By Brad Kanter
Business is booming. Customers and staff seem happy. The company has negotiated good pricing from vendors and is pricing services accordingly. There is even proper adjustment for inflation.
But for some reason, profits are falling and cashflow is reduced – or worse.
How could this happen? Something is not right.
So, what are the next steps?
A deep dive into the accounting system and a review of the books sometimes are not as easy as it sounds. Bookkeepers are there for a purpose, and insecurity can arise when you realize you may not know your way around financial information as well as you should.
Remember, things are going rather well in the plant, and nobody knows this business better. But regardless of success, it is time to be more attentive to financial operational results.
During a mini review, it becomes apparent that something does not look right.
For example: “How on earth are we spending so much money on shop supplies?”
Further down the spreadsheet, office supplies expenses are through the roof relative to prior year. How could this be?
The accountant sends a detailed report of each category. The further it goes, the tighter that stomach knot gets.
“Why are we buying double the amount of all these items? And why did no one discuss this with me?”
After reviewing hundreds of transactions spanning the last two years, more than $150,000 of unauthorized purchases are found. What are the next steps?
- Is every staff member a suspect?
- Can the accountant take care of this?
- Who can I trust enough to discuss this with?
Few business owners and not all outside accountants are trained in fraud examination. So what is the answer?
Unfortunately, this scenario is all too common. In fact, according to the Association of Certified Fraud Examiners (ACFE), private companies and small businesses rank 42% higher in occupational fraud compared to large corporations. That means 1 in every 2.5 businesses are experiencing fraud now.
According to the ACFE report, private companies and small business experience a median loss of $164,000 due to fraud.
It is shocking to realize fraud is occurring at a company. It is important to know what steps to take.
WHAT IS FRAUD?
Fraud is any activity that relies on deception in order to achieve a gain. Fraud becomes a crime when it is a “knowing misrepresentation of the truth or concealment of a material fact to induce another to act to his or her detriment,” according to Black’s Law Dictionary.
In other words, if someone lies in order to deprive a person or organization of their money or property, it is fraud.
WHY DO PEOPLE COMMIT FRAUD?
The most widely accepted explanation for why some people commit fraud is known as the Fraud Triangle, which was developed by Dr. Donald Cressey, a criminologist whose research on embezzlers produced the term “trust violators.”
The three sides of the Fraud Triangle include:
- Financial pressure (motivation). Someone feels the need to commit fraud, such as the need for money.
- Opportunity. The situation that allows the fraud to occur.
- Rationalization. Justification for the deceptive act by the one committing the fraud.
Based on the story above, here is an example of the fraud triangle.
- Motivation. The employee needs money. He was expecting his first child and felt financial pressure.
- Opportunity. Nobody ever looks at the office or shop supply purchases. He is the only person who makes the orders. Since many of the shop supplies and small tools are easy to sell online, he over-ordered once, and it went unnoticed. Then he did it repeatedly escalating his purchase volume over time.
- Rationalization. The employee felt underappreciated and began to resent the owner. This resentment created a self-serving feeling that he deserved the money. Other rationalizations are the employee believes he will pay it back and it is merely a loan or the owner makes more than enough money.
The study showed that the largest contributing factor to fraud being committed is the lack of internal controls. Ironically, these controls are easy to implement and minimize the opportunity for fraud.
AN OUNCE OF PROTECTION
Business owners are responsible for every aspect of the business. From the start, they personally perform many of the tasks themselves.
As businesses grow, they more often rely on others to manage the larger operation. Owners promote people they like and trust to manage many of the business functions, often times with little oversight or direct management, in order to move forward with growing the business.
Sound familiar?
The primary method of preventing fraud is implementing proper internal controls.
Internal controls are the mechanisms, rules and procedures implemented by a company to ensure the integrity of financial and accounting information, promote accountability and prevent fraud. Here are common controls that can go in place right away:
- Segregation Of Duties. Segregation of duties is a critical internal control designed to reduce the incidence of mistakes or fraud by assuring that no single employee has the potential to both perpetrate and hide errors or fraud in the course of activities. Assigning one person to write checks and another staff member to authorize the payments is an example of segregation of duties.
- Pre-Employment Screening. Pre-employment screening is a procedure where employers check candidates’ backgrounds, screen them for drugs, check references and assess their conduct. It is used in the recruiting process to screen out undesirable candidates before investing in the onboarding process.
- Reconciliations and Financial Reporting. Reconciliations are performed to verify financial reporting among various sources. For example, comparing – or reconciling – a bank statement to a company’s internal records is one form of reconciliation. Financial reporting documents the company’s revenues, spending, cash flow and financial health. It allows executives and investors to make informed judgments on performance and opportunities for improvement. Unusual or unexpected figures in financial reporting and financial statements help detect inadvertent errors and inappropriate actions.
- Physical Inventory Counts. Physical inventory counts are performed periodically to assure actual inventories match what is recorded in business systems and financial statements. Physical inventory values directly affect the balance sheet, so it’s imperative they are reflected accurately. Inventory discrepancy investigations can reveal system issues, inadvertent errors and theft. Business owners ultimately are responsible for creating the control environment in a business.
- Control Environment. A control environment is the set of standards, processes and structures that provide the basis for carrying out internal control across the organization. A business owner and senior management establish the tone at the top regarding the importance of internal control including expected standards of conduct.
HEARD OF ENRON?
In 2001, Houston-based Enron went from trading at $80 per share to $1 per share following a series of fraud abuses that resulted in executives being arrested and jailed.]
The unethical tone set from the top literally brought down the largest company in America at the time.
Owners and executives set the tone for themselves, employees and customers. Intentions may not start out as illegal or even nefarious, but when motivation, opportunity and rationalization mix, temptation typically follows.
There are a number of steps owners should take to insulate themselves and their business. Fraud prevention is a necessary state of mind and to be effective must be a regular part of a company’s routine.
The byproduct of doing things the right way goes further than preventing fraud. It improves operations and security deriving, allowing for peace of mind. And who does not want more of that? PI
Brad Kanter, CPA/CGMA/CFF, CFE, CVA/MAFF, EA, M.AC, is the president of Kanter Consulting Group CPAs and Advisors and Kanter Financial. He has worked with hundreds of businesses, minimizing their risk of fraud and increasing profitability for more than 20 years.
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