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November 2005 — Vol. 83, No. 9

SMALL BUSINESS

Don’t fall victim to employee fraud

Study shows fraud hits small businesses hardest

By Chris Amorosino

Freelance writer in Unionville

One midsize manufacturing firm lost tens of thousands of dollars through fraud when an unsupervised accounting manager couldn’t resist her desire for expensive jewelry and her love of gambling. The company’s frequently absent owner had delegated virtually all financial responsibilities to the accounting manager and was so tough on employees that many of them hated working there.

Certified fraud examiner and C.P.A. David Reynolds tells this true story to illustrate some of the common characteristics of an employee fraud case. Reynolds heads up the financial investigation services group at Konowitz, Kahn & Co. in North Haven.

He and two of his associates, Matt Strilbyckij, C.P.A., and David Grindle, C.P.A., C.F.E., agree with a finding of a study by the Association of Certified Fraud Examiners (ACFE): The typical U.S. organization loses an estimated 6% of its annual revenue to fraud.

The ACFE study, “The Report to the Nation on Occupational Fraud and Abuse,” found that small businesses suffer disproportionately large losses from occupational fraud and abuse. A lack of internal controls, too much responsibility in one person’s hands, and a poor work environment — all factors in the fraud case at the manufacturer described above — are some of the major reasons.

“Many small firms have only one person who does the accounting functions. ... If someone wants to do some funny business, they have a great opportunity,” says Grindle. Even small businesses with an accounting staff can be vulnerable if one staff member has overriding financial duties and receives all the financial information.

The surprising offenders

ACFE research shows that fraud usually is not committed by career criminals or repeat offenders. The study says longtime employees who are high on the company’s organizational chart typically commit more fraud. Such employees have greater access to company funds and information, and tend to be more trusted or above suspicion than those lower in the ranks.

“The more autonomy and authority someone has, the greater the risk of fraud,” says Strilbyckij.

Preventing fraud

ACFE and the experts at Konowitz, Kahn strongly advise focusing on preventing fraud rather than just detecting it. By the time most fraud is detected, it’s likely to have gone on for at least 18 months, according to ACFE, and trying to recover stolen assets or property is expensive and time consuming. What’s more, the recovery of losses is low, about 20%.

Creating a culture of high ethics and honesty helps prevent fraud, according to Konowitz, Kahn’s fraud examiners. Employees, they say, will generally emulate their leaders and abide by company culture. Having a written code of conduct makes company ethical standards tangible. The code should tell employees what they may and may not do, and reinforce compliance with laws, rules and regulations.

It’s also important to establish a good working environment, says ACFE. If employees think management cares about them, sets reasonable financial targets and is forthright, they are more likely to avoid fraud.

Grindle says a strong system of internal controls can also reduce the likelihood of fraud. In a strong system, all financial transactions are authorized, recorded and reported. The small-business owner or senior management takes a proactive role in the company’s financial record keeping. For example, some owners receive company bank statements at home, review canceled checks for mysterious payees, routinely question unusual checks, and review support documentation before authorizing disbursements.

Another strong fraud deterrent is to have a fraud hotline that provides a confidential and anonymous way for employees to report suspicious behavior. Martin Biegelman, a certified fraud examiner and director of the Financial Integrity Unit at Microsoft, says hotlines can cut fraud losses by as much as 50%.

When you suspect fraud

When a small-business owner suspects employee fraud, Reynolds and Grindle advise contacting an attorney. The company should not fire the employee immediately. Management may want to interview that employee to find out as much as possible about the extent of the fraud and confirm whether anyone else is involved. Also, the business needs to avoid abusing employee privacy rights.

“When small-business owners read about the Enrons and WorldComs, they may think, ‘I’m just a small guy — this stuff doesn’t happen to me.’ That’s not true,” says Grindle. “As a matter of fact, fraud can be more detrimental to a small business, because a $100,000 loss can shut its doors.”

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