As businesses grow, trust and delegation can cause the business owner to be less hands-on with their financials. Small businesses don’t always have the people and resources to put the proper checks and balances in place. As a result, small businesses are more susceptible to employee fraud. It’s important to understand how employee fraud happens and the red flags to watch for.
How Does Employee Fraud Happen?
Most employee frauds are committed by first-time offenders. The Fraud Triangle explains why a seemingly normal, good person, commits fraud. This model was created by sociologist and criminologist Donald Cressey to explain the cause of employee fraud. The three elements of the fraud triangle are pressure, opportunity, and rationalization. Cressey wrote that none of these elements alone would be enough to result in embezzlement, but when all three are present, a fraud is likely to occur.
- Pressure – an un-shareable financial need, such as gambling, drug addiction, or expensive medical bills
- Rationalization – the justification for the fraud, such as, “I’ll pay it back,” “No one will notice,” or “They owe me.”
- Opportunity – the means of committing the fraud
How Can You Prevent Employee Fraud?
Opportunity is the only element of the fraud triangle that you, the small business owner, can control. Here are three steps to identify and eliminate the opportunities for fraud in your business.
- Evaluate your current internal controls. Think through your procedures for cash receipts, cash disbursements, and payroll. What checks and balances do you have in place?
- Identify areas where there’s an opportunity for something to go wrong. No one employee should ever have control of all three primary accounting functions of authorization, record keeping, and custody of assets
- Implement necessary changes to prevent, or at least quickly detect issues.
- Reconcile accounts monthly.
- Pay attention and review detailed reports.
- Ask questions and investigate discrepancies.
- Implement cash monitoring systems. Obtain supporting documents for transactions.
- Require employees to take time off.
What are the Red Flags to Watch For?
You can’t control the pressure or rationalization elements of the fraud triangle, but there are red flags to watch for. The Association of Certified Fraud Examiners’ (ACFE) 2018 Report to the Nations provides a list of the most common behavioral red flags. The report also notes that in 85% of cases, fraudsters displayed at least one behavioral red flag. These six red flags below have been the most common in every one of ACFE’s studies dating back to 2008.
- Living beyond means
- Financial difficulties
- Unusually close association with vendor/customer
- Control issues, unwillingness to share duties
- Divorce/family problems
- “Wheeler-dealer” attitude
Improving controls is possible, even with a two-person office. It does require the business owner to take on certain financial duties or use outsourced accounting, though. At Forge, we work with small business owners to recommend improved internal controls, provide outsourced accounting, or to investigate known or suspected fraud. Please contact us if you have questions about evaluating your internal controls, or if you’d like to discuss your situation in more detail.