WHAT YOU DON

WHAT YOU DON’T KNOW

CAN DESTROY YOU

Moran Media Group

Produced under the direction of the

SBA’s Office of Marketing and Customer Service

By-Anthony Box

Corporate fraud is nothing new, but in recent years, the increased attention to corporate fraud has forced many large companies to implement fraud prevention programs. However, fraud prevention continues to be woefully neglected by many small businesses who view fraud prevention efforts as too costly and time-consuming. While some programs may be costly, other can be done simply by assessing your fraud risks and implementing the appropriate safeguards. Small business owners should learn as much as they can about preventing fraud in their organization and take the necessary steps to protect themselves.

Law enforcement agencies are frequently contacted by small businesses after they become victims of various fraud schemes. The losses from these schemes can cripple or destroy a thriving business. Fortunately, there are ways to protect company assets before being victimized. The following are a few ways in which small business owners can minimize their fraud risk.

Promote ethical and honest behavior

Small business owners need only read about the latest corporate scandals to realize how important it is to create a culture of ethics with solid leadership at the senior level. Company management should establish the roles of owners, managers, and all other employees in promoting ethical and honest behavior. At a minimum, employees should be made aware that the company values and expects ethical and honest behavior in all business dealings. The message should be frequently communicated through formal and informal messages.

Fraud will almost certainly have financial costs; however, there may be other serious consequences. In addition to the financial costs, fraud can damage a company’s reputation and destroy employee morale, especially if they have a history of fraud occurrences. A culture of honesty and integrity will be welcomed by ethical employees and will discourage dishonesty in the workplace.

Protect assets by having strong internal controls

In addition to promoting strong ethical policies, small businesses should consider strengthening their internal controls. Having effective internal controls is the best way to protect company assets from fraud. The type of internal controls will vary depending on the size and type of business, but every business regardless of size should:

Examine the operations of the business and look for ways in which it may be vulnerable to being victimized by fraud.
Assess the likelihood of each of the events and focus on the ones that pose the greatest risks or hold the potential to cause the greatest harm to the business.
Implement improvements or new controls based upon the risk assessment.
Regularly review internal controls and implement improvements as business changes.

On of the most important elements of an effective internal control system is separation of duties, designed to ensure checks, balances, and accountability in the financial process. When possible, it is best to separate the operational and financial responsibilities of those actively involved in the business process to minimize the risk of fraud or mistakes. Effective separation of duties can deter fraudulent activity because it will require employees to work together to commit the fraud.

Complete separation of duties s not always possible in small businesses that may only have only one or two employees to manage the company’s financial affairs. However, some controls can be established even in very small businesses. Here are some of the specific controls small business owners should consider implementing:

Require receipts and disbursement records for all funds received and disbursed.
Require that all checks over a certain amount have a second signature.
Ensure that the cosigner fully understands that checks are to be signed only after they are completely filled out and the cosigner knows the purpose and legitimacy of the check.
Ensure that the bank account balances are reconciled with bank statements.
Require backup documentation for check transactions.
Examine cancelled checks for consistency of payee and endorsements and comparing the amount and payee on each check with the information recorded on check stubs and in the disbursement journal.
Ensure supporting documentation for all invoices is maintained.

The following is a case study demonstrating the importance of internal controls.

Joe is the office manager at Mike’s camera shop. In addition to being the office manager, he also handles the accounting. Joe has carried out these dual responsibilities for years and has always done a good job for Mike. Yet in the last six months, Joe has been experiencing financial difficulties. Meanwhile, Mike has been spending an increasing amount of time away from the business, touring the country on his new motorcycle.

While Mike is away, Joe sees an opportunity to get some extra money from Mike’s company. Joe sets up a fictitious vendor in the system. JC’s Supply Company. JC are Joe’s initials; he has named the company JC’s because it is likely that he will be able to cash checks made out to JC’s without creating a new company or operating a new bank account. Joe knows that many legitimate invoices are received and paid by Mike’s, and a few small invoices to JC’s would not stand out among the many larger invoices.

Joe submitted the false invoices to the company and paid himself with a company check payable to JC’s. He then placed the check in his personal bank account at the local bank. Joe was so successful with his initial false billing scheme that he continued it for three years and eventually stole more than $250,000 from Mike’s.

In this case, having the appropriate separation of duties would have made Joe’s theft very difficult and would have probably saved Mike a lot of money, time and inconvenience.

Some recommended separation of duties for Mike’s include:

Regularly reviewing vendor lists for new additions.
Requiring official documentation from all new vendors such as providing the company’s articles of incorporation.
Have a process for reviewing vendor list for names similar to other known vendors, vendors with names similar to employees, and vendors with initials the same as employees.
Require all vendors to provide the company with their business identification numbers, physical addresses, and telephone numbers.
Review vendor lists for addresses and telephone numbers which match employee data.
Ensure that the person who enters the vendor information does not have additional disbursement duties.
Require a different person to approve payment of the invoice only after confirming that the goods or services have been received.

3. Know your employees

Many small businesses operate off a system of trust. Trusted employees are often responsible for conducting the most important aspects of the business. Many small businesses cannot maintain a complete separation of duties, but they can minimize their fraud risk by using their close contact with employees to observe unusual activities and attitudes.

Be alert to changes in lifestyle where employees appear to be living well above their means in a lifestyle that cannot easily be explained. Such lifestyles could indicate that company assets have been or are being stolen. Employers should be attentive to indications of financial distress, excessive gambling, and the use of drugs or alcohol. These types of behaviors increase their employees’ need for money and may motivate them to steal from the business to satisfy their needs.

Pay attention to changes in employees’ attitudes, such as unexplained defensiveness, paranoia, or anxiety. These attitude shifts may indicate that the employee is hiding something about their activities at work and may provide early warning signs of a trouble employee.

Be attentive to behavior indicating displeasure or dissatisfaction with the company or its treatment of employees. Employees are more likely to steal and commit other unethical or illegal acts when they are dissatisfied with their employer or with management. Owners and managers should pay attention to and investigate any of these behaviors or activities. Because of the nature of small businesses, they are particularly vulnerable to the activities of a few trusted employees. A breach of trust and theft by a trusted employee may mean the end of a friendship or possibly the end of your business. Your attention to these matters will show concern for the company and contribute to a positive work environment where employees feel that management is concerned about their feelings.

In addition to observing their activities and attitudes, small business owners must protect their companies by carefully screening possible employees. Companies should not rely on checking resumes as a way to thoroughly screen potential employees. According to a poll conducted by ResumeDoctor.com, recruiters and hiring managers stated the most common misleading information being put on resumes is: inflated titles; inaccurate dates to cover up job hopping or gaps of employment; unfinished degrees, inflated education, or mail-order degrees; inflated salaries; inflated accomplishments; and false information about specific roles and duties.

Background checks for new employees are an excellent way to cut down on hiring dishonest employees. At a minimum, they shod be obtained for key positions and for those involved in the financial process. Background checks should include:

FBI Fingerprint check.
Criminal history from all appropriate county and federal districts where the applicant has recently lived.
Driver’s license check for revocations, suspensions, and other serious violations.
Education verification for degrees attained from the institutions listed on the employment application.

The information from the background check should be used along with the resume and all additional information from the job application to evaluate and make a hiring decision. During the interview, the applicant should be asked questions about their application to check their honesty and integrity.

4. Investigate complaints and suspicious activities

The following is a case study illustrating the importance of investigating complaints.

A business owner receives a call from a person who claims to have important information about embezzlement at the business. The caller informs the owner that the company’s bookkeeper has been forging and cashing checks stolen from the company. The owner does not believe the allegations because the bookkeeper has worked for the company for several years and there has not been a noticeable change in her lifestyle. The owner believes the bookkeeper is honest and loyal to the company, and that is why she has not taken a vacation or a day off in years.

Several months later the owner found out the allegations were true. The bookkeeper stole checks directly from the company checkbook and entered them as VOID in the check register. She also changed the bank statement address and had the statements diverted to her personal P. O. Box. A change in lifestyle was not noticed because the bookkeeper had a gambling problem and the money was being spent to support her gambling habit.

She had not taken a day off in years because she was afraid that her scheme would be discovered by her replacement if she was not there to hide it. Small business owners should require employees involved in the business process to take days off and to take annual vacations. Many small businesses have been victimized by employees who were once good and loyal workers but were tempted and believed they could get away with the crime. The policy of mandatory days off should apply to all employees, especially long-term employees.

Companies should also immediately investigate complaints from customers that statements or letters of delinquency are in error, particularly those with copies of cancelled checks attached. The complaints could indicate instances of lapping, a scheme where payments by customers are partly or wholly misdirected by an employee and future payments are used to make up deficits in older receivables before customers are billed for goods they have already paid for. If a business owner hears about or suspects fraud, they should always investigate it.

The latest National Retail Security Survey reports that theft cost U.S. retailers $41.6 billion last year including $19.5 billion or 48 percent from employee theft. Fraud in the workplace continues to be a pressing problem for small businesses and is one of the primary reasons why they fail. Every small business owner should consider the risk of being victimized by fraud, assess their strengths and vulnerabilities, and immediately implement the necessary fraud protection measures to safeguard the business.