Is your Business exposed to FRAUD?
The Association of Certified Fraud Examiners (ACFE), the world’s largest anti-fraud organization, indicated in its 2018 Report to the Nations, that Small businesses (those with less than 100 employees) lose twice as much to fraud as large businesses. ACFE also reported that most small business frauds are perpetrated from within by trusted employees (Occupational Fraud).
What makes small businesses so vulnerable to fraud and how does this actually take place? The following is an account of one business owner’s unfortunate experience.
The case of Fred Flintstone & Son, Inc:
Fred Flintstone (name and some particulars changed) is the owner of a very successful business. Fred built this business from scratch and spends long days meeting customers, bidding on contracts and directing his work crew, while his son Barney manages the office, pays the bills and keeps the books.
One day, Fred gets a call from a supplier who complains that he has not been paid for some time. Fred immediately calls Barney for an explanation. Barney apologizes for the oversight and promises to take care of it right away. One week later, another supplier calls Fred with a similar compliant. Fred again calls Barney, but this time he wants more information and asks Barney to meet with him. Barney says that he is “really busy” because one of the office staff resigned suddenly and he has to do extra work to meet payroll deadlines. Although he promises to meet with Fred, Barney keeps putting it off. Fred becomes concerned that something is wrong and calls a friend, who calls me.
Barney Flintstone’s secret:
Barney Flintstone is a nice guy; he is well liked in the community and is a regular volunteer at charity events. The problem is that Barney has a secret gambling addiction and has been spending and losing his own money as fast as he was earning it. Eventually he finds that he is not able to pay his personal bills, his rent is overdue, his credit cards are maxed out and he has been “borrowing” money from the business to make ends meet. Here are some of the ways in which he did this:
1) He begins paying his personal rent with a company check signed by him. His landlord thinks nothing of it because the check is issued by Fred Flintstone & Son, and after all, Barney is Fred Flintstone’s son. Barney conceals this in the books by charging these payments to the business rent account.
2) He tells one of his “financiers” that the business owes him a performance bonus which he will pay over via a company check to settle his debt. Barney signs the check and conceals the transaction in the books by charging it to the “Materials Purchased” account.
3) Barney makes a series of small checks out to himself which he cashes on a Friday, in time for his weekend gambling activities. He accounts for these checks as “Miscellaneous Expenses.”
By the time the dust settled, Barney had embezzled over $100,000 from the business. This impacted operating cash flow and Barney resorted to staggering payments to suppliers to keep things afloat, which eventually led to the calls to Fred.
The Fraud Triangle:
Barney was more than just a trusted employee, he was and is, Fred’s son. What would cause him to do such a thing? According to the ACFE, most fraudsters get lost in what is known as the “Fraud Triangle.”
The first point of the Fraud Triangle is the pressure of an Unshareable financial need. Barney had a severe gambling addiction and went to great lengths to conceal this from his family. This is a common feature among people who commit occupational fraud. Some fraudsters are driven to steal by gambling habits, substance addictions, the desire to live lavishly, blackmail, or even a legitimate need like having large medical bills to pay.
The second point of the triangle is Opportunity. Because Fred’s business lacked proper financial structure, it presented Barney with the opportunity to perpetrate and conceal the fraud (discussed further below).
The third point is Rationalization. Each of us has a conscience that alerts us when we do something wrong. We however also have the ability to silence or ignore our conscience by offering it some form of rationalization. Some fraudsters convince themselves that they are not really stealing, they are merely leveling the playing field. Maybe they were passed up for a promotion, or think they are doing all the work while the boss reaps all the benefits, and rationalize fraud as a means of getting their due. In this case, Barney’s rationalization was that he was simply “borrowing” from the business and would pay it all back as soon as he won big.
Limiting opportunities for fraud:
Fred trusted Barney completely, however the issue here is not trust, it is governance. It is your responsibility as owner, to manage your business properly and ensure that you limit its exposure to fraud. You do this by implementing the highest level of internal controls and fraud prevention procedures that can be applied under the circumstances. Here are two simple measures that would have limited Fred’s exposure to fraud, even by a trusted person:
1) Segregate fraud-sensitive processes to the fullest extent possible. Having one person initiate and approve payments, sign checks, handle banking, manage accounts receivable and payable, do the accounting, and reconcile the bank accounts, is placing control over a critical area of potential fraud (the cash cycle) into too few hands. One simple control that Fred could have implemented, was to ensure that all company checks are signed by two people, of which he is one. If this was done, Fred would have seen and questioned the payment to Barney's landlord and the unusual payment of the “bonus” to Barney’s financier.
2) Impose supervisory oversight on key performance functions. Fred’s focus as owner, was almost exclusively on business development and operations. He should have paid more attention to actually managing the business and insist that Barney meet with him regularly to review financial statements, cashflow projections, revenue growth, expense control and so on. Performing these management oversight functions would ensure that the owner is aware of the major issues affecting the business and at the same time, impose a culture of accountability on those performing fraud exposed functions. If as owner, you lack the expertise to do this yourself, then find competent help, especially if your business is expanding or becoming more complex.
You work hard and make sacrifices to achieve success and it is very upsetting to find that someone whom you trusted, has been stealing even small amounts of money from you. However, you would have to assume much of the responsibility for this, if you left the door open for a motivated fraudster to walk in and rip you off.
I hope that this note causes you to evaluate your business’ exposure to fraud and take appropriate precautions.
Robert Fullerton, CFE, CPA, MBA.