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Valuation Advisor - February 2018

 

Ignoring Warning Signs May Be Detrimental to Your Business

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A circuit breaker shuts off in your home. You open the circuit breaker box, determine which circuit breaker was tripped, and flip the circuit breaker back on. Most people give no thought as to why the circuit breaker shut off, or consider whether there might be an issue with the electricity. However, there is a reason the circuit breaker faltered, and that should be taken as a warning sign that something is amiss. It could be as simple as having plugged in an appliance, such as a toaster, that pulled too many amps for the circuit. It could, however, be a more serious situation. A short in the wiring hidden in the wall could be disastrous. Prudence would suggest that the cause be investigated.

This same philosophy applies to warning signs that appear in your business. Much like the circuit breaker, warning signs should always be investigated. However, you must first know how to recognize warning signs when you see them.

One common example is fraud by individuals who take advantage of their role as fiduciaries; those responsible for protecting the very assets they steal. According to the Association of Certified Fraud Examiners’ 2016 Report to the Nation, the median loss caused by the occupational fraud cases in their study was $150,000.1 While significant for any business, theft in this amount can be truly devastating to a small business.

A hypothesis known as “The Fraud Triangle” was developed by sociologist and criminologist Donald R. Cressey, while researching his doctoral thesis in the 1950s, to explain this type of fraud.2 Still employed by criminologists today, Cressey’s Fraud Triangle has three main points: opportunity, motivation, and rationalization.

Opportunity may be perceived or real. It could be as simple as one person performing two procedures and having the ability to maneuver and alter their actions between the two procedures. The perpetrator may also believe that the fraud being committed will be hidden and, therefore, the scheme cannot be caught.

Like opportunity, motivation can be real or perceived; it is most often fueled by financial need. Some clear examples of motivation are drugs, alcohol, gambling, medical bills, extramarital affairs, and greed. Some of these motivations have been identified as diseases and should be treated with medical care or other techniques. When individuals feel they are backed into a corner and do not know where or how to reach out for assistance, they may relieve their pressure by stealing.

Rationalization is the perpetrator’s mechanism to reconcile his or her actions with their personal morals in order to justify the behavior. It is the perpetrator’s way of saying that it is okay to commit fraud.

For example, assume your bookkeeper, controller, or chief financial officer has a gambling habit. She may rationalize that the fraud she commits is temporary, only to recoup previous losses, and that she is only “borrowing” the funds, which she plans to return. Other rationalizations may include: “the company is making enough money,” “my contribution to the company is greater than my salary,” and “my bonus was insufficient for the effort I put into my work.”

Remember, a warning sign is just that. It does not indicate that a fraud is occurring, but that a fraud may be present in the company. The following are some red flags that should be addressed seriously:

  • Employee lifestyle. Is this employee driving a vehicle, dressing, or residing in a manner that would not be supported by the salary being earned? The employee may have been a beneficiary to an inheritance, won the lottery, or have a life partner who is the major wage-earner for the family. However, barring such exceptions, an employee’s lifestyle can prove to be a large tipoff that a fraud exists.
  • An employee who does not take vacations and/or is the first to arrive and last to leave the office. These employees are very protective of their work because they may be hiding a fraud and want to keep their work from other employees. Consequently, they do what is necessary to protect their “territory.”
  • Employees who are opposed to cross-training others about their responsibilities and duties. These are typically the same employees who do not take vacations and are the first to arrive and last to leave the office. They may claim that they have been doing their job for years and do not like change. Additionally, they may explain that any changes to their job would only “disrupt the value and efficiencies” that the employee has developed over the years.
  • Is there a “fire drill” mentality in the company? Is there always an expressed need to get everything completed “now”? If yes, then certain deceptive activity may be taking place. Normal operations and standard procedures are more difficult to follow when in crisis mode. While it is natural to concentrate on the big picture in a crisis situation, putting details aside temporarily, paying close attention to details is most essential when it comes to discovering fraud. For example, if an employee is asked to provide a report pertaining to transactions of the business, does the report take longer to prepare than would be expected? There could be many reasons for this; however, it could also indicate an employee is attempting to “cover up” fraudulent activity.
  • Employees who consistently take their laptops home may be concealing fraud. Such employees may want to ensure that their computers will not be subject to scrutiny. More often than not, perpetrators will look to protect their space, including their electronic files.
  • Employees who decline promotions and/or transfers. Conventional wisdom would suggest most employees would welcome advancement, additional compensation, and responsibility. There are good reasons why an employee might decline a promotion and/or transfer; however, the fact that an employee declines new employment opportunities could translate into potential wrongdoing.
  • Lack of effective internal controls. Internal controls are put into place to safeguard the company’s assets and assure the accuracy, consistency, and reliability of the recording of transactions. Effective internal controls must be in place for a company to protect itself. A lack of segregation of duties could be the very essence of the opportunity that the perpetrator needs to commit fraud. The company may need to increase its number of employees to allow it to segregate various functions; however, there are other procedures that can be implemented to accomplish the safeguarding of assets while avoiding an increase in the cost of labor.

Safeguarding assets and protecting profits are important objectives for all companies. A company should place itself in the best position possible to prevent fraud from occurring. Ignoring warning signs only places the company at risk, which could lead to devastating long-term effects. Do not allow ignored warning signs to be the beginning of the end for a thriving business.

SOURCES

1. Report to the Nations on Occupational Fraud and Abuse, 2016 Global Fraud Study, p.4.
2.Joseph T. Wells, Corporate Fraud Handbook, Third Edition (Hoboken, New Jersey: John Wiley & Sons, Inc., 2011), p. 8.

 
Related
Arlen Lasinsky, Director, Advisory

Director
Advisory
Deerfield, IL
 





 
 
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