Financial Fraud: Believe it Or Not You Have Been Had!

Financial Fraud
Financial Fraud

The effects of fraud can be felt throughout our economy. Tax fraud can lead to higher tax rates and \ or lower amounts of services citizens receive. Business fraud can lead to higher prices for consumers, value destruction for shareholders, lower profits and low quality products and services just to name a few examples.

Fraud can affect small business by funneling cash and assets out of the business and potentially increasing the liabilities (payroll tax fraud). So how can a small business owner spot a potential fraud? A red flag for small business owners is any set of circumstances that are unusual in nature or vary from the “normal” activity of the employee. Business owners should understand what normal activity is for their employees in order to understand what un-normal activity is. Additionally business owners should investigate any red flag to determine the reason for the abnormal circumstance. Too often, business owners get too busy to investigate the red flags or have a over dependency on trust. During the investigation the business owner should understand if the abnormal transaction was a mistake or if the intent was to defraud. As Dennis Dycus, CPA (an expert in fraud) stated “fraud and stupid often exactly the same.”

According to Dennis Dycus, CPA, fraud occurs when three ingredients are added together. The ingredients include a need, rationalization and opportunity. Small business owners can control the environment (opportunity). Small business owners usually have minimal internal controls, relying primarily on trust. The number one reason fraud occurs is blind trust. Trust is good, but as the old saying states “trust, but verify”.

Financial Fraud
Financial Fraud

As noted in the article “What’s Your Fraud IQ?” by Andi NcNeal, CPA, CFE: “Placing a sizable amount of trust in staff members is a part the cost of doing business. Trusting workers with access to information, products, vendors and funds is necessary to run an effective and efficient operation. But some employees, when faced with sufficient pressure, a perceived opportunity, and the ability to rationalize a criminal act, will take advantage of that trust and defraud their employers.” Good and ethical individuals can rationalize a criminal act by saying to themselves it is OK (I work hard, I am underpaid, I will repay the “loan”, etc.)

When trust is the only (or one of few) internal control employers should remember employees will circumvent internal controls because it makes their job easier, but in doing so an opportunity for fraud is available. An employer might not clamp down on not following internal controls since the employee mentioned the new efficiency or that they too busy to make the correction. This leaves a dangerous door open.

Humans are human. Sooner or later the employee will have a need and they will rationalize the reason for the fraud (the first and second ingredients in fraud). Remember that overtime and work on the weekend which they were not paid for? Remember how they are underpaid?
Good and ethical people can rationalize fraud. An employee’s need is usually financially motivated (spouse laid off of work, medical expenses, debt pressures, etc.). The employee then usually rationalizes the fraud by stating to themselves that they will pay back the monies or they deserve it because they are underpaid, etc.

What type of employee red flags should employers be looking for? Some of the red flags an employer should look out for include an employees lifestyle changes, an employees personal debt and credit card problems, behavior changes (drugs, alcohol, gambling, affairs, fear of losing job, etc.), high employee turnover, refusal to take vacation or sick leave, lack of segregation of responsibilities and duties, low or inadequate salary, difficulty in obtaining audit evidence, severe disciplinary actions, lack of respect or appreciation by superiors, and resentment for not being treated fairly. I believe it is fair to assume that employers have employees with at least one of these red flags.

The employer finds a red flag or three, now what? The employer should analyze the flag. Did the transaction evolve out of error or fraud? Is there a history of similar transactions? Does the employer understand the transaction? Does the employee understand the transaction? Are the correct internal controls in place? Is trust enough? If no fraud exists should the employer understand the warning?

How can an employer create an environment hostile towards fraud? Management must set the tone for the organization. In doing so, actions count more than words in a manual (especially if the words and flow charts are not followed) i.e. management must lead by example. Management should follow internal controls, never bypassing them to get the job done quicker. Management should walk, talk and listen to employees. Management should walk the floor and see your employees in action. Are they really following the rules? Management should talk with the employees to find out what is really going on behind their back and find out about employees personal lives. Management should be looking for actions out of the ordinary course of an employee’s job, their employees’ lifestyle, dress code, home life, personality, etc.

Small business has created a ripe environment for fraud. They created an environment which over relies on trust. Combined the over reliance of trust with today’s challenging economic environment where employees are more worried about their personal finances and you have the potential for fraud.

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