|EXECUTIVE SUMMARY |
- A PRACTITIONER FOUND ONE RISK OF A STRONG economy is that small business clients may loosen their internal controls, discovering fraud or theft only long after it has happened.
- THE MOST VULNERABLE ARE PRIVATE COMPANIES in the $10 million to $30 million range because they are large enough to lose substantial sums but often not yet big enough for adequate finance departments. Not even very small companies are exempt, however.
- EMPLOYEE RESENTMENT, MISPLACED TRUST and technology are elements that make fraud possible. Other factors include heavy cash businesses; companies with 10 or fewer employees, because controls are often weak; and employees with check-writing privileges.
- CPAs CAN CREATE A PRACTICE OPPORTUNITY by alerting small company owners of the potential problem and describing how their firms can analyze and improve their internal controls.
|ANITA DENNIS is a JofA contributing editor. |
ot long ago, CPA Stanley Person uncovered an embezzlement at a small company client. The thief was a veteran employee who had oversight of the company’s finances. Why had the fraud gone undetected for several months? “The company was doing so well nobody noticed it was losing cash.” According to Person, whose 15-person New York firm serves mainly small businesses, one risk of a strong economy is that small clients may loosen their internal controls, thus discovering fraud or theft long after it has happened.
|Check Them Out
Here are some ways business owners can find out more about the background of employees:
- Driving record search.
- Consumer bankruptcy record search.
- County criminal record search.
- Multi-county criminal seven-year address record search.
- Professional license check.
- Employment verification.
- Employment credit report.
- Education verification.
Source: e-VERIFILE.com .
Good times have not necessarily made life easy for small company owners, Person says. “People’s dreams expand as the economy does. They look around and see that their next-door neighbor has just become a multimillionaire. They’re chasing the Golden Fleece much more than they used to, and they forget to pay attention to the basics.”
Person says the most vulnerable are private companies in the $10 million to $30 million range because they are large enough to lose substantial sums but often not yet big enough for adequate finance departments. Since they aren’t public, they aren’t having the audits that might uncover such problems. Even the smallest companies aren’t exempt. “It can happen at a $2 million business with smaller amounts—say, $100 to $200 a shot.”
Could it happen to your clients? Here are some insights into why it happens and suggestions for services CPAs can offer clients to help them avoid it.
Person identified a number of factors that contribute to internal fraud:
Employee resentment. In one case, a client was showing Person his new luxury car when a key employee came in to ask for a small raise. The owner refused, saying he couldn’t afford it. “You just set yourself up for fraud,” Person told him. Employees who spend years taking care of mundane details can become resentful if they are left out when business booms. CPAs should warn clients to be sensitive to employee hopes and expectations—or at least to avoid showing off on the job if they don’t intend to reward workers with improved pay, working conditions or perks. “Fraud doesn’t happen in a vacuum,” Person says. “Someone doesn’t just wake up and say, ‘I’m going to start writing checks to myself.’ The owner has to become a mark.”
While they may be resentful, not all embezzlers can be identified by their sour personalities. “The people doing the stealing are usually very nice to the accountant,” Person observes. “They’ll say to the CPA, ‘Don’t worry, I’ll take care of those bank reconciliations.’”
Misplaced trust. Very often in smaller businesses one long-term employee bears an inordinate amount of financial responsibility. “A company may not have the proper segregation of duties,” says Person. “We’ll look at it and see that Barbara Jones has too much control over cash. She opens the mail, she makes up the deposit slips, she deposits the money in the bank and she signs checks in the absence of the owner. When we bring it to the owner’s attention, he or she will usually say, ‘Why, Barbara Jones has been with me forever!’” While the person may be completely reliable, it makes more sense to distribute these financial duties among more staff members.
Technology. Electronic transfers and computerized check writing make a thief’s work that much easier, according to Person. In one situation he heard about, a worker was paying off her own debts with wire transfers from her employer’s account. The transfers turned up on the company bank statements, but the person who received those statements was the worker herself. “If the business is doing $40 million to $50 million a year in sales and making purchases of $30 million a year, no one is going to miss, say, $10,000 a month, because it’s not a big enough percentage to notice,” Person says.
Besides companies that do a lot of wire transfers, others that can fall victim to fraud are heavy cash businesses, since cash is easy to misappropriate, and those with 10 or fewer employees, because controls are often weak. Another potentially fatal mistake involves company officers who allow others to sign checks or who leave blank checks for employees to use. “Owners should look at checks, check registers and bank reconciliations regularly,” Person advises, but should not review them only at predictable intervals.
They should also keep a tight rein on cash. “Some businesses leave a lot of money sitting in bank accounts without activating a sweep of the funds into another investment or savings program,” and that cash is ripe for misappropriation, Person says. Young businesses are also in danger. “The most poorly organized businesses are newly successful ones because they haven’t grown into their success,” he says. “Maybe they’re run by eight college classmates who only trust each other,” making it easier for a thief among the group to operate and harder for an outsider to impose financial discipline.
|How to Get Started in |
Internal Control Consulting
- Consider which clients are the most vulnerable to fraud or poor controls.
- List what you believe are their problem areas. For example, do they have a cash business? Does one employee have too much oversight responsibility?
- Make clients aware of their situation by sending them a letter detailing the possible problems and how your firm could solve them.
- Follow up with client meetings to explain the potential engagement further.
Person’s firm turned the problem into a consulting niche. After he found the embezzlement, Person made a list of 25 small business clients of similar size in terms of sales and employees, that might fall victim to the same type of crime because they shared some of the attributes mentioned above. He wrote a memo outlining the importance of segregation of duties and describing how his firm could analyze and improve their internal controls. In the next year, he picked up six engagements.
The CPAs carefully examine how duties are spread out among employees and how checks and confirmations pass through the office, even using flowcharts where necessary to illustrate workers’ activities. Person says that, among small businesses he’s worked with or heard about, “this is the worst time for internal control I’ve known because of the economy and technology.”
Not all the problems he’s uncovered involved crimes. One client had a $4 million business and 16 employees, including a controller. The owner scoffed at Person’s memo when he first received it because he believed the controller was above reproach. The company typically makes a high volume of payments to outsiders, so Person offered to have a member of his firm scan the payments for three days. While the CPA firm found no sign of dishonesty, it uncovered 12 accidental double payments in the three-day span—despite the fact that the owner reviewed the controller’s work. The firm designed a more effective system that didn’t rely on the busy owner as the only backup for a key employee’s work.
“Most of these losses would not happen in less prosperous times when people are focusing on their businesses rather than on making more money,” Person says. The owner of the business that was making the accidental double payments “loves the stock market. He’s always on the phone to 14 brokers because he has the time now that his business is booming.”
Person believes owners are key in the fight against internal control failures. In a small business, “all fraud starts with the owner. It happens because the owner has been too trustful or is too distracted chasing more business or enjoying success once it happens.” CPAs can make these small company owners aware of how vulnerable they are and how their problems can be addressed.
|Advice for Good Times and Bad
B esides looking out for weak controls, another smart move during peak periods is to plan for a downturn. Remember all things must pass. Not every part of the country has benefited from a strong economy, and in Hawaii, CPA Rodney Harano says many of his clients outside the tourist industry have faced bleak sales over the past few years. Since boom times almost inevitably go bust, Harano—whose five-person Honolulu firm serves mainly construction contractors, professional service providers and retailers—offers some advice on how to prepare for a less robust economy, advice he believes is valuable for clients no matter what their financial situation.
- Stockpile cash. “Positive cash flow is the fuel of any business,” Harano says. “Clients that have a lot of reserves are able to withstand a downturn.”
- Appreciate the benefits of moderation. “I have had clients who bought themselves luxury cars only to have to sell them later,” he says. If clients are funneling all their spare cash into new cars, boats or other luxury items, it’s prudent to remind them they may need some kind of cushion if the economy sours.
- Review credit policies. Harano advises clients to do thorough credit searches before granting credit. “Only do business with people you know will pay you.”
- Establish a good working relationship with a bank. The best time for a small business to establish a line of credit is when sales are strong and the company doesn’t really need credit, Harano notes. That allows the business time to develop a good credit history and a solid partnership with a banker. Both steps are easier when the business is in good financial health.
- Keep the lines of communication open with employees. “Let them know in general terms when times are tough,” Harano advises. That way, employees will be prepared if cutbacks are needed. “I’ve had clients cut their business hours from 40 hours a week down to 24,” he says. Because the owners warned them in advance of the change, employees were less resentful and more willing to support the business.
- Remember that the strongest and the smartest survive. Some of Harano’s clients have ultimately benefited from a bad economy because their competitors go out of business. Small businesses that follow sound practices during a strong economy are more likely to weather bad years.