Although the publicity with larger corporations often captures the news headlines, the majority of fraud occurs within smaller businesses, usually with less than $5 million in annual revenues. In general, identifying fraud can be very difficult due in part to the fact that the perpetrators usually know and understand the system. In a small business, where fewer people may be wearing more hats, noticing the warning signs of fraud can be that more difficult. However, by cultivating a “perception of detection,” as well as by being familiar with certain warning signs, the incident rate of small business fraud can be greatly reduced.
For fraud to occur, typically three factors, or points of the “Fraud Triangle,” must be present: incentive, opportunity, and rationalization. Incentive refers to why people commit fraud. Typically, personal issues such as a gambling problem, substance abuse problems, financial stress, medical bills, or just living above one’s means often drive reasons for fraud. Opportunity contributes to the likelihood of fraud taking place, and occurs when there is too much trust, weak internal controls, no supervision, and no independent outside audit. Finally, with regard to rationalization, most perpetrators, over time, actually convince themselves that what they are doing is justified based on an injustice that they believe is present: Being overlooked for a promotion, harboring feelings of being underpaid, or feeling that the owner is making too much money are all motivators that can rationalize the crime.
Fraud is best described as the “misappropriation of assets.” Historically, over 80% of all misappropriations of assets (fraud instances) involve cash. Billing schemes are one of the most common methods for diverting cash. In these instances, checks are written to nonexistent vendors, or to a company controlled by the employee perpetrating the fraud. Payroll and T&E expenses are other areas where companies are often the victims of fraud. This could be in the form of fictional employees drawing a paycheck, excessive overtime being paid when not actually worked, overstatement of T&E expenses, unauthorized pay increases, inaccurate payroll deposits, and excessive vacation pay.
Misappropriation of cash receipts is a major issue in cash businesses, but can also be a problem with companies that have outdated systems, no segregation of duties, and a lack of proper supervision. Cash receipts and cash disbursements are the major areas for opportunities involving fraud, making it critical that the policies and procedures are in place to deter individuals from fraudulent activities.
The “perception of detection” is the key to preventing fraud. When individuals believe that the chances are remote that any fraud will be detected, the probability of fraud occurring is greatly increased. The biggest deterrent to potential perpetrators is the cultivation of this “perception of detection,” or a feeling that fraudulent activity will be caught. Some actions that will help to enhance this perception include:
- Let employees know that the owners often require unopened bank statements so that they can analyze the activity and review all expenditures for appropriateness.
- Have the outside CPA conduct a surprise audit at various times during the year. This could involve multiple areas but a good example would be a verification of vendors by validating the vendors’ existence, confirming balances owed, matching source documents, etc.
- Conduct payroll audits to verify changes in compensation levels, employees, overtime calculations, accurate W-2 reporting and proper tax deposits. This is a critical area where frauds often go undetected.
- Prepare a “proof of cash” report for a given period to confirm that all disbursements and receipts were accounted for during the audit period and cash balances were reported accurately for the specified period.
- Have an outside advisory board that discourages the business from operating in a “vacuum” and instead enhances overall credibility with everyone involved in the organization.
These types of activities create the perception that ownership will be actively testing the company’s policies and procedures on a regular basis, and will act as a deterrent to any fraudulent activities.
What makes fraud more prevalent in a smaller business stems from a number of factors. Employees at smaller companies tend to have responsibilities in multiple areas, thereby making it difficult to have proper internal controls in place. Proper controls require the segregation of duties but, due to the limited resources at smaller companies, this is often cost prohibitive. Smaller companies also tend to have reviewed, or compiled, financial statements prepared at year end. CPAs tend to have limited involvement with their smaller clients due to the cost of professional fees and lack of complexity with the financial and tax concerns. As a result, the chance of an independent person getting involved with the internal procedures and controls is unlikely.
As mentioned earlier, identifying fraud can be a major challenge, especially given that those committing the fraud usually have a good understanding of what auditors will look for and take steps to circumvent the efforts. In addition, most internal embezzlements involve someone in the company’s accounting department. For those frauds that are detected, the major sources for detection come from a whistleblower or tip (40%), management review (15%), as a result of an internal audit (14%), and by accident (8%). Discovering that fraud has taken place also takes time – the average period of time that elapses, before a fraud is discovered, is eighteen months.
Patrick Furnari, CPA, MST, CVA is a partner at KAF Financial Group of Braintree and Woburn, Mass. He has over 18 years of experience in turnaround management, mergers and acquisitions, and business tax strategies, with particular strength in the areas of finance, strategic planning, vendor and secured creditor negotiations and deal structure. KAF Financial Group offers accounting and auditing services, business advisory services, financial services, tax compliance and consulting, human resource consulting, business valuation, tactical solutions and employee benefits services.