Business Accounting

How to Address Fraud in a Small Business

2019-09-17 | by Gene B. Reynolds, CPA

When you think about costs associated with running a business, your mind probably jumps to monthly expenses, insurance, or long-term debt paydowns. You may not think about fraud as a cost, but it can have a tremendous negative impact if left undetected.

According to the 2018 ACFE Fraud Report to the Nations, organizations lose five percent of their annual revenues to fraud.

Unfortunately for small businesses and private businesses, fraud is even more prevalent.

  • Businesses with 100 or fewer employees: $200,000 median fraud loss
  • Businesses with more than 100 employees: $104,000 median fraud loss
  • Private companies: $164,000 median loss for each fraud that was detected

Here’s the question. Why is the impact on smaller businesses almost double the impact in larger organizations? The key that we have found is a lack of internal controls.

A Lack of Internal Controls Opens the Door to Schemes

One of the primary misconceptions about small business fraud is that it’s a large, one-time theft. The research from ACFE indicates that the opposite is true — it’s long-term schemes where employees take little by little over a period of time.

In fact, businesses are typically victimized by schemes from long-time employees, usually because of a lack of oversight. According to the ACFE survey:

  • The median duration of detected fraud was 16 months.
  • Internal control weaknesses led to nearly 50% of detected fraud.
  • Fraudsters with the company for more than 5 years stole an average of $200,000.
    • Comparatively, fraudsters with a company for less than 5 years stole $100,000.

The most common types of schemes are collections and billing schemes, especially for a small business. Other schemes include wire transfer schemes, expense reimbursement schemes, inventory theft, and check tampering.

There’s an important point to be made. Not all employees start off thinking about frauding the company. Sometimes it’s a small thing such as taking office supplies. Then, the theft progresses to something larger or more significant. Strong internal controls helps reduce the likelihood of something small becoming something much larger or consequential.

The Most Effective Internal Controls for a Small Business

One of the most effective internal controls for a small business is simply paying attention and asking questions. We know that it can be difficult for a small business owner, entrepreneur, or manager who simply wants to run the company.

Your focus and your passion is the business; not whether your company is being victimized by fraud. But, if you only glance at the financials and give employees carte blanche access to financial data and reporting, then you open the door for employees to find opportunities to take advantage of a lack of internal controls.

Whether or not you suspect fraud in your company, one critical change to consider is separating duties among financial personnel. Why is this important?

You want to make sure that one person is not controlling each transaction from the beginning of recording the transaction to the end of reconciling the transaction. Make sure these are separate duties within your financial recording and reporting structure.

Consider this example. A typical small business only has one person involved in Accounts Receivable. This person handles billing, the phone call or email to collect the bill, the reconciliation of the transaction, and the aging. Those duties need to be separated. Otherwise, there is an opportunity to set up false customers and fake invoices to send fraudulent payments to the individual’s own bank account.

Usually, this occurs in small, regular increments over a prolonged period of time. Without a separation of duties, the fraud could go on for a while without being detected because it would appear to be a regular transaction for a regular dollar amount to a regular “customer.”

In addition to separating duties, small businesses need to consider these other important forms of internal controls.

  • Implementing a fraud prevention tip hotline.
  • Assigning individuals from other departments to perform random spot checks.
  • Performing surprise audits so that fraudsters are unable to prepare to cover their tracks.

How Can a CPA Firm Help With Internal Controls?

Another misconception about fraud is that an independent auditor will catch the fraud. That’s usually not the case. In fact, only one out of every 10 frauds is caught by an independent auditor.

Fraud is usually caught by a co-worker or another individual who interacts with an employee on a regular basis. That’s why hotlines are critical for small businesses to set up so that employees or third-parties can anonymously report fraud and set in motion an investigation. According to the ACFE Report:

  • Fraud losses were 50% smaller for organizations with fraud hotlines.
  • Tips were the initial detection method in 40% of fraud causes.

You may also consider extending hotline access to vendors and customers, as 32 percent of fraud tips came from these third parties.

Here’s where a CPA firm such as Reynolds & Associates comes into play. We can help your small business or private business set up internal controls to help reduce the likelihood of fraud.

Whether it’s identifying where duties need to be separated, helping set up a fraud hotline, or supporting another aspect of internal controls, we are available to strategize next steps in fraud prevention.

We want to make sure that your business is protected against the cost of fraud, especially because the majority of victims recover nothing from their loss. Contact us today to discuss setting up internal controls for your business.

About the Author

Gene B. Reynolds, CPA

Gene is the Founder and President of Reynolds and Associates, a Houston-based CPA Firm. He has spent 42 years helping Houston entrepreneurs navigate their enterprises through both calm and stormy waters.


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