Fraud and the Small Business Owner

Can you recognize it when you see it?

National Society of AccountantsAnnual MeetingAugust 15, 2009

Erik H. Lindquist, CFEPresenter

Definition

• “The use of one’s occupation for personal enrichment through the deliberate misuse of the employing organizations resources or assets”

Trends and Concerns

• Estimated Losses from Fraud

– 1996 -- 400 Billion Dollars – 2006 -- 660 Billion Dollars

• Estimates are based on 6% of GDP for period

How we classify fraud

• Asset Misappropriation - 89% of all cases• Corruption - 27%• Fraudulent Financial Statements - 10%

– percentages will be greater than 100% due to cross-over in categories

In Asset MisappropriationCASH IS KING

• 84 % of reported frauds in 2006 survey were cash related

• Median loss is $93,000 per CASE

• Types of Asset Misappropriation– Fraudulent Disbursements 74.1%– Skimming – 16.6%– Larceny – 10.3%

Fraudulent Disbursements

• The greatest opportunity to the employees of a small business– Billing Schemes (1)– Payroll Schemes– Check Tampering (2)– Expense Reimbursement (3)– Register Disbursement

• Median Loss - $125,000

Summary from ACFE Report to the Nation--2006

How do you discover fraud?

• Tip 46.6%• Internal Audit – 19.4%• Accident – 20.0%• Internal Controls – 23.3%• External Audit – 9.1%• Notified By Police – 3.2%

How do you discover fraud?

• Tip from employee - 59%• Tip from customer - 19.7%• Anonymous tip - 12.9%• Tip from vendor - 15.7%

How to Prevent Fraud

• Internal Controls• Background Checks

on Employees (pre-employment)

• Regular Fraud Audits (six month cycle)

• Established Fraud Policy

• Be Willing to Prosecute

• Ethics Training• Anonymous Reporting

Mechanism• Workplace

Surveillance

Fraud Vulnerability - another 12 step program

• Preliminary meeting• Gather Information• Customize Assessment• Management interviews• Preliminary Interviews

with supervisors• Field interviews and

Controls testing

• Use findings to ID Vulnerabilities

• Determine Prob. of Occurrence

• Determine Severity of impact

• Develop Recommendations

• Post Assessment• Report

Fraud Prevention

• Fraud prevention is the most cost-effective way to reduce fraud

• Involves two fundamental activities:– Sustain a culture of honesty and high ethics – Assess the risks for fraud, develop concrete

responses to mitigate the risks, and eliminate the opportunities for fraud

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Fraud Prevention

Sustain a Culture of Honesty & High Ethics

Five critical elements:1. Have management model appropriate behavior2. Hire the right kind of employees3. Communicate expectations and require periodic

written acceptance to the expectations4. Create a positive work environment5. Enforce policies for handling fraud

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Fraud Prevention

Research on Why People Lie

– Have fear of punishment or adverse consequences– Have a habit of lying– Seen others lie or have had negative modeling– Feel if they tell the truth they won’t get what they want

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Fraud Prevention

Eliminate Fraud OpportunitiesOrganizations should:

• Identify and measure fraud risks• Implement preventative and detective controls• Create widespread monitoring by employees• Have internal and external auditors

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Organizational Culture

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Way to Create a Culture of Honesty, Openness,and Assistance

 How This Step Is Accomplished

1. Hire honest people and provide fraud awareness training.

1. Verify all information on the applicant’s résumé and application.2. Require all applicants to affirm the truth of the matters set forth in their application and résumé.3. Train management to conduct thorough and skillful interviews.

2. Create a positive work environment.

1. Create expectations about honesty by having a good corporate code of conduct and conveying those expectations throughout the organization.2. Have open‐door or easy access policies.3. Have positive personnel and operating procedures.

3. Provide an employee assistance program (EAP).

1. Implement an EAP that helps employees deal with personal and nonsharable pressures in their lives.

Eliminate Opportunities for Fraud

Five ways to eliminate fraud opportunities: 1. Have good internal controls2. Discourage collusion 3. Monitor employees and provide a whistle-

blowing system4. Create an expectation of punishment and 5. Conduct proactive auditing19

Early Fraud Detection

Three Primary Ways to Detect Fraud1.By chance2.By providing “whistle-blowing” systems3.By data mining

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Early Fraud Detection

Whistle-blowing SystemsA reporting hotlines or online system that

allows others to call in or submit an anonymous tip of a fraud suspicion

Examples:• Internal systems/hotlines• The Association of Certified Fraud Examiners• Allegiance

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Early Fraud Detection

Mining Company DatabasesMining databases for suspicious trends,

numbers, and other anomalies.

Data-mining programs:• ACL• Picalo

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How to delicately ask the owner about “this issue”

• Are you concerned about sales and cash trends not tracking consistently?

• How many employees have access to the checkbook - who signs checks - who reconciles?– No less then 3 people should handle the cash

disbursements!• One to draft check-one to sign and one to reconcile

the bank statement

How to delicately ask the owner about “this issue”

• How often do you count inventory?• Are your employees paid a competitive

wage?• Do you do background checks on financial

staff?• Have you ever had a fraud “vulnerability

check-up”

How to delicately ask the owner about “this issue”

• Do you believe an annual audit or review covers your risk to fraud?– It doesn’t…this is called the expectation gap

• Can your employees anonymously report concerns to you?

• Do you review your monthly financials for unusual trends?– A/P, Inventory, Cash, A/R, Trial Balance

• Ensure that all Journal Entries have descriptions

Preventing Fraud – A Summary

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Create a culture of Honesty,

Openness, and Assistance

Eliminate Opportunities

Implement Employee Assistance Programs

Have a Code of Ethics

Create a Positive Work Environment

Hire honest people and provide fraud awareness training

Have good internal controls

Discourage Collusion

Publicize company policies

Monitor employees

Provide tip hotlines

Create an expectation of

punishment Proactively audit for fraud

Preventing Fraud – Suggested Model

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Tone at the Top

Education and Training

Investigation and Follow-up

Proactive Detection

Integrity Risk and Controls

Reporting and Monitoring

Reforms Bypass Non-Profits

– Sarbanes-Oxley Does Not apply– Public Trust Is Being Eroded– IRS Is Raising Alarms in Congress For

Regulations To Be Implemented

Loss Of Public Confidence

• Leads To Drop in Donations/Contributions• Increase of Negative Press• May Actually Attract the Wrong Type of

Employee• Death Spiral of Drops in Membership and

Donations

For more information

Erik H. Lindquist, CFELindquist & Associates, LLC517-281-6551

lindquist@fraudmedic.com

www.fraudmedic.com

Resources:Fraud ExaminationW. Steve Albrecht et alThird Edition, Cengage Learning; 2009Association of Certified Fraud Examiners www.acfe.comFraud Casebook – Lessons from the Bad Side of Business edited by Joseph T. Wells, CFE, CPA; Wiley, 2007