The High Cost of Employee Fraud
Lack of oversight and accountability makes small businesses particularly susceptible.

By Clara Hemphill

Occupational fraud affects almost every organization-it does not discriminate based on business type, size or location. Small businesses, however, are usually more vulnerable because many have inadequate internal controls.

The Association of Certified Fraud Examiners (ACFE) has been conducting studies and publishing reports about Occupational Fraud and Abuse since 1996. The ACFE defines occupational fraud as: "The use of one's occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization's resources or assets."

All fraud schemes have four key elements in common:

• They are clandestine.
  
• They violate the perpetrator's fiduciary duties to the victim organization.
  
• They are committed for the purpose of direct or indirect financial benefit to the perpetrator.
  
• They cost the employing organization assets, revenue or reserves.

Key Findings of Fraud Report
 The 2006 ACFE Report to the Nation on Occupational Fraud & Abuse used data collected from 1,134 cases. Using this data as a basis, the study made several key findings:

• Participants estimated that 5 percent of annual revenues was lost due to fraud. Applying this 5 percent to the estimated 2006 U.S. Gross Domestic Product would translate to approximately $652 billion in fraud losses.
  
• Fraud is difficult to detect. The median length of fraud schemes was 18 months from the time the fraud began until the time it was detected.
  
• The most common tool for detecting occupational fraud in all cases is a tip from an employee, customer, vendor or an anonymous source. The importance of encouraging tips is evidenced by the cases involving losses of $1 million or more. Tips uncovered 44 percent of the million-dollar frauds in this study, which was more than twice the rate of detection by internal audits and three times the rate of detection by external audits. Tipsters are often best positioned to witness violations, questionable ethical standards or other indicators. After tips, the next most frequent detection of fraud was by accident.
  
• For small businesses, the most common way of detecting occupational fraud was by accident. That is, 36.3 percent of small business cases were discovered by accident versus 25.5 percent for all cases combined. The percentage of fraud detected by tips was 32.2 percent for small businesses and 34.2 percent for all cases.
  
• One reason small businesses suffer such high fraud losses is that they generally do a poor job of proactively detecting fraud. Less than 10 percent of small businesses have internal audit departments, conduct surprise audits or conduct fraud training for their employees and managers.
  
• Small businesses suffer disproportionate fraud losses. Based on number of employees, the median loss for small organizations (fewer than 100 employees) was $190,000. This is higher than the median loss of $150,000 for the largest organizations. The most common frauds in small businesses involve employees fraudulently writing company checks, skimming revenues and processing fraudulent invoices.
  
• The size of the loss caused by occupational fraud is closely related to the position of the perpetrator. Because fraud is a "crime of opportunity," the well-educated, senior executives commit the most costly frauds. These employees tend to have higher ranks, which correspond to control over greater amounts of assets. Frauds committed by owners or executives caused a median loss of $1 million. This is nearly five times more than the median loss caused by managers, and almost 13 times as large as the median loss caused by employees.

Fraud Prevention
Small businesses can take measures to decrease their vulnerability to fraud. First and foremost, every business should segregate its cash-related functions (e.g., receiving and disbursing funds, signing checks and reconciling accounts). A single employee should never be given responsibility for all such functions.

Create budgets and follow up with timely reports comparing actual results to budgets. Investigate significant variances.

Question and look at detail of any income and expenses that are not in line with expectations. Use the budget as a tool to monitor expenses and look for signs of misappropriation of funds.

In addition, small businesses should have the monthly bank statements delivered sealed to the owner, who should scrutinize them for unusual transactions. Businesses also should have a financial professional conduct an annual review of cash accounts and bank statements.

Businesses of every size should establish fraud-reporting mechanisms, such as a hotline for employees. Even if the hotline is underused, the perception of fraud detection serves as an important deterrence. Employees should be educated on the negative impact fraud has on the company and, by extension, them.

Clara Hemphill, CPA, is vice president of finance and administration at the Enterprise Center of Johnson County, a business incubator that provides to early-stage, high-growth companies and entrepreneurs the resources they need to build successful businesses in Johnson County. You can reach her at (913) 438-2282 or .