Small business fraud and the trusted employee
Protecting against unique vulnerabilities
Small businesses have it rough. They're particularly vulnerable to fraud because they lack the resources to implement complete systems of internal controls and properly
segregate accounting duties among their limited staffs. However, small businesses don't have to be rife with fraud. Here are some viable prevention options.
Bob and his brother, Bill, owners and operators of Acme Tractor for 30 years, were close to retirement. A local bank had continually financed Acme, which had an inventory of farm tractors worth millions of dollars. The owner's wives, Jane and Julie, shared accounting duties in the company. Jane would approve invoices. Julie would prepare the checks and either Bill or Bob would sign them. The receipt and payment cycle included a series of checks and balances with no one employee responsible for the entire cycle.
Jane and Julie retired from the business, and James, Bob's son, assumed the bookkeeping responsibilities. James, 30, had been working in various jobs at the business since high school. Now the brothers entrusted him with all aspects of bookkeeping for the business: accounts payable, accounts receivable, payroll, and all account and bank reconciliations. They gave him check-signing ability and a business credit card.
Soon after becoming the bookkeeper, James married and began a family. As his personal monthly bills increased, he found it difficult to maintain the lifestyle he had known when he was single and living with his parents.
The fraud scheme began simply. At first, James began illegally using his business p-card (or purchasing card) for small personal expenses, such as gas for his personal vehicle and fast food meals. After several months, his charges for personal expenses increased in number and dollar amount, including charges for taking out his wife and children to fine restaurants, clothing for himself and his family, and even high-end electronic products. No one at Acme noticed the continual increase in charges for personal items because James controlled all payment checks to the credit card company.
James' fraudulent activities expanded. He began embezzling from the payroll system. Because he was a manager, he didn't have to use the time clock and began to pay himself for excessive overtime pay. He would give himself paychecks in lieu of not taking vacation time, even though he took all his vacation days. Acme management was still oblivious.
He then began writing checks payable to himself, but he would write a regular recurring vendor's name on each check stub and hand-key it into the computer system. When the bank statements came each month, James would alter the images of the checks on the statements to match the vendors on the check stubs and in the system. Then he would hide evidence of the fraudulent checks he had cashed by photocopying the altered pages of the bank statements and shredding the original statements.
Crafty James wasn't done yet. He opened a new personal credit card at the business' bank. Now it was easy for him to electronically make bank drafts for paying the business' monthly credit card statements and then write company checks to pay his personal card. If anyone reviewed the check stubs, it would only appear that one credit card invoice had been paid each month. James could charge the company's credit card for his personal expenses and charge additional purchases to this new credit card. He used company funds to pay off both cards. Sweet deal.
Some fraudsters rationalize their thefts as "temporary" loans they will repay later. James executed his frauds without any intention of returning the money. His thefts from the company for 2½ years were large enough to create company cash flow problems.
One of James' cousins accidently discovered the crimes in December 2010 when he was searching the business' online banking system for a canceled check and discovered that several checks in one month had been payable to and signed by James.
Management didn't contact law enforcement nor engage an outside accountant. During its internal investigation, the family determined that it had lost at least $60,000 (though it was probably quite a bit more than that). Family members confronted James. He confessed and explained how he had stolen the money. The business fired him after he signed an agreement for restitution, which stipulated that the family wouldn't prosecute.
Before they discovered James' crimes, Bill and Bob had attributed cash-flow problems to a downturn in the economy. And James, of course, concurred. The brothers had to lay off employees and cut or reduce employee benefits for both family and non-family employees. The company still hasn't recovered from James' fraud schemes.
Small businesses are particularly vulnerable to fraud because they lack the resources to implement complete systems of internal controls and properly segregate accounting duties among their limited staffs. Therefore, accounting personnel may be tasked with completely inappropriate job functions that provide easy opportunities for committing financial frauds. Furthermore, the business cultures of small businesses are developed around a concept of a "trusted family" of employees. Consequently, placing trusted employees in positions without proper internal controls doesn't appear to be an unreasonable decision to managers of a "family" business.
According to the ACFE's 2012 Report to the Nations, estimated median losses for small organizations — those with fewer than 100 employees — that experienced a fraud were $147,000. The report indicated that small organizations are the most common victims in fraud instances at 31.8 percent — the highest rate of any business size category. (For example, organizations with 100 to 999 employees had a fraud incident frequency of 19.5 percent; 1,000 to 9,999, 28.1 percent; and 10,000 plus, 20.6 percent.)
The five most common fraud schemes for organizations with fewer than 100 employees in the ACFE report were: billing fraud, corruption, check tampering, skimming and expense reimbursement fraud. Corruption schemes deal with crimes such as bribery, illegal gratuities and kickback arrangements. The largest number of perpetrators in the entire study, 41.5 percent, had been with the organization between one and five years, most of them had a college degree and worked in the accounting area.1
Even using ACFE survey data, it's difficult to estimate the true losses from employee frauds. Small businesses often don't report these crimes because of families' embarrassment, decisions not to file criminal charges or wanting to keep knowledge of the crimes privy. Only a small number of small business embezzlement victims — roughly two percent — report crimes even though 40 percent of small businesses report they have been victimized, according to the May 16, 2011, article in The Daily Record, "Employee theft at small business high and hard to detect," by Kathleen Johnston Jarboe (accessible for a fee).
In this article, we provide several practical recommendations for small business managers to help them prevent these fraud schemes.
THE TRUSTED EMPLOYEE
Employee thieves normally don't fit the stereotypical career criminal profile. They often are in good standing, have worked with a company on average of four to five years and nine out of 10 of them are first-time offenders, according to the January 2011 article, "Opportunity Knocks," by Brian Shappell in Business Credit magazine (available only to NACM members).
Approximately 87 percent of the occupational fraudsters studied in the ACFE's 2012 Report to the Nations had never been charged or convicted of a fraud-related offense, and 84 percent had never been punished or terminated by an employer for fraud-related conduct. Consequently, the most trusted employee — who has easy access to funds and has never stolen anything — may yield to the overwhelming temptation to take company resources when he or she is faced with personal financial stress. Donald R. Cressey's well-known fraud triangle highlights factors such as personal stress (what he called "perceived non-shareable financial need" or pressure) that contribute to the implementation of a fraud scheme. (He said the other two points of the triangle are perceived opportunity and rationalization. See the ACFE's 2013 Fraud Examiners Manual, 4.502 – 4.504.)
The motives for committing a financial fraud include greed, financial pressures or employee disenfranchisement. Disenfranchised employees become resentful after spending years handling mundane details for their employers without recognition, according to "The Downside of Good Times," by Anita Dennis in the November 2000 issue of Journal of Accountancy. They feel forgotten.
Other employees are motivated because they believe they're entitled to more financial compensation. They also rationalize they'll only "temporarily" borrow the money, and they'll return it later. Motive, rationalization and opportunity work in combination to increase the potential for employee fraud in any organization.
In many small businesses, the major reason fraudsters can commit their crimes is because management trusts them so much; they're family members or longtime friends, or they have proven work records and years of service, according to "The Trust Factor," by George A. Cassola in the Managerial Auditing Journal, volume 8, 1993, issue 7. That high trust level enables fraudsters to hide their activities. Even when business owners find suspicious behavior, they often believe it's inconceivable that employees would violate these trusted relationships. So, consequently, they hesitate to investigate, which results in much larger frauds.
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