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Employee Fraud: Warning Signs, Deterring and Responding to It

These days it seems like you can’t pick up a newspaper or log on to the Internet without reading another story about multimillion-dollar fraud. Just when we thought we’d heard the last of Enron, Tyco, and WorldCom, along comes Bernie Madoff. But fraud isn’t a problem only for Fortune 100 companies and millionaire investors. It hits businesses of all sizes. For smaller businesses, misappropriation of assets — usually by employees — is far and away the most common form of fraud. This article looks at employee fraud, the warning signs, strategies for deterring fraudulent activity, and what to do if you suspect it in your organization.

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The nature of fraud in smaller organizations
Fraud requires three things: (1) need or pressure, (2) opportunity, and (3) the ability to rationalize. Opportunity presents itself in the form of access. An employee with access to assets (i.e., cash or other tangible valuables) may experience financial pressure that could lead to fraud. There are many sources of pressure: medical expenses, high credit card debt, children’s educational expenses, and gambling losses, just to name a few.

An employee who is under pressure and has the opportunity to misappropriate assets can often find ways to rationalize fraud. He may think he is underpaid, overworked, or both, so the company owes him. He may convince himself that it’s just a loan that he’ll pay back later but never does. Clearly, these situations occur with employees in companies of all sizes.

In 85% of reported cases in small businesses, fraud takes the form of asset misappropriation. Most misappropriation involves employee theft of assets, primarily cash. Employee theft also occurs through fictitious disbursements and use of customer data. Ex-employees may steal customer data or trade secrets, while vendors defraud through intentional overbilling. Customers can steal inventory and create fraudulent credit transactions.

Deterring fraud
Fraud cannot be eliminated, but it can be deterred, and strong internal controls are the first step. Internal controls take various forms, including hiring an auditor. It may not be cost-effective for a smaller business to incur the cost of a full-time internal auditor, but for that matter, neither is installing a security camera to monitor a supply closet. But a cost-benefit analysis still must be undertaken.

However, many internal controls require little or no cost. Computer passwords are inexpensive and effective at protecting proprietary information. It may cost nothing to realign employee duties so that one employee records incoming checks while another is responsible for endorsing and depositing the checks. On the expense side, the employee approving expenses shouldn’t be the same one incurring the expenses. Similarly, the manager in charge of verifying timecards should actually verify the cards, not rubber-stamp them.

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Danger, Will Robinson
Because fraud, by definition, involves deception, the warning signs are rarely obvious. Rather, they are varied and often subtle.

Managerial characteristics and attitudes can be predictors of which environments are ripe for fraud. Studies have shown that an unduly aggressive attitude by management regarding profitability and performance is a fraud red flag. A lax attitude toward internal controls is a red flag as well. Employees may display red flags by living beyond their means, while a company’s books may exhibit red flags to an auditor, internal or external, who knows what to look for.

Understand that red flags are not evidence of fraud; they are simply risk indicators — and the basis for suspicion and further investigation.

Since fraud can’t be eliminated, employers must address indicators of possible employee fraud. When you notice one or more red flags, promptly consult with legal counsel. Many firms have attorneys experienced in fraud investigations who can provide guidance through what is often a difficult and delicate process — particularly as it pertains to your legal obligations to your employees. No company wants to get rid of a suspected fraudster only to be hit with a wrongful discharge lawsuit.

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Bottom line
First, be aware that no business is immune to fraud. Second, examine your company’s internal controls, and think about cost-effective ways to strengthen them. Third, be alert to potential fraud indicators. And fourth, when addressing red flags, contact legal counsel to help with the investigation and guide your response.

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