by Glenn Carniello
December 15, 2011

We have heard much about fraud relating to business in recent years. In the early 2000s, the news was filled with scandals involving various types of fraud. The mere mention of Enron or Worldcom is now virtually synonymous with the word "fraud." Although these scandals involved very large, publicly traded companies, fraud occurs most often in smaller businesses.

According to the Association of Certified Fraud Examiners (ACFE), the fraud losses incurred in the smallest companies are 100 times greater than those incurred by the largest companies. According to the ACFE's "2006 Report to the Nation on Occupational Fraud and Abuse," "The median [fraud] loss suffered by organizations with fewer than 100 employees was $190,000 per scheme...higher than the median loss in even the largest organizations. Small businesses continue to suffer disproportionate fraud losses."

I have never seen the frequency of detected fraud and embezzlement as great as it is at this time in the business community. It's tough to know exactly why fraud frequency has increased. It may be due to tougher economic times or specific personal circumstances causing more people to steal. Whatever the case, this abundance of fraud-related activity has only shone a brighter light on the issue.

Let's first understand the definitions of fraud and embezzlement. Fraud can be defined as "a deception made for personal gain," while embezzlement is "the act of dishonestly appropriating goods, usually money, by one to whom they have been entrusted."

Being too trusting is one of the key reasons fraud occurs, and why it is more frequent and severe in the small business environment. In a smaller business office, employees are often entrusted with more responsibility and greater authority because the financial resources do not exist to spread the responsibility and authority by hiring more people. This situation leads to the classic "lack of segregation of duties," which is a critical internal control concept. This scenario is inherent in small businesses, thus making small business owners highly susceptible to fraud and, more specifically, embezzlement as a result.

Also, this trust is often earned over many years. It seems that in many fraud cases, the person committing the fraud has been working for the owners for ten years or longer. In these relationships where trust and authority are given far more than they should be because the comfort is so great with the familiar individual, any and all guards are let down. It is an unfortunate observation that these most trusted individuals are, in many cases, the ones who are stealing frequently and in large amounts over long periods of time.

In my career, I have uncovered fraud and seen its effects both financially and emotionally on the principles of the business. The cost to small business is greater than the hard dollar cost of the monies misappropriated. The distraction to the business, its employees, owners and others involved with the business is costly in terms of lost productivity as well as the cost to replace a once trusted and valued employee. There is also the cost of recruitment and training of a new person and, in many cases, the cost of aggregating information to provide to authorities for prosecution. In many of these instances, the perpetrator is not prosecuted.

Here are some reasons why prosecution is not pursued.

  • Remaining loyalty to the individual due to what used to be a strong relationship
  • Not wanting to hurt the person beyond the loss of their job
  • Embarrassment in being the victim of such a crime

I would suggest that one has a duty to prosecute in certain scenarios. When you are involved in a situation where there are multiple shareholders, you have a fiduciary responsibility to prosecute and file related reports in an attempt to recover corporate assets. In many situations, the embezzlement occurs in a company owned by one individual, and in those cases, the decision comes down to a personal choice, since there is no responsibility to other shareholders. However, the rights of creditors should also be considered if there is any question that the embezzlement could place the company in a position where repayment of debt becomes questionable. Prosecution is a good idea so that the record of the individual committing the crime becomes public record. This public record will be discoverable by future employers performing background checks.

 

Some Ways Fraud Is Committed

 

There are many ways fraud can be committed. Embezzling cash is most common. However, misappropriating goods or engaging in kickback schemes also occur with regularity. Let's begin with a few methods used to steal cash from the company.

If you search Google for "signature stamp for checks," you will find approximately 276,000 links. Many of those links are attempts to sell signature stamps for convenience, while other links discuss the fraud associated with the use of signature stamps. I believe using signature stamps is a bad practice because I have seen many accounting personnel use the signature stamp to commit fraud. I had suspected a controller of embezzling cash once before and I strongly recommended the owner of the company get rid of the signature stamp. I also led an effort to determine whether fraud was, in fact, occurring in this instance.

Later that year, we had built such a strong case against the controller, who had been there for over fifteen years, that he ended up confessing. I was thanked for taking away the signature stamp months earlier. As it turned out, despite loyalty to the family who owned the business, this person's personal financial woes (which included a spouse who had been out of work for eighteen months) simply made the temptation to steal too great. This person did not want to steal from the business (and the family). However, they felt as if they had little choice. The controller stole in a number of ways, but most notable was the use of a signature stamp in preparing unauthorized checks.

We have also seen straight forgeries on unauthorized checks. In a more recent case, an accountant was allegedly forging checks to fictitious companies he had established, as well as checks written to his own business. The accounting person had been employed with the company for over fifteen years-another trusted employee.

In another case, a controller, who had worked in that role since the company's inception over ten years ago (and with the management four years prior, for a total relationship of over fourteen years) was the sole authorizing party for electronic fund transfers and payroll disbursements. This person was modifying the company's payroll, including expense reimbursements on his paycheck. Then, to cover the trail, he was doing journal entries to reclassify the amounts out of payroll into indirect job costs-essentially spreading the stolen money over all the jobs in progress. The bank was preparing certain reports that actually highlighted the activity. However, those reports were also sent directly to the controller, who in turn destroyed the reports upon receipt, helping to cover a trail in the short term.

For one large subcontractor client, we discovered that, within six months of hiring a new president, the financial reports noted that materials were costing 51 percent of contract revenues. The concern we raised was that, historically, materials ran approximately 37 percent of contract revenues. During a meeting with the owner, president, controller and one of my partners, we asked the president to explain the increase. Instead, we were provided a quick, meaningless, response and the president proceeded to move on to explaining variances in other areas of our report. Afterwards, I again asked for an explanation for the material increase. After the truth was discovered, within a month of this meeting, the president left the company. The owner chose not to investigate whether a kickback scheme was being perpetrated or any other possible wrongdoing. It was possible that because of the very close relationship with the materials suppliers, the president was authorizing above market value pricing to be charged to the company with some personal financial incentives paid by the suppliers. As the owner didn't wish to pursue the issue, we never were able to discover what may or may not have happened.

I had a client recently share a story about copper being taken from a jobsite by one of his top field personnel who had been with him for over twenty years. This person took excess copper to a recycling business to sell it for scrap value. The owner of the recycling business suspected something wasn't right and asked the employee where he worked. The owner knew the company and made a call to its owner from a back office phone while the senior field person waited at the front desk. The senior field person was fired, and two days later another employee walked into the company president's office and handed him $50. When the president asked what it was for, the employee responded that earlier in the week he had filled up a personal vehicle and later realized he had used the company gas card to do so. A culture of non-tolerance was created by firing the senior field person. If that field person was fired, anyone in the company knew they could be fired for any similar offense. It's hard to say whether that was the first time a company gas card was used for personal benefit, but we can all make guesses on that subject. The important point to note is the response by management and the creation of a culture of zero tolerance.

 

What Can You Do About Fraud?

 

Fraud is rampant, and I'm not sure you can ever put a stop to all the ways that money, goods or services can be stolen. But there are many ways you can mitigate fraud and the chances that it will occur in your business. Here are just a few items to consider:

1.  Consider obtaining a bond on certain employees 

The cost of a bond is cheap insurance should embezzlement or other fraud occur. Also, if you let prospective employees know that you will be bonding them and that the bond company will conduct thorough background checks including criminal offenses, etc., you may find that the candidate chooses another job. With this practice, you may prevent a possible "bad apple" from preying upon your company in the future.

2.  Perform criminal and credit background checks 

Employees to whom you will entrust financial assets should be checked-perhaps even conducting a check on a receptionist who may open the mail and list out the checks. We had one situation where an employee was stealing checks straight from the mail. Be sure to get the appropriate legal permissions to conduct these checks from the prospective employees. Asking for this permission could also have a similar effect as discussed above regarding the prospect choosing a different employer.

3.  Force employees to take vacation time every year 

Do not let employees forego vacations, get paid for unused vacation or carry over unused vacation. Most of the embezzlers work very hard to cover up their trail. If you take them out of that job for a few weeks a year, that trail will most likely surface, and any wrongdoing will be uncovered.

4.  Look for changes in employees' lifestyles, circumstances and/or behaviors 

A change in a spouse's employment situation could be a catalyst. Look for a new luxury car in your company's parking lot that you might suspect could be outside the expected financial ability of your employee. In a few of the cases we're currently aware of, gambling addictions are a common thread. Authorities have traced a few of the controllers to southern California casinos. Many indicators can lead to the identification of fraudulent activity.

5.  Monitor your financial statements and management reports 

As discussed in one case above, we noticed a spike in the cost of materials relative to earned revenue. That fluctuation in a simple metric alerted us to the possibility of a kickback scheme. Monitoring financial reports can provide clues to the possibility of fraud. When cash leaves the building, oftentimes the general ledger will reflect that activity. Paying close attention to your company's financial metrics will allow you to understand what a "normal" range is. If the numbers stray outside the norm, it could potentially be an indicator of fraud.

6.  Prosecute and communicate 

The creation of a zero-tolerance culture is important. In another case discussed above, the owner was able to recover approximately $60,000 almost immediately by letting the individual know that the authorities were going to be brought in. That individual thought that making partial restitution would prevent the prosecution process from occurring, but they were wrong. The situation was communicated to all the employees as it was happening. The owner was careful to only stick to the facts. The underlying message: This activity was not acceptable, would not be tolerated and would be prosecuted to the fullest extent of the law.

7.  Always have an invoice or other support attached to the back of any check you sign 

Oftentimes, due to the large volume of checks owners will sign, they will only handle the checks themselves and sign in short order without taking the time to review supporting documentation to ensure the expenditure is justified. A controller may run into the owner's office with only the check and ask for a signature. The payee may be familiar, such as American Express. But is it your American Express account or someone else's account? You don't know unless you have the backup for the check agreeing to the amount. Take the time to review the backup.

8.  Run a vendor history showing invoice numbers and amounts 

You may find an interesting trend by simply running a vendor history. Would you agree that it would be peculiar if the history showed a sequential order of invoice numbers (e.g., 1001, 1002, 1003, 1004, etc.)? This would indicate you are the only customer of this vendor, which is highly unlikely. This type of invoice number pattern could indicate a fictitious vendor was established by someone in your office.

9.  Conduct seminars about workplace fraud 

Creating awareness in your business about fraud is important. Educating your employees about fraud and letting them know how prevalent it is, what the consequences are and that it is not tolerated is a step toward prevention. Coordinate with your human resources department and labor law attorney to ensure you are communicating the issue appropriately.

10.  Be sure to communicate the need to issue a 1099 to the embezzler 

There is some discussion, based on case law, that the proceeds from embezzlement are to be included in taxable income. This should be communicated to the person who embezzled funds and explained that if they make remuneration in the same year, then those amounts would not need to be included in taxable income. That could be one of the factors motivating an individual to make restitution.

11. Provide instructions to your bank 

In many of the cases I've seen, the embezzler will write checks from the operating account directly to him/herself. Instruct your bank to never honor a check from your operating account written to an individual. It is also a good policy to provide your bank with a list of your approved vendors to whom checks written may be honored. Of course, you'll need to continuously update that list as you add vendors, but your accounts payable clerk will add a new vendor to your accounting system to write the check in the first place. Make communicating vendor updates with your bank part of the same process as setting up the new vendor in your accounting system.

Also, be sure to provide your bank with a list of your employees. Instruct the bank to only honor payroll checks written to names on that list. As with the new vendor procedure listed above, have your human resources manager or controller regularly communicate new employee names to the bank to add to that list and delete employee names who are no longer associated with the company.  Have a copy of the bank statements, or the originals, mailed to your home. Review each statement for appropriate employee and vendor names.

12.  Hand out employee paychecks at least once a year 

Require each employee to provide identification when picking up their paycheck. Paychecks left over will be for employees who are on paid time off (vacation, sick, etc.) or employees who don't exist. These could be checks for fictitious employees established by someone in your office. There are rules and regulations, certainly in the construction industry, regarding where you must hand out the checks. You may have to go to each jobsite to physically hand out the checks. In that case, you may want to rotate which jobsites you or your designee will visit on a monthly or quarterly basis.

13.  Participate in a limited scope fraud program 

Your accounting firm may have a program in place to perform spot checks for unusual activity in certain areas of your business and, therefore, decrease the chances of it happening in the first place. After one of the first times your controller and other accounting personnel note that you are bringing in people to perform procedures specifically designed to help lessen the chances your company will be victimized by fraud, the greater the chance they will not engage in that activity to begin with. There is an old saying, "Employees do not do what we expect, they do what we inspect." If you are inspecting for possible fraudulent activity, the chances of employees engaging in that practice should decrease.

Fraud has been part of our society for thousands of years. It is driven in part by greed and sometimes by fear. Preventing it in absolute terms is most likely a losing proposition. But implementing controls-such as having an outside party come in periodically to perform procedures to help identify unusual activity and being alert to changes in your employees' behavior and circumstances-are ways to help prevent fraud. Do not tolerate fraud if you experience it in your company-prosecute. If these criminals are not prosecuted, the chances of one of them landing in your company and doing the same to you is increased.

Lastly, be aware that the chances of becoming a victim are very real. This type of activity happens every day and everywhere. Position yourself by being proactive and alert so that you lessen the chances it happens to your company.

 

Construction Business Owner, August 2008