Over half of the US workforce is employed by a small business. These small businesses also account for 46 percent of non-farm GDP. Despite their contribution to employment and the economy, little about them is covered in college level accounting and business courses. Most material covers accounting for midsize to large corporations. In this paper, I will highlight how vulnerable small businesses are to fraud due to impracticalities of implementing separation of duties and steps they can take to mitigate fraud.
Small businesses, those with 500 employees or less comprise of 99.7 percent of employer firms and 42 percent of private sector payroll (Bureau of Labor Statistics, 2014). As important as internal controls may be to all businesses, they are less prevalent in small, privately held businesses. Implementing these controls as taught in college level accounting and businesses courses, is impractical in small privately held businesses since there is only one person, the office manager, or bookkeeper, in charge of most financial responsibilities. This individual has both access to and custody of the business assets, providing an opportunity to commit fraud (Hrncir, 2012). More could be done in in the college level accounting curriculum to cover practical relevant material with regard to small businesses especially since these businesses neither have the volume of business, nor the capacity to hire more accounting staff to implement internal accounting controls. Even though these businesses may have a relationship with a CPA, he/she is in most cases just a tax preparer and has no knowledge of the accuracy of the entity’s books and his/her engagement never seeks to uncover fraud.
In this article I will highlight the fraud diamond (Exhibit 1), and how the sheer small size of businesses contributes to lack of internal controls and how that exacerbates fraud. I also introduce an actual case of fraud I uncovered to illustrate how to mitigate fraud and embezzlement in a small enterprise.
THE FRAUD TRIANGLE
According to Cressy (1953), there are three factors that must be present at the same time for an ordinary person to commit fraud as illustrated in Exhibit 1. Understanding the fraud triangle may help a small business owner understand what motivates fraud and the importance of implementing internal controls.
- Pressure: This is an element in which an individual has a financial problem, be it an actual need or desire.
- Opportunity: This is an element in which an individual sees or finds a way that a crime can be committed. This is the area that makes most small businesses very vulnerable. More than 80% cases of fraud are due to perceived opportunity due to weak or lack of internal controls (Kapp, 2011). In this instance the embezzler knows that if caught, he might suffer consequences as much as the underlying problem that led to the fraud. So, not only does he/she need to embezzle the funds, but also do it in such a way that the crime will not be apparent.
- Rationalization: Most embezzlers are not career criminals (Hrncir, 2012) and are usually upstanding employees. To steal they have to find a way to justify their actions e.g. I was only borrowing, my employer is dishonest and so deserves it, I am underpaid and this is what I am due, I have to provide for my family, I am entitled to the money because I have saved this business money by being aggressive in collections, etc.
STUMBLING INTO FRAUDULENT TRANSACTIONS: A PERSONAL EXPERIENCE
The case of two Payroll Checks
I recently received a call from a local company to fill in for Stacy, the sole accountant on staff who had to go on medical leave. My first task on assignment was to reconcile bank statements and establish cash on hand. Bank reconciliations had not been done for four months on the payroll account.
All the banks reconciliations indicated that nine voided checks actually cleared the bank. All nine checks were payable to Stacy. All checks were genuine with either the signature of the owner (President) or his wife (VP). Out of curiosity, I reviewed statements for the past 13 months and I found a pattern. I was stumped!
By circumstance, Stacy called while I was doing the bank reconciliations to check on things and I broached the subject of “a few” uncashed checks, however, I did not mention that I had run the audit report in QuickBooks and established that those checks were voided. She was dismissive and said that her original paychecks were wrong and had manual payroll checks written to her and she was yet to enter them. She asked me to put the bank reconciliations to the side for her to do. A quick check on the payroll records revealed that Stacy had paychecks for the same dates and amounts as the voided ones.
I could have accepted her explanation but there were three glaring anomalies:
- Copies of the cashed but voided checks were in the voided check folder. They were all endorsed by Stacy.
- The checks spanned more than 13 months
- There were other payroll checks for the same pay dates payable to her and they were all salary, not commission or any other payroll item.
- Her salary per payroll records was $62,000 but she had $156,000 in pay the previous year (voided but cashed checks included) and only the $62,000 was on her form W-2.
How did Stacy perpetuate the fraud and keep it going for so long?
For each payroll period, Stacy cashed her paycheck by e-deposit to her bank. She then wrote void on it and wrote a new check with a slightly lower amount and told the owner that she made a mistake and had to deduct hours because she left early the week before. She presented the voided check and the new check to the business owner who was happy to sign it and thank her for her honesty not knowing that she was cashing a second check.
SMALL STEPS TO MITIGATING FRAUD
Even if a business is too small to have more than one accountant or bookkeeper on staff, never underestimate the value of separation of duties. “Many small business owners may think internal controls are an expensive luxury that they cannot afford” (Hrncr, 2012) but a small business owner should consider instituting the following to reduce fraud:
- Outsource routine functions such as bank reconciliations and payroll reconciliations to a local freelance bookkeeper/accountant. A company like BookTemps Inc. (www.booktemps.com) is an excellent resource. They typically cost $200-$500 per month. A CPA or tax preparer will not spot anomalies such as Stacy’s deceit. In fact, the CPA for this company did compilations of financial statements and prepared tax returns covering these periods and never noticed any fraud.
- Have bank statements and credit card statements sent to the business owner’s home address or other mailbox such as PO Box or UPS Store mail box where someone other than the bookkeeper picks up and opens the mail first and reviews the statements. Knowing that someone else might find out is a deterrent enough.
- Enforce vacation time and have a bookkeeper from your CPA firm or a freelance bookkeeper feel in those absences. A company like BookTemps Inc. (www.booktemps.com) is an excellent resource.
- Consider using direct deposit for payroll and review payroll reports for unusual discrepancies in both gross and net payroll amounts.
- Assign Responsibility i.e. divide and conquer (Tysiac, 2015). If possible consider having mail opened by a party other than the bookkeeper/controller. A company like BookTemps Inc. (www.booktemps.com) is an excellent resource. They can come in once a month usually the second week of the month after you receive bank statements. They can open the bank statements and reconcile the accounts.
Association of Certified Fraud Examiners (ACFE). 2010. Report to the Nations on Occupational Fraud and Abuse. Retrieved from http://www.acfe.com/uploadedFiles/ACFE_Website/Content/documents/rttn-2010.pdf
Bureau of Labor Statistics (BLS). Business Employment Dynamics. (2014). Retrieved from http://www.bls.gov/bdm/entrepreneurship/entrepreneurship.htm
Cressey, D. R. 1953. Other People’s Money: The Social Psychology of Embezzlement. New York, NY: Free Press.
Dorminey, J., Fleming, A. S., Kranacher, M., & Riley Jr., R. A. (2012). The Evolution of Fraud Theory. Issues In Accounting Education, 27(2), 555-579. doi:10.2308/iace-50131
Hrncir, T., & Metts, S. (2012). WHY SMALL BUSINESSES FALL VICTIM TO FRAUD: SIZE AND TRUST ISSUES. Business Studies Journal, 4(1), 61-71.
Kapp, L. A., & Heslop, G. (2011). Protecting Small Businesses from Fraud. CPA Journal, 81(10), 62-67.
Tysiac, K. (2012). Small Businesses, Big Risk. Journal Of Accountancy, 214(2), 38-43.
The author, Joel Moman, is a Principal at BookTemps, Inc. He is a Certified Fraud Examiner (CFA).