Organizational Factors and Red Flags of Occupational Fraud

By Michael Targia
October 01, 2011

I was recently involved in a troubling case whereby I was contacted by the elderly owners of a small business with concerns of fraud. After operating their reasonably profitable business for many years, the owners were suddenly faced with having to contribute cash monthly, out of their personal savings, just to keep operating; something they had previously not had to do. After draining their savings accounts dry over a two-year period, they contacted me. Upon careful investigation, it appeared as if a long-term trusted employee was skimming cash out of the business while a close relative maintained the books. 

Unfortunately, while I found this case disturbing, this case is also very typical of occupational fraud in small businesses. While these owners were well versed in operating their business, they lacked the accounting expertise to understand the red flags of fraud. As the business was small and operated by “trusted” employees, the owners failed to understand the need for proper internal controls. 

Estimates say the typical fraud incident costs a small business approximately $200,000. For many small businesses, this could be the difference between staying in business or bankruptcy. Small businesses tend to be more susceptible to fraud because they typically lack the accounting expertise and internal controls of larger enterprises and tend to rely on a few “trusted” individuals. Regrettably, small business owners tend to learn the importance of proper accounting procedures and internal controls when it is too late and an occupational fraud has already been discovered. 

The term “occupational fraud” may be defined as: “the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s resources or assets.” Estimates indicate that the typical organization loses anywhere between 5 percent and 10 percent of its annual revenues to occupational fraud. 

The typical fraud has three elements, also known as the fraud triangle; incentive or pressure, opportunity, and rationalization. Each leg of the triangle represents one of these three elements. 

The incentive element typically stems from circumstances that cause the perpetrator to feel pressure to commit fraud. Examples of pressures that may lead to fraud include personal financial problems, potential job loss and fear of failing to meet earnings expectations. 

Opportunities to commit fraud generally arise when circumstances allow an individual to carry out a fraud. For small businesses, such opportunities usually appear in the form of weak internal controls. Opportunity is the element over which a company can exercise the greatest amount of control. 

Rationalization involves the perpetrator’s ability to justify the commission of fraud. The fraudster often adopts an attitude that the fraudulent act is harmless to others, that the money is deserved, or, in the case of embezzlement, that he or she is “borrowing” the money and intends to replace it as soon as they are caught up, which rarely ever happens. 

The Association of Certified Fraud Examiners (“ACFE”) publishes a report approximately every two years which compiles data reported by Certified Fraud Examiners related to occupational fraud cases. The ACFE noted during their studies that a large percentage of the organizations that suffered losses had commonalties in both the characteristics of the person who perpetrated the fraud and the organization’s environment. 

While there is no clear alarm that a fraud is being committed, perpetrators of fraud often display “red flags” or warning signs. The following characteristics were commonly cited as being associated with the fraud perpetrator: 

  • Living beyond their means or high personal debt 
  • Overwhelming desire for personal gain 
  • Close association with customers 
  • No recognition for job performance or a feeling pay was not commensurate with job responsibilities 
  • Excessive gambling habits 
  • Undue family or peer pressure 

Although these characteristics are not necessarily an indication of fraud, they may be a warning. Being aware of these behaviors and your employees’ circumstances may help you to detect and prevent fraud. Offering employees avenues for seeking assistance when unusual family and financial pressures arise and making employees feel appreciated may reduce an employee’s pressure to commit fraud. 

An organization’s environment may also be a contributing factor to occupational fraud. The ACFE has noted certain organizational characteristics present in a high number of occupational fraud cases. 

These organizational characteristics included: 

  • Placing too much trust in key employees Lack of proper procedures for authorization of transactions 
  • No separation between authorization of transactions from custody of the related assets 
  • Lack of independent checks on performance 
  • Inadequate attention to details No separation of duties between accounting functions 
  • Lack of clear lines of authority and responsibility 

Although you cannot always control a person’s perceived pressures to commit fraud, setting the proper tone in an organization and having critical internal controls in place such as proper segregation of duties can help reduce their opportunity. 

Employees are less likely to commit fraud in an organization with a “tone at the top” that ethical behavior is expected and management clearly demonstrates this by their actions. This tone can be established by having a defined ethics policy for the organization, communicating this policy to new hires, emphasizing this policy with existing employees, as well as taking appropriate action when this policy is violated. 

Segregation of duties is one of the key concepts of internal control and is sometimes the most difficult for a small business to achieve. Under segregation of duties, business critical duties are generally categorized into four types of functions: authorization, custody, record keeping, and reconciliation and the duties related to each category are segregated. In smaller organizations, where segregation of duties cannot be achieved due to limited staff, it is critical to have mitigating controls in place. For example, having an owner or a designated employee open and examine the monthly bank statements and the cancelled check copies prior to the bookkeeper reconciling the bank account, provides a level of oversight when bookkeeping duties cannot be segregated. 

Preventing occupational fraud in a small business can be a daunting task if you lack the expertise and training in accounting and internal controls. A trained accountant, with education and experience in these matters, can be an invaluable resource. Seek one that has training and expertise in preventing and detecting fraud. 

There are upfront costs to having such an individual evaluate your internal controls and make recommendations for improvements; however, this cost will surely be less than the cost and heartache associated with the discovery of a fraud after the fact. Make sure to have the proper procedures and controls in place to avoid becoming another small business occupational fraud statistic.

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