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Safeguard against internal fruad

  • Douglas Freer, CSP
- Posted: October 1, 2015

Employee fraud is a significant problem, particularly for small and medium-sized businesses.

The employees who most often commit fraud are in roles in which they have access to financial information (bookkeeping, payroll, etc.). Detecting and preventing fraud is critical to reducing this cost to the business. Preventing losses is much easier than trying to recover funds after the fraud is detected; therefore, it’s important for owners to develop and maintain adequate systems to protect their companies from this growing threat. The challenge for small businesses is that they often do not have the resources to set up adequate loss prevention safeguards.

The trusted employee
Most small business owners believe they will spot fraud when it occurs, but statistically this isn’t the case. Fraud is fairly easy to hide, and people are very creative in their schemes. The average fraudster operates for two years before being caught; and, in most cases, the fraud is exposed through a tip from an employee, customer or vendor. 

In many small businesses, the major reason fraudsters can perpetrate their crimes is because they are trusted; they may be family members, longtime friends or employees with a long and distinguished service history. Even if suspicious activity is found, it is difficult to believe that a trusted employee could steal; and, therefore, the activity is often overlooked or dismissed.

Employees who steal do not generally fit the stereotypical criminal profile, so background checks may not identify a potential fraudster. They often are good employees, have worked with the company on average four to five years and 90% are first-time offenders.  

The fraud triangle
The fraud triangle highlights the three preconditions that lead to fraud: 

1. Pressure. The old saying, “Desperate people do desperate things” is true. When the economy falters or is weak, there is a corresponding increase in fraud. Those who are overextended, have an addiction or live beyond their means are exposed to increased financial pressure and may take advantage of opportunities they would never have considered otherwise. 

2. Opportunity. Weak financial or internal controls, poor management oversight, or a failure to establish fraud detection procedures may open the path for a fraudster. Of the three conditions, this is the one that businesses have the most control over. 

3. Rationalization. Most people have the ability to recognize right from wrong, but those that commit fraud rationalize their decision in any number of ways. The employee may feel they are only “borrowing” the money, but as the fraud goes undetected, the “loan” becomes permanent and the fraud increases. A fraudster may believe it’s justified because others are doing it or they’ve become disenfranchised and feel they are owed additional compensation. A “Robin Hood” bookkeeper may justify the theft as noble because they steal to give money to friends in need or charities. 

Types of internal fraud
Fraud falls into three major categories: corruption, fraudulent statements and asset misappropriation, which is the most common fraud perpetrated against small business. Depending on the size, type of company and number of people in certain roles, you may have more or less exposure to certain types of fraud. 

Corruption is using one’s influence to bribe or extort a kickback for making or influencing a purchasing decision to benefit a particular vendor. An employee who either accepts a gratuity or who demands payment or some type of remuneration from the vendor is committing fraud.

Fraudulent statements come from employees who falsify records to hide revenue or expense reporting or payroll schemes. Small businesses are most frequently affected by fraud related to asset misappropriation, which can come in various forms:

  • Check tampering can occur when the fraudster steals checks or forges or alters a check to divert money to their account.
  • Vendor fraud generally includes billing schemes and check tampering, as well as bribery or kickbacks. Billing schemes involve an employee who creates false documents and records in the company’s payment system to divert funds. The fraudster may create a fake company identity, using bogus information and mailing address, and then create invoices for services or materials never delivered. Payments are diverted to the fraudster. In a non-accomplice vendor scheme, the fraudster will manipulate the account of a legitimate vendor, causing a double payment or overpayment to be made. The overpayment can be diverted directly to the fraudster; or when the vendor returns the payment, the check is intercepted and altered for deposit into the fraudster’s account. 
  • Payroll fraud occurs when an employer pays an employee based on false claims for compensation, inflated overtime hours, or adding ghost or fake employees to the payroll.  
  • Skimming occurs when an employee takes cash payment for materials or service and does not record the payment in the company’s records. This is more common in retail transactions.
  • Credit card fraud occurs when an employee either uses their assigned company card for unauthorized personal purchases or steals the company credit card information to make illegal purchases. An employee may also make a seemingly ordinary purchase using the company card, and then return the item later for store credit. 
  • Expense report fraud is when an employee makes false claims about reimbursable expenses, such as meals, travel or materials purchased on a job. 
  • Theft of assets is when an employee steals cash, materials and/or equipment from the company. A salt truck driver may divert and sell a portion of his load to someone willing to pay cash. An employee who is responsible for fueling company equipment and trucks may fill a personal gas can or vehicle, or have a friend or family member meet them at the gas station. An employee may take materials or equipment from the shop or job site, and report them either stolen or missing.
  • Theft of service occurs when an employee performs work on the side either during or after business hours unbeknownst to the company. Employees may approach the customer and offer their services at a discount or the customer may approach them for additional work. Homeowners or businesses that are willing to pay cash for plowing or salting may flag down drivers. Beyond the employee taking the money and possibly using the company equipment to perform the work, the company may also be liable for damages that the employee causes while performing the unauthorized work. A damage or injury claim cost could far outweigh the original petty theft loss. 
  • Fraudulent workers’ compensation claims occur when an employee makes a false injury claim and collects compensation and injury benefits.

It can be very difficult to prevent fraud, particularly where collusion exists. Some forms of theft are less tangible than others and may be harder to detect. The bottom line is that fraud can have a tremendous financial impact on the business, its relationships with employees and vendors, and may expose the company to legal or insurance issues. 

Fraud prevention strategies
While creating and maintaining a workplace that rewards honesty, hard work and ethical practices may help reduce the potential for fraud, it cannot be the only fraud prevention strategy. 

A variety of strategies should be put in place to combat fraud. It’s important to implement systems that are appropriate for your size of business. The majority of snow companies are not likely to have a large office staff that handles all of the accounting and business functions. In fact, most snow companies may have one or two part- or full-time employees or family members involved. The owner should insert himself in a few key areas in order to identify potential patterns of behavior, essentially serving as a continual audit of the business. 

Reality checks
The examples below break down the ideal recommended solution into a practical or manageable application for the small business. 

  • Database management: The person who is responsible for entering new employees or setting up new vendor accounts should not issue checks. 
    Reality check: The business owner may not be able to separate this function, since the bookkeeper is likely to set up a new vendor, employee or customer in the system. The business owner should check the vendor and employee lists periodically, deactivating old names and/or accounts and validating existing accounts.  
  • Payables: The person or department that creates the purchase order should not authorize and issue payment. Require approval for each invoice after receipts and invoices are matched to statements.
    Reality check: An owner may delegate check writing to someone who can match invoices to checks, but the owner should sign all checks after reviewing and approving invoices and/or statements.
  • Receivables: The employee who posts the payment to the customer accounts should not prepare and make the deposit. A cash management policy is necessary to balance daily receipts against cash prior to depositing and recording it on the books.   
    Reality check: A small business owner can open the mail, collect checks and process the deposit in a relatively short time. Photocopy the deposit for an employee to post payments to the customer accounts. The photocopy prevents the employee from handling the checks, and serves as a handy reference of your deposited items. 
  • Bank reconciliation: Bank statements should be reconciled as soon as they arrive, and by someone who is not responsible for writing the checks. Reconciliation should not only include matching check numbers and amounts from the statement to check register, but also verify the payee information is correct to ensure checks have not been tampered with. Periodically skim your bank statement online to check for irregularities. 
    Reality check: The business owner, owner’s spouse or accountant should reconcile the statements. If in a business partnership where one partner authorizes payments, the other should reconcile the accounts. 
  • Incoming mail: If opening the mail is relegated to an employee who has control over other functions, there may be an opportunity to hide or disguise fraud when notices of late or nonpayment or other written statements arrive. 
    Reality check:  The business owner is often too busy to open, sort and process the mail. However, the owner can often quickly surmise what is junk, and what mail needs to go to which person for processing. In most cases the mail is legitimate, but the owner should be able to spot differences between a new vendor sending a legitimate invoice and a red flag that requires investigation.
  • Expense reimbursement: Require employees to submit a stated reason and supporting receipt or invoice over a certain threshold. Set an internal budget so that if a threshold is exceeded for the period of time, then it requires review.
    Reality check:  Require all receipts to be turned in daily for any company purchases. Employees should put their name on any receipts or invoices they turn in with their daily paperwork. Even if every receipt doesn’t receive the same level of scrutiny, asking follow-up questions from time to time conveys an increased level of awareness. 
  • Secure financial instruments: Make sure cash, checks, credit cards and other financial information and instruments are kept in a secure location and conduct periodic, unscheduled inventory checks. Account for all written checks, including voided ones.
  • Secure login information and credentials: Do not store or share sensitive login information or passwords where they are accessible to those who should not have access. 
  • Audits: Employees who handle financial information should take at least one mandatory week of vacation per year when an audit can occur. Beware of the employee that never takes vacation or time off; they may be hiding something. 

Develop safeguards
Establish protocols, develop policies and enforce them. Your business depends on conscientious employees who will follow the established processes. Regularly reviewing and enforcing policies will maintain an environment that is less hospitable to fraud. 

Stories about business partners stealing from the business or one another are practically cliché. And, businesses have been taken advantage of by trusted family members. While trust is essential, it’s important to set up proper prevention and detection safeguards so you can focus on running the business without worrying about employee theft.

Determining actual loss

It is difficult to measure true losses from employee fraud. The statistics from reported incidents shown below do not include crimes that go unreported because of families’
embarrassment or the decision not to file charges. According to the 2012 Report to the Nations by The Association of Certified Fraud Examiners (ACFE):

  • A typical organization loses approximately 5% of its business revenue to employee fraud each year.
  • Median loss for businesses with 100 or fewer employees was $147,000.
  • 32% of small organizations reported being the victim of fraud, the highest rate of any business size category. 
  • 87% of fraudsters studied had never been charged or convicted of a fraud-related offense.
  • 84% had never been punished or terminated by an employer for fraud-related conduct.  

Douglas Freer, CSP, owns Blue Moose Snow Co. in Cleveland. Contact him at (216) 539-3688 or

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