Karl Jarek

Monday, 24 May 2004 13:20

Fending off fraud

Ask yourself: Where would your business be if your revenue dropped 6 percent during the course of the year? What if your equity decreased by $127,500 during the year?

According to a recent study, Report to the Nation on Occupational Fraud and Abuse, by the Association of Certified Fraud Examiners, businesses are incurring such financial disasters not as a result of outside operations but internally through employee fraud.

It reports that businesses with fewer than 100 employees are the most vulnerable, as their median loss-per-fraud scheme is actually higher than that of larger organizations. The report says that approximately 86 percent of the 663 cases examined had either insufficient controls or allowed employees and management to override such controls.

According to the U.S. Department of Commerce, three out of five businesses fail during the first five years of operation; one-third of those failures relate to some kind of fraudulent activity.

This statistic is a cause of concern for business owners. When applied to the U.S. gross domestic product, fraud translates to losses of approximately $600 billion.

Financial statement frauds account for $4.25 million per scheme on average, according to the ACFE. Luckily, this is the least common type of fraud. Asset misappropriation, which includes skimming cash and inventory, accounts for 80 percent of occupational fraud losses, with an average loss of $60,000 when committed by employees and $250,000 when committed by managers.

Measures can be taken to reduce the risks associated with occupational fraud, such as developing and following a code of ethical conduct, implementing a fraud hotline, allowing a certified public accountant to review your internal control system for risks and establishing a zero-tolerance fraud policy.

Some of the most common warning signs of fraud include customer complaints about billing or collection efforts; refusal of an employee to take vacation; employees who are territorial about their work and/or refuse help; staff taking work home; books and financial papers being inaccurate, messy or in a confused state (i.e. the bank and books never match); missing records; incorrect or incomplete information or inability to provide information in a timely manner; vendor complaints about nonpayment; and unexplained, recurring adjustments.

Most internal control experts say the most important way to deter unethical activities such as fraud is to set an ethical tone at the top of the organization. By sending a clear message to all employees throughout the organization that unethical behavior is not permitted, employees are less likely to rationalize their unethical behavior.

Rationalization, opportunity and the need for cash are the three elements that lead to fraud. Management must understand its role in not only establishing a code of conduct, but also abiding by it at all costs.

A simple overstatement of meals and entertainment expenses by a manager or person in a higher position sends a clear message down the chain of command. Although this may be only a $10 transaction, the overall message sent to employees is significantly larger. Drafting an organizational code of conduct is a first step in sending a clear message to your organization that unethical behavior is not acceptable.

Unfortunately, the it-will-not-happen-to-us attitude is a major fallacy because it may take only one undetected fraudulent activity to force closed the doors of your business. Similar to failing to regularly change the oil in an automobile, deferring the costs of implementing a strong internal control system may save money now, but the consequences of a weak system in the future are far worse. Karl A. Jarek is a shareholder for Alpern Rosenthal. Reach him at (412) 434-8204 or at kjarek@alpern.com.