Reference no: EM132227105

Task: Make a briefing of this article

Ignoring Red Flags: Perilous Consequences for Small Businesses David Glodstein State University of New York, Old Westbury

Abstract

Losses suffered by small businesses due to fraud are disproportionate to larger companies because of a lack of internal controls. This paper presents an educational case study of occupational fraud. Specifically, it examines the methods of how a manager of accounting and human resources of a small manufacturing company managed to embezzle more than $250,000. In addition, the paper presents indicators or “Red Flags” that the business owners and their accountants failed to observe over the course of the defalcation. Forensic accounting students and practitioners can apply the “Lessons Learned” to help combat the threat of fraud through the use of internal controls, employee job responsibilities and oversight procedures.

Keywords: Occupational Fraud, Internal Controls, Defalcation, Red Flags

I. Introduction In today’s global, competitive marketplace, fraud does not discriminate among its victims. The misappropriation of assets by employees, particularly those of small businesses, adds unnecessary burdens on owners in their efforts to compete effectively and operate profitably. The Association of Certified Fraud Examiners (ACFE) 2006 Report to the Nation on Occupational Fraud and Abuse (Report) indicates that small businesses suffer disproportionately from losses due to fraud. In fact (p.5), “The median loss suffered by organizations with fewer than 100 employees was $190,000 per scheme.” The median fraud losses by small companies are larger per case generally due to the lack of internal controls, predominantly the lack of segregation of duties.

II. A Common Scenario

This paper examines a specific case of “occupational fraud” involving an employee who used multiple techniques to misappropriate more than $250,000 from a small manufacturer of satellite components. The ACFE Report (p.6) defines occupational fraud as “The use of one’s occupation for the personal enrichment through the deliberate misuse or misapplication of the employing organization’s resources or assets.” In such cases, the employee steals either directly or indirectly from the employer. The unwitting victims of this scheme were the two principal owners who were engineers by trade and, Journal of Forensic Studies in Accounting and Business Winter 2009 63 typical of most small business owners, who focus their efforts on generating their product and maintaining customer relations. Essentially, the owners left the oversight of the day-to-day operations to their “trusted” employees. Ultimately, the discovery of a problem, followed by a forensic investigation, left the two owners shocked that a fraud was committed in their organization. Embarrassment and shame then followed because they felt guilt over their failure to prevent the loss. Such reactions are quite common among business owners after they learn that a trusted employee has stolen company assets. This case highlights the need for accountants and consultants to be proactive and to work in tandem with their clients in the fight against small business fraud. By asking the right questions, focusing acute attention on red flags, and educating clients and fraud investigators about the realities of fraud, we can assist clients in detecting and preventing such schemes by employees.

III. Background: Discovery of the Fraud

In this case, the problem was discovered by the “part-time” Chief Financial Officer (CFO)/consultant. The CFO served as an advisor to the company for a number of years and was paid as an independent contractor. His functions were to review the accounts receivable, accounts payable and internally generated financial statements and consult with the owners. Accordingly, he had familiarity and experience with the company and its operations. Though the CFO was confident that the company was profitable, he believed that the company’s cash flow was insufficient given existing operating results. Since labor costs were one of the largest expenditures of the company, the CFO and one of the owners performed an initial review of the company’s payroll register and related summaries. They compared the payroll for Jack, the manager of Human Resources, in the current year with the same period in the prior year. Their suspicions grew deeper as they discovered that approximately $15,000 to $20,000 had been misappropriated by Jack, one of their trusted employees. The other owner of the company then contacted his attorney who subsequently contacted s forensic accountant..

IV. The Manager of Human Resources and Accounting

Jack was hired as the manager of human resources in 1998 and was also entrusted with the responsibility for administering the payroll and benefits for forty to fifty employees. Interestingly, the “Professional Profile” on Jack’s resume contained the following descriptive qualities: • Highly motivated individual and loyal team player • A problem-solver, dedicated to tackling all problems to a positive conclusion • Willing to accept new challenges • Self-starter, quick learner and flexible Jack’s resume showed that he had an Associate’s Degree with a concentration in accounting from a local community college. Jack also indicated that he was a Program Manager for a security technology company for the years 1982 through 1993. His resume contained no other work or professional experience after that time. The owners questioned Jack regarding his employment with the security technology company and wanted to contact them for a reference. Jack indicated that his prior employer was out of business, but did provide a name of an individual who was out of the state. No further background check was completed since the owners felt “comfortable” with Jack. Journal of Forensic Studies in Accounting and Business Winter 2009 64

Red Flags

What was Jack doing from 1993 to 1998? During the interview process, Jack explained that his prior employer had gone out of business. Moreover, he indicated that his recent employment consisted of part-time maintenance and handyman work. Unfortunately, no phone calls or other communication was made to obtain background information confirming Jack’s employment for the prior five years. To compound this issue, no background check was performed to confirm Jack’s academic credentials.

Lessons Learned

The job of a forensic accountant is to put the pieces of the puzzle together to tell or explain a story. Prior to Jack’s employment, the owners had pieces of a puzzle and unanswered questions, but did not perform their due diligence or have the controls in place to identify this potential threat. Though small business owners may find employee background checks to be costly and time-consuming, they face far greater risks later on if they are the unfortunate victims of occupational fraud.

V. Asset Misappropriation: Testing the Water

The misappropriation of assets started approximately one year after Jack was hired. One of Jack’s responsibilities was to phone the weekly payroll information (hours worked, pay changes, etc.) into the outside payroll service. With oversight over both human resources and accounting, Jack identified an opportunity to take unauthorized vacation pay. He began by taking one additional week of unauthorized pay during his second year of employment. Once Jack realized that neither of the owners reviewed the supporting payroll documentation, he saw an easy opportunity. During the next seven years (until his termination), he took an additional two to twelve weeks of unauthorized vacation pay per year. The forensic investigation included an examination of the payroll register and various payroll reports to verify the number of additional weeks of unauthorized vacation pay. The amount of this defalcation totaled $56,375. Jack then identified other areas for his enrichment. The company required its employees to contribute towards the cost of their medical and disability insurance through withholdings from their weekly paychecks. Initially, Jack deducted only a fraction of the full contribution for medical coverage for his family. Similarly, Jack neglected to withhold his portion of short-term and long-term disability insurance from his weekly paychecks. This scheme continued for almost seven years. The loss to the company from this defalcation amounted to $16,700 for medical insurance and $9,190 in disability insurance. These misappropriated assets were those that could be quantified. Other “gray areas” existed but could not be quantified during the forensic investigation. For instance, Jack had the authority to approve his own overtime and his hourly wage increases. Unfortunately, no time cards were maintained to verify hours worked and performance reviews were not mandatory. Jack’s annual salary grew from approximately $30,000 to over $80,000 in slightly over nine years.

Red Flag

This company had an accounting department consisting of three individuals in addition to Jack. Unfortunately, neither the proprietors nor their external accountants noticed Journal of Forensic Studies in Accounting and Business Winter 2009 65 the significant increase in Jack’s annual payroll or the total payroll expense for this small department.

Lesson Learned

Even a cursory review of the payroll information would have exposed this defalcation. If proper controls were in place for overtime and annual reviews, the owners of this company would have known how much the perpetrator should have earned each year. Owners and their accountants need to examine the weekly, monthly and quarterly payroll information provided by the payroll service. Companies are paying for this critical documentation and should use it as an important internal control. This is especially true in small companies where it is often difficult to segregate the accounting functions. Moreover, it is especially important to review the salaries/wages of the employees who have access to liquid assets (as further illustrated below).

VI. Direct Access to Liquid Assets

Signature Authority

If any internal controls were present at this company, they became inconsequential once Jack was given check-signing authority over both the regular checking and medical disbursement accounts. In addition, Jack was one of the individuals in the accounting department who reconciled the bank accounts. Here was another opportunity for Jack to use his position to divert substantial dollars from his employer. With a few of years of experience and some confidence under his belt, Jack started writing (and signing) checks payable to “cash” from the regular checking account. The checks were endorsed and cashed by either Jack, his spouse or son-inlaw. Checks written to cash amounted to between $8,500 and $32,300 per year and were posted to the “cleaning and maintenance expense” account in the company’s general ledger. The forensic examination included segregating all checks written to “cash” from the time Jack was given check signing authority. This was accomplished by reviewing the cash disbursements journal and reviewing the company’s bank statements. This defalcation totaled $90,825. Though the company was not subject to an annual audit, it was reviewed by a mediumsize, local accounting firm. At a minimum, the relatively large fluctuations in this expense account over a period of five years should have been a point of concern for the CPA firm during the engagement. Aware that checks he wrote payable to cash from the regular checking account went undetected, Jack then began to do the same with checks from the medical reimbursement account. Again, the perpetrator was both the signator and endorser on these checks. The total amount taken from the medical reimbursement checking account amounted to $62,845.

Cash Bonuses

At the end of each year, the owners paid a $100 to $150 bonus in cash to each employee on the payroll as of the second week in December. In order to obtain the currency to distribute to employees, Jack wrote a check payable to cash and had a different accounting department employee cash it at the local bank. The other employee then returned the cash to Jack who divided the money into separate envelopes for each employee. The only problem was that the check was written for more than the amount needed to cover the total bonuses. The excess amount taken was $3,700 over a three-year period prior to his termination. Journal of Forensic Studies in Accounting and Business Winter 2009 66

Red Flags

The red flag for the accountants was that Jack was given signatory authority over the checking accounts. No second signator was required for any checks written. A periodic review of the bank statements and canceled checks would have signaled that Jack had signatory authority and that checks were written to cash. This can be completed simultaneously when the reconciliations for the bank accounts are reviewed. This was another red flag because this business did government contract work. Therefore, it was not the type of business that received cash from its customers or paid cash to its vendors.

Lessons Learned

No one can predict when even the most trusted employee might turn into a fraud perpetrator. Accordingly, business owners cannot let their guard down with any employee, including those who have worked for the company for a long period. Accountants need to review with their small business clients the internal control procedures over those employees who have access to liquid assets. They need to ask questions and obtain information about the company’s “trusted” employees and their respective job functions. This will provide clients with valuable independent information to help prevent misappropriation of assets.

VII. Personal Relationships

This case also included an unusual twist. The forensic investigation revealed that the defalcator paid unauthorized vacation pay to another administrative employee and did so without deducting any related employee medical insurance contributions. These were not simply errors. Medical insurance had been properly withheld from the “friend” on a weekly basis prior to the start of this misappropriation. Though no conclusion was reached as to the motive for this defalcation, a sexual relationship between Jack and the other employee was suspected. The loss amounted to $5,325 in additional vacation pay and $12,155 in lost medical withholding. The company also had to pay additional Social Security taxes in the amount of $4,720.

VIII. Related Costs

The misappropriated assets and lost benefits noted above do not include the additional interest income lost during the period of the defalcations due to the time value of money. In addition, the fees paid to attorneys, forensic accountants and others to investigate the loss directly impact the company’s bottom line.

IX. Summary

Unfortunately, accountants often narrowly focus on the end product for their clients. Whether the engagement involves attestation services or tax services, accountants still need to educate themselves and their clients to better combat the threat of fraud. Accountants also need to consult with their clients regarding their internal control structure, employee job responsibilities, and oversight procedures in order to minimize occupational fraud. Once clients realize the devastating effects of fraud on their companies, they should be willing to invest time and resources as a preventative measure to minimize loss from employee misappropriations.

X. Appendix

The following are educational questions to use with this case: Journal of Forensic Studies in Accounting and Business Winter 2009 67

1. What procedures should this company have instituted prior to hiring employees? When documentary evidence is lacking, what information is available electronically to verify a prospective employee’s background?

2. Many small businesses experience difficulty in adequately segregating critical accounting functions. In such instances, what can the principals do to mitigate the risks inherent in such a control environment?

3. What specific internal control procedures could have prevented this fraud? What would these procedures have cost the company? Does the cost of instituting these procedures outweigh the long-term benefits?

4. What investigative techniques would be used to uncover the fraudulent activity in each of the areas described above?

5. How can the company better use the services of the part-time CFO to assist in minimizing any future occurrences of fraud?

6. How can this company effectively use its external accounting firm to assist in minimizing any future fraud?