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Fraud Risk Prevention

As published in the November 2010 issue of The Greater Lansing Business Monthly .

Fraud. For many of us, the word conjures up images of highly publicized, scandalous corporate activities resulting in considerable loss and defamation. We often think of large, publicly traded corporations as being most susceptible to fraud; however, small to midsize businesses also need to be concerned with fraud risks.

Consider your organization—have you assessed your risks? Each organization and its operating environment will have unique risks and risk tolerances. Once those risks are identified, it’s imperative to take preventive measures. Since implementing a fraud prevention program is a strategic business decision, it should be subjected to the same cost-benefit analysis approach utilized with any other business decision. Depending on the nature of the organization, these measures could be as simple as independent reviews of the cash register tapes on a daily basis or random spot checks of activity by the business owner.

Within the small to midsize business environment, managers are concerned with asset misappropriation schemes, which tend to involve theft of cash or other corporate assets. According to the Association of Certified Fraud Examiners’ 2010 Report to the Nations on Occupational Fraud and Abuse, nearly 90 percent of U.S. fraud cases considered by the study involved a form of asset misappropriation, resulting in a median loss of about $100,000.

When $100,000 goes missing, you would assume it to be easily noticed. This may be true if the assets were stolen all at once, but consider the situation where there is $20 of fictitious voids several times per week, over the course of several years. Or perhaps an employee confiscates a small amount of inventory several times per month. The amounts can add up quickly.

Business leaders also should consider what fraud examiners call the Fraud Triangle. The Fraud Triangle is a sliding scale of three factors: opportunity, rationalization and pressure. The theory states that an organization has a higher fraud risk when:

1. Opportunity is high

2. An employee can rationalize his or her activities easily

3. The employee is under a high amount of perceived pressure

Although these three pieces may seem unavoidable, fortunately they can be controlled. Opportunity is addressed by the organization’s internal control environment. Organizations with a strong system of internal controls and built-in checks and balances present their employees with less opportunity for fraud. For a given asset, a strong system of internal controls should include separating the functions of the asset’s physical custody, recording the asset’s activity and authorizing the asset’s use.

Rationalization often is addressed through corporate culture. Consider the message a management team’s actions send to employees. If owners and managers tend to play fast and loose with the rules, employees could have similar thoughts about corporate assets.

Pressure is primarily internal to the employee, and most often manifests itself as perceived personal financial pressure. Since pressure often encompasses both an employee’s work life and personal life, it is often the most difficult to control through corporate policy. Regular communication with employees could help managers identify potential red flags before they result in fraud. The recent financial crisis may have increased the perceived financial pressure of your employees, which might in turn affect your risk profile.

It is critical to keep these fraud risk factors in mind to keep your business protected. As a business manager, it is a key function to do as much as possible to minimize these factors and reduce your risk.

Gregory H. Soule, CPA, CFE is a senior accountant with Andrews Hooper Pavlik PLC. He specializes in assurance, attestation and consulting services including financial statement audits, fraud prevention and investigation engagements, and IT security reviews .