrick Braley, senior manager in the dispute resolution and forensics practice of Bennett Thrasher PC, an accounting firm in Atlanta.


“A very simple but effective way to deter fraudulent behavior is by the owner proactively communicating intolerance for employee misconduct, and then ‘walking the talk’ himself or herself,” Braley says.


Braley also encourages owners to implement a fraud hotline through which employees can report suspicious activities anonymously.


“A hotline increases the chance of fraudulent activity being reported, since the anonymity typically gives an informant a higher sense of security from retaliation.”


What You Can Do


One of the most encouraging findings of the ACFE report was that business owners can do things to protect themselves.

“Implementing anti-fraud controls appears to have a measurable impact on a company’s exposure to fraud,” says ACFE President Ratley.


The ACFE report examined 15 specific anti-fraud controls and measured the median loss in fraud cases depending on whether organizations did or did not have a given control in place when the fraud occurred.


“In every comparison, there were significantly lower losses when the controls had been implemented,” Ratley notes. “A lack of adequate internal controls was most commonly cited as the factor that allowed fraud to occur.”


There are a number of practical steps you can take to limit the opportunities employees have to commit fraud. Davis suggests the following three tips for small-business fraud prevention:


1. Put it in writing. Create a formal ethics policy that clearly states the parameters of acceptable employee behavior. While it should go without saying that outright stealing and theft are unacceptable, specifically written behavioral do’s and don’ts removes any potential doubt from the minds of employees. It also makes clear the consequences of breaking the rules.


2. Don’t use signature stamps. Instead, sign all checks yourself. Before you do, carefully review the invoice, purchase order and delivery receipt to make sure they’re legitimate.


3. Watch receivables processing and posting of payments closely. Slowdowns in either of these areas could be a sign of a fraud scheme known as “lapping of receivables.” It’s kind of like a Ponzi scheme: A fraudulent employee will steal a customer’s payment instead of depositing it and apply another customer’s payment to the account to cover it up.


This must be repeated over and over, of course, and it’s impossible for it to go on forever. But a dishonest employee could steal tens of thousands of dollars before getting caught if you’re not diligent. The best prevention is segregation of financial duties, making sure different employees process payments and post transactions.


Talk To The Money Experts

Most banks offer fraud prevention services, such as Positive Pay.


“This service helps safeguard against check fraud by verifying the authenticity of checks written from a business account,” explains James Hicks, executive vice president, Treasury Management with Regions Bank in Birmingham, Ala.


Here’s how Positive Pay works: You provide the bank with an electronic file of check serial numbers, dollar amounts, check dates and payee names as soon as checks are written or issued. The bank will then compare checks presented for payment to this list and flag any that aren’t an exact match so that you can decide whether to pay them or not.


Hicks notes that crooks are following the shift from paper checks to electronic payments.


“To protect against this growing problem, you may want to sign up for a bank service called EPA Block that blocks unauthorized electronic automated clearing house charges to your account.”


He adds that micro-business owners who use consumer checking accounts instead of setting up business accounts can open themselves up to fraud.


“This can be problematic if more than one employee is tasked with keeping the books. The online banking platform designed for businesses helps reinforce the separation of duties among employees. For example, one employee can be given authorization to initiate payment transactions, while a second employee, using a different computer, can then approve and release these payments.”


You may also want to talk to your accountant about fraud prevention, suggests certified fraud examiner Davis.


“He or she can give practical advice on how to best segregate financial duties to lessen opportunities for employees to embezzle company funds.”


Unfortunately, it’s impossible to completely shield your company from the risk of fraud. But taking concrete steps to beef up internal controls and reduce employees’ opportunities to steal will significantly reduce the chances of your company becoming a victim.


Freelance writer Don Sadler specializes in small business and self-employment. He has written extensively about the rising instances of internal fraud. Reach him at don@donsadlerwriter.com.

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