Are your small business clients vulnerable to fraud?

Are your small business clients vulnerable to fraud?

If you work with small business, eventually you will come across a case of fraud with one of your clients. In my time in public accounting, I worked with three small businesses that were victims of embezzlement by a trusted employee. In one case, the organization’s controller used a company debit card for something like $20,000 worth of personal purchases and cash withdrawals.

Sadly, those cases are not anomalies. By estimates from the Association of Certified Fraud Examiners (ACFE) in their 2018 Report to the Nations, organizations of all sizes lose about 5 percent of their annual revenues to fraud.

External fraud may be on the rise

ACFE recently released its 2019 Benchmarking Report on in-house fraud investigation teams, where they surveyed 886 ACFE members who work in their companies to prevent fraud in their organizations. Nearly half (49 percent) of internal fraud investigators think their organizations are more vulnerable to external fraud than in the past, and 38 percent think that occupational fraud is getting worse.

Occupational fraud, as defined by ACFE, is “fraud committed against the organization by its own officers, directors, or employees.” Occupational fraud falls into three broad categories: asset misappropriation, corruption and financial statement fraud.

Even though the organizations surveyed for the 2019 Benchmarking Report were fortunate enough to have someone in-house dedicated to preventing fraud, well over half (58 percent) said their organizations still didn’t have enough staff or resources in-house, and 60 percent said their organizations were planning on dedicating more resources to fraud prevention in the next two years. These organizations had, on average, about two internal fraud investigators for every 1,000 employees. Embezzlements were the most common type of fraud investigated by these teams.

Even with in-house investigators, 15 percent of the organizations recovered nothing, and 64 percent recovered less than half of their losses.

For smaller organizations, which ACFE classifies as those with fewer than 100 employees, fraud can be even more damaging, and occupational fraud poses a huge challenge. This is partly due to the lack of resources that smaller businesses have available for fraud prevention.

Small businesses especially vulnerable to occupational fraud

According to ACFE’s 2018 Report to the Nations, small businesses had the highest rates of occupational fraud, with 28 percent of the 2,960 cases analyzed occurring in businesses with fewer than 100 employees. Even more troubling, the median loss for those small businesses was $200,000 – nearly double the median of $104,000 for larger businesses.

Overall, 89 percent of the 2,960 fraud cases ACFE surveyed for its 2018 Report to the Nations were cases of asset misappropriation. Asset misappropriation can be theft of either cash or inventory. Theft of cash can occur through skimming cash receipts or fraudulent disbursements, which can include fictitious employees or vendors, reimbursement for fake expenses and check or payment tampering.

Not surprisingly, the duration of a fraud tends to be proportional to the amount of the losses. Median losses that weren’t detected for 60 months were around $715,000 while those detected within six months were about one-twentieth that amount — $30,000.

How can advisors help their small business clients prevent occupational fraud?

When all three elements of the fraud triangle are present for an individual (or a group of individuals, in case of collusion), that person is much more likely to commit fraud. The three elements are:

  1. Financial pressure – the perpetrator has unusual financial demands, which may range from expensive healthcare crises to gambling problems.
  2. Rationalization – the perpetrator may believe they are owed additional compensation or may intend to repay the stolen funds.
  3. Opportunity – the perpetrator has access due to poor internal controls or as a trusted employee.

In all three cases I witnessed, all of those elements were in place. The thieving controller, besides having expensive taste in clothing and bicycles, made lots of cash withdrawals at a casino. And, in all three cases, the fraud would have been detected immediately if the business owner had simply monitored bank and credit card accounts.

ACFE’s 2018 report notes that active detection methods such as IT controls, account reconciliation and management review can reduce the duration of fraud and the magnitude of losses by as much as 50 percent. Small businesses may have difficulty with segregation of duties, but simply ensuring that bank and credit card statements are delivered to the business owner can be an effective deterrent. Advisors can also help by monitoring their clients’ financial records with an eye towards odd transactions.

The best way for advisors to help clients prevent workplace fraud is simply education. ACFE’s biennial Report to the Nations is an eye-opening read. Additional, easily-digestible resources are also available on the Fraudweek website.