The Hidden Expense – Case Study

Let’s assume you are an owner of the small business in Figure 1. Based on these financial statements you are making $280,000. Now, answer this question: Would you be fine with knowing that $350,000 ($5 million times 7%) might be walking out the door every year with your employees? Of course you wouldn’t.

The problem is that fraud is a hidden expense and is not easily identified. But for discussion purposes, let’s assume that you could easily identify the cost of employee fraud for your company. As you can see in Figure 2, after separately classifying Employee Fraud, all three expense categories have gone down. Why?

· For cost of sales, it might be that your director of purchasing has worked out a deal to buy product at an inflated price in return for a kickback.

· For selling expenses, it might be the result of Slick Williams, your top salesman, submitting false travel and entertainment expenditures on his monthly expense report.

· For general and administrative expenses, your office manager might be writing a weekly check to a “ghost employee.”

If you could isolate and remove all instances of fraud in your company, your net income would be $630,000 instead of $280,000. Short of doing that, the only way to make up the amount lost to fraud is to create an additional $1,400,000 in sales ($350,000 divided by 25% gross profit percentage). That shouldn’t be too difficult for Slick.

Preventing and Detecting Occupational Fraud

So what are some practical things you can do to prevent fraud within your organization? Here are just a few ideas:

• Create a corporate culture that communicates clearly that stealing or improperly using company assets will not be tolerated and could be grounds for prosecution by adopting a written code of ethics for all corporate directors and employees.
• Maintain adequate segregation of duties between all departments. For example, make sure that the person who opens the mail is not the person who applies payments to accounts receivable.
• Utilize an effective budgeting process. This allows you to compare results with a baseline expectation of where expenses should be.
• Implement an internal or third-party fraud hotline. According to the ACFE this is the single most effective means of detecting fraud.
• Offer a $500 bonus to employees who report an employee theft, no matter how small the theft is.

• Be wary of those employees who insist on doing everything themselves, work long and unusual hours, or never take vacation.

Use of Data Extraction Tools to Detect Fraud

There are many simple things that you can do by mining existing data in your internal systems. Here are just a few examples:

• Identify vendor price increases greater than acceptable percentages (identify potential kickback situations).
• Compare employee home addresses and telephone numbers to those in the vendor master file.
• Analyze invoices and expense reports falling just under the corporate authorization levels.
• Perform tests to identify “ghost employees” on the payroll.

In Conclusion

Good internal controls along with a culture of “checks and balances” are among the best deterrents against fraud. It’s important to note that if you do come across an instance of fraud within your organization, take the appropriate measures to ensure that the evidence could be used in a court of law. While you can’t be skeptical of every employee, a certain amount of systems review could save you a significant amount of money as well as provide you with an additional competitive advantage over firms who have not taken measures to mitigate occupational fraud.