Triangle of Fraud - Take Steps to Protect Your Company

By James E. Merklin, CPA, CFF, CFE, Partner

There are many potential repercussions of a slowing economy to small and closely held businesses — fewer sales, lower revenue and lost customers, to name a few.

Here’s another one that might not have occurred to you: fraud. During sluggish economic times like these, many small businesses experience rising instances of fraud and embezzlement. Losses from internal fraud can literally wipe out a small business that doesn’t have the financial means to recover.

Of course, most owners don’t believe it could ever happen to them. “I only hire honest, trustworthy employees who would never consider stealing from me,” they think. However, the truth is that given the right circumstances, even the most loyal, long-time employees can be tempted to commit fraud.

The fraud triangle Internal fraud is illustrated by a concept known as the fraud triangle, a term that was coined by Professor Donald Cressey when he was studying fraud schemes in the 1950s. Cressey determined that there must be three elements in place for fraud or embezzlement to occur: pressure, rationalization and opportunity. Fraud schemes can’t develop, he concluded, without all three elements present.

Pressures are personal circumstances and factors that convince employees of the need to steal — large medical bills, overwhelming debt, gambling losses or substance abuse, for example. Given enough financial pressure, employees may be able to rationalize fraud to themselves (e.g., “I deserve a raise” or “I’m only borrowing the money”). Unfortunately, you have no control over the pressures your employees are facing or their ability to rationalize stealing.

However, you do control whether employees have opportunities to commit fraud. One of the best ways to limit these opportunities is to implement sound internal controls. These include a proper level of management oversight of business finances and proper segregation of financial duties among employees.

Delegation of financial duties and bookkeeping to trusted employees is a necessity for most businesses, of course. However, some owners and managers delegate complete responsibility for financial management to staff, failing to so much as look at bank statements or even sign checks.

As the owner, you must maintain at least a minimal level of personal financial oversight of your business. This will not only ensure that you are aware of what’s going on in your company financially, but it will also cause most employees to think twice before attempting to steal.

Segregation of duties Ensuring proper segregation of duties is the most important internal control step most companies can take to limit the possibility of loss due to fraud and embezzlement. This simply means that employees (at least two) should handle different financial and accounting tasks in order to limit opportunities for one employee to commit fraud and cover his or her tracks.

A single person is often given responsibility for multiple and conflicting tasks, which may provide ample opportunities for theft and cover-up. The key is to separate the controller and treasurer functions. For example:

  • One person should open the mail and fill out deposit slips while another enters cash receipts in the books.
  • Someone other than your purchaser should make payments to vendors and suppliers.
  • Bank reconciliation should be done by someone who does not have access to daily checkbook transactions.

Internal control steps Here are some more internal control steps you can take to help limit opportunities for employee theft and fraud:

  • Draft a policy on company ethics that explains clearly what is and isn’t acceptable employee behavior and the consequences of non-compliance.
  • Approve all vendors yourself, and make sure all orders are checked to see that they are accurate and of acceptable quality.
  • Sign all checks yourself — don’t let employees use signature stamps — and review the invoice, delivery receipt and purchase order before signing each check.
  • Monitor slowdowns in accounts receivable processing and posting of payments, as these may be indications of “lapping of receivables.” In this scheme, an employee steals a customer’s payment instead of depositing it and covers this up by applying another customer’s payment to the account. Obviously, this process must be repeated frequently over time, and may even necessitate keeping two sets of books. The best prevention: simply make sure different employees are receiving payments and posting transactions.
  • Establish a fraud “hotline” through which employees can anonymously report suspicious activities. Remember that the vast majority of employees are honest and do not want fraud to occur in their workplace. Companies with fraud hotlines have cut their fraud losses nearly in half, reports the Association of Certified Fraud Examiners.
  • Ask your bank about Positive Pay services, which help prevent check fraud by allowing payment only of checks that are authorized. Checks presented to the bank for payment are compared against a check-issued file and only those with an exact match are paid. Others are flagged as suspect and reported to you for a pay or no-pay decision

Minimizing segregation conflicts It’s not uncommon for small businesses to have segregation of duty conflicts and not even realize it. An experienced fraud professional or Certified Fraud Examiner can help determine how vulnerable you may be to fraud and demonstrate safeguards to help protect your business. In addition, your CPA can give practical advice on how to best segregate financial duties to lessen opportunities for fraud and embezzlement.

While it’s impossible to completely eliminate all opportunities for fraud in your business, implementing sound internal controls will go a long way toward discouraging fraud and protecting your hard-earned revenue.

We can help you implement appropriate internal controls to guard against fraud, including segregation of financial duties.

Contact Jim Merklin, partner, at 330.762.9785 or by email to discuss some ways BMF can help you sleep better at night.


Fraud: by the Numbers
According to the Association of Certified Fraud Examiners’ 2006 Report to the Nation:

  • A typical U.S. organization loses 5 percent of its annual revenue to fraud.
  • A disproportionate percentage of fraud reported between 2004 and 2006 was committed against small businesses with fewer than 100 employees.
  • The median loss experienced by small businesses in the study was $190,000.
  • Only 8 percent of the fraud perpetrators had a previous conviction

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