How many times have you said something like this: “If I had a nickel for every time you . . .”? Well, if you were only out a nickel for every time one of your employees stole from you, it would probably not break you. Unfortunately, the cruel reality is that each time someone steals from your business, it will cost you much more than that.
In the “2002 Report to the Nation on Occupational Fraud and Abuse”, the Association of Certified Fraud Examiners (ACFE) estimates that fraud costs American companies $600 billion per year or $4,500 per employee each year. If you do the math, this equates to approximately 6 percent of the gross national product. That is a lot of nickels. Even though most businesses take precautions to prevent occupational fraud, many have no idea how much they might really be losing to their employees.
The ACFE report defines occupational fraud as “the use of one’s occupation for personal enrichment through the deliberate misuse of the employing organization’s resources or assets.” This definition includes employees and executives from all levels within the organization and everything from complex corruption schemes to the theft of Post-it Notes from the supply closet.
The Hidden Expense – Case Study
Let’s assume you are an owner of the small business in Figure 1. Based on these financial statements you are making $160,000 or 8 percent of sales… not a bad year. Now, answer this question: Would you be fine with knowing that $120,000 might be walking out the door every year with your employees? Of course you wouldn’t.
But think about it, when is the last time you saw a line item on your financial statements that said “Employee Fraud”? If that were the case you would most certainly march into your controller’s office and demand that he reduce this line item in next year’s budget!
The problem, as most people know, is that fraud is a hidden expense and is not easily identified. For now, let’s assume that you could easily identify the cost of employee fraud for your company. As you can see in Figure 2, after separately classifying Employee Fraud, all three expense categories have gone down. Where is all this employee fraud coming from?
- For cost of sales, it might be that your director of purchasing has worked out a deal with a major supplier to buy their product at an inflated price in return for a kickback.
- For selling expenses, it might be the result of Slick Williams, your top salesman, submitting false travel & entertainment expenditures on his monthly expense report.
- For general and administrative expenses, your office manager might be writing a weekly check to a “ghost employee” who just happens to reside at a post office box.
If you could isolate and remove all instances of fraud in your company, your net income would be $280,000 instead of $160,000. Short of doing that, the only way to make up the amount lost to fraud is to create an additional $640,000 in sales ($160,000 divided by 25 percent gross profit percentage). That shouldn’t be too difficult for Slick.
Separating the Facts from Fiction
Based on information provided in the “2002 Report to the Nation on Occupational Fraud”, several myths can be put to rest.
MYTH – Pre-employment screenings will protect you from fraudsters. The fact of the matter is that only about 7 percent of fraud perpetrators had previously been convicted of a crime. However, most people will agree that pre-employment screenings are still a good idea.
MYTH – Most fraud is a result of a complex web of collusion. In reality, only 33 percent of the instances of fraud include more than one individual. This highlights the need for better segregation of duties.
MYTH – Smaller companies are less prone to fraud than large public companies. Actually, companies with less than 100 employees suffered larger median losses than did the largest organizations.
MYTH – The younger generations are more likely to commit fraud. However, based on the ACFE report, employees over the age of 60 caused losses that were 27 times greater than the youngest generation in the report.
Preventing and Detecting Occupational Fraud
So what are some practical things you can do to prevent fraud within your organization? Essentially there are three factors that are generally present when fraud occurs: motive, opportunity, and the ability to rationalize one’s actions. It may be nearly impossible to know or change an employee’s motives, but you can certainly take measures to mitigate opportunities where fraud could occur. You can even do certain things within your organization which might reduce the chance that employees could rationalize stealing from your company. Here are just a few ideas.
- Create a corporate culture that communicates clearly that stealing or improperly using company assets will not be tolerated and could be grounds for prosecution. Some employees really think that it is OK to steal from the company because it’s just a “write-off” for the company. A clear communication of the company’s policy makes it more difficult for a potential perpetrator to be able to rationalize committing fraud. Moreover, for public companies, the American Institute of Certified Public Accountants has recommended that all companies adopt and disclose a code of ethics for all corporate directors and employees, implement a system to monitor compliance, and disclose any instances of non-compliance.
- Maintain adequate segregation of duties between all departments. For example, make sure that the person who opens the mail is not the person who applies payments to accounts receivable. This is one of the most effective ways to reduce the opportunities available where fraud could occur. If your company is too small to establish an adequate segregation, consider outsourcing portions of your accounting function. Consider additional controls if your company deals with significant cash transactions.
- Utilize an effective budgeting process. It is easier to identify where fraud is occurring if you can compare results with a baseline expectation of where expenses should be.
- Implement an internal or third-party fraud hotline. One company actually gives a $500 bonus to employees who report an employee theft, no matter how small the theft is. According to the ACFE this is the single most effective means of detecting fraud.
- Create an internal audit department or hire an independent CPA firm to perform an external audit or regular fraud detection procedures. The ACFE reports that companies that have internal or external audits experience median losses of 35 percent less than those companies who have no audit function.
- Be wary of those employees who insist on doing everything themselves, work long and unusual hours, or never take vacation. The reason they are always at work may be due to the fact they are afraid someone might discover their fraud.
- Watch for people who might be spending beyond their means or are experiencing financial problems. These are the people who can often rationalize their need to steal from the company.
Use of Data Extraction Tools to Detect Fraud
Detecting fraud is generally very difficult since those who have committed the fraud will generally go to great lengths to cover their tracks. However, there are several simple things that you can do by mining and analyzing data that already exists in your internal systems that can help identify instances of fraud. Here are just a few examples as provided by Audimation Services, Inc., the distributor for IDEA (Interactive Data Extraction and Analysis) software.
- Identify vendor price increases greater than acceptable percentages or instances where the company is paying vendors above market rates.
- Compare employee home addresses, telephone numbers, and bank routing and account numbers to those in the vendor master file or identify invoices to suppliers not in the approved vendor master file.
- Identify invoices without valid purchase orders or identify duplicate invoices or purchase orders (valid invoices or purchase orders that have been “recycled”).
- Analyze invoices and expense reports falling just under the corporate authorization levels.
- Match information in the payroll master file with the organization’s personnel file to determine if there are any “ghost employees” on the payroll. Or, test the database to see if there are any duplicate bank accounts to which direct deposits are made.
In Conclusion
While you can’t be skeptical of every employee, a certain amount of systems review could save you a significant amount of money as well as provide you with an additional competitive advantage over firms who have not taken measures to mitigate occupational fraud. Good internal controls along with a culture of “checks and balances” are among the best deterrents against fraud. It’s important to note that if you do come across an instance of fraud within your organization, take the appropriate measures to ensure that the evidence could be used in a court of law. Remember, every fraudulent nickel saved is real money added to the bottom line.
