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Gender Representation on Company Boards of Directors

Causes and Solutions to Small Business Fraud

Spotting the Red Flags is Key to Fraud Prevention and Detection

All companies are vulnerable to fraud, but small businesses are particularly vulnerable because decision-making and other responsibilities are often concentrated in a few key positions. Small business owners tend to be overly-trusting of employees, especially those in sensitive financial positions, and do not institute sufficient internal controls to help prevent and detect fraud. A fraud can go on for many years undetected and cause the downfall of a small business. The owner-manager is typically the driver of sales, out promoting the business and working to create revenue, yet not comfortable with the reporting requirements internally and therefore not aware of how receivables and payables are being managed. The owner may be oblivious to the problem and those in the know are reluctant to blow the whistle on wrongdoing.

Workplace fraud is a big problem that affects all kinds of businesses from religious institutions to small, community-based organizations. According to the Association of Certified Fraud Examiners' 2014 Report to the Nations, on average, 5% of an organization's gross annual sales are lost to fraud. The report also indicates that the average case of fraud occurs over a period of at least 18 months before it is detected.

Two theories exists as to why small businesses suffer disproportionately from small business fraud. The first theory is that 20% of individuals are inherently honest. That is, no matter what the situation, those employees will not take advantage of an employer. A further 20% of individuals are inherently dishonest; no matter what they face, these employees are self-interest oriented and looking to work a deal for themselves to the detriment of the company. That leaves 60% of employees who are honest or not, depending on the situation. They may view ethics through the prism of relativism and are not guided by underlying moral values. 

The second theory is that in order to commit fraud, there are three elements that are prevalent in the business. Sometimes known as the fraud triangle, these elements speak to an underlying greed and egoistic motivation that crowds out any ethical standards established by the business. The professional services firm Mondaq identify them as:

1. Financial pressure – a need to generate additional funds either to support a habit (shopping, gambling or drugs, for example) or support an image (breadwinner).

2. Rationalization – the belief that the company or owner 'owes' the employee or that the company has so much, it won't even notice, or that others do similar things so it's ok to join in.

3. Opportunity – the ability (knowledge and or access) to commit the fraud is present due to the experience level of the employee, the lack of internal business experience of the owner / manager, complacent management or weak internal controls.

There are basic steps a small business owner can take to protect his or her assets. First, it's important to establish an ethical culture in the organization. Employees must believe that owner-mangers walk the talk of ethics. An ethical culture is one that promotes honesty, integrity, respect, responsibility and accountability. These values lead to trustworthiness in business and a framework by which all business actions and decisions should be evaluated.

There should be a consistent performance management process whereby employees' work is reviewed and assessed regularly. It can also be a more complex system whereby employees sign a corporate code of ethics annually acknowledging the expectations. Keep in mind, however, that no matter how strong the corporate governance is, an employee can still rationalize the theft by tying the act to 'saving a loved one' or 'just borrowing the funds', thereby avoiding the guilt associated with harm to the corporation.

It's also important to be aware of red flags that may indicate financial pressure. These indicators can include, but are not limited to: suddenly purchasing more material items, suddenly carrying large amounts of cash, frequent calls from creditors, irritable or moody behavior, unnecessary overtime, arriving for work early and staying late, the mention of medical problems, signs of drug or gambling addictions, dissatisfaction at work. Generally after an employee is caught stealing, the owner-manager looks back and recognizes the signs, but it's important to be aware of the signs before they lead to the fraud.

Finally, implementing a system of internal controls that helps to both prevent fraud from occurring in the first place and detect fraud after it has taken place is a key step to undertake for all small business owners. This element is the one the owner has the most control over and yet developing a system of processes, procedures and controls that deter employees from committing fraud is usually overlooked due to a lack of understanding by the owner-manager.

However, no set of internal controls is likely to be effective unless there is a comprehensive set of ethical standards in the organization that helps to set strategies and goals and is used, at least in part, to evaluate employee performance. Otherwise, employees may come to believe that the business-owner is not committed to ethical values and that they should guide operational decisions in all ranks of the organization.

Blog posted by Dr. Steven Mintz, aka Ethics Sage, on February 19, 2015. Professor Mintz is on the faculty of the Orfalea College of Business at Cal Poly San Luis Obispo. He also blogs at: