Question: How do internal controls such as separation of duties, redundancy, and centralized processes discourage employees from committing fraudulent acts why are some small businesses more susceptible to employee fraud and theft? Explain. The High Cost of Theft and Fraud Owners and managers want to believe that their employees are honest, hardworking, and have only the company’s best interests at heart. And most employees do fit that description. There are some, however, who feel that they are entitled to an occasional box of pens or can run off unlimited copies from the company machine. These sorts of unintentional perks may go unnoticed by management, but they do add up. And the reality is that few companies recognize the deep bite that employee theft—big or small—can take out of a company’s profit margin. That is, until a major incident makes headlines or cuts into the company’s bottom line. Take a nationally known beverage retailer, for example. This Pacific Northwest business found success with premium coffee and expanded rapidly—so rapidly that it perhaps outgrew its internal controls. Managers no doubt kept an eye on employees to make sure they did not pass out free beverages to their friends. But despite internal controls, in 2001 an employee created a fictitious consulting firm, submitted invoices to the beverage retailer, and arranged for the retailer to send payments to a special post office box. In less than a year, this employee embezzled $3.7 million, using the money to buy a collection of automobiles, motorcycles, a yacht, real estate, three grand pianos, and a variety of other luxury goods. That same year, a leading boat manufacturer filed suit against its former CFO, accusing him of embezzling $14 million in company funds over 16 years to finance his own stock purchases, to run three businesses, and to pay off personal credit card expenses. In 2005, a national office supply retailer began the year by firing four employees who were believed to have fabricated documentation for $3.3 million in invoices to the company. This fraud was uncovered only when a vendor complained that kickbacks were being demanded and that bills were being falsified. Fast-forward to 2009 when a mind-boggling case of e mbezzlement hit a family-owned business in Milwaukee. A well-respected senior employee was indicated for embezzling $31.5 million over a five-year period. The firm’s credit card company, American Express, was the first to identify the unauthorized transactions b ecause it noticed that the employee was withdrawing large sums of company funds to pay off her personal credit card account. Ms. Pressman felt that this created a conflict of interest, she confronted her supervisor about it. Her supervisor became angry, gave her negative performance evaluations over the next year, and she was subsequently terminated for poor performance. During the previous three years, Ms. Pressman’s evaluations had consistently indicated that her performance exceeded the company’s expectations. Mr. Mansfield Mr. Mansfield was a technician in the machine shop of Millfield Corporation. During his employment, he met at lunchtime, during breaks, and after work with employees, attempting to persuade them to start and support a union. After six months of meetings, Mr. Mansfield was informed by his supervisor that he was fired. He was told that he had violated union organization procedures and was using the company premises without permission to organize a union. Therefore, because he had violated the rules about union organizing, he was terminated. Are these isolated incidents? Not according to the Association of Certified Fraud Examiners (ACFE). In its “2010 Global Fraud Study,” the ACFE investigated fraud cases in the United States and in over 100 other countries and reported that organizations lose 5 percent of their annual revenues (or, approximately $2.9 trillion) to fraud. The ACFE study notes that fraud can happen at any level of a company, from the mailroom employee to the account executive to the senior executive. While fraud is more prevalent at lower levels, the damage is usually more substantial when high-level executives are involved. The ACFE found that the median loss when owners/executives are involved ($723,000) was more than six times the median loss caused by managers ($200,000) and more than nine times that involving lower-level employees ($80,000). Despite the examples cited above, losses are not limited to major corporations. Small businesses are often the hardest hit by employee fraud. Almost half of the fraud cases s tudied by the ACFE involved small businesses, with the median loss pegged at almost $100,000, a difficult amount for any company to lose, let alone a small business with limited resources. An effective control is to have a separation of duties whenever employees handle money. For instance, if one employee reviews invoices and authorizes payment, then a second employee should write and send the check, and yet another employee should reconcile the bank statements. In addition to a separation of duties, redundancy is also a powerful control. This means having more than one person look at the same transaction. For example, checks should be cosigned rather than authorized by only one person, and multiple employees should have responsibility for overseeing specific bank accounts preventing one employee from “lapping” or moving funds from account to account ahead of any audit so that no irregularities are detected. Centralized processes also allow tighter control. When procurement is centralized, employees in satellite offices are not able to buy more than needed and then resell or return items for cash. When inventory is centralized, employees know that the company’s assets are tracked and monitored. Internal controls should also be used to detect fictitious vendors. In addition, processes should be in place to verify that vendors exist, that they are performing their duties for the company, and that payment is in line with the services provided. While internal controls are vital, they are not the only way to detect and to discourage employee fraud. In fact, today more fraud is found by accident than through the strength of internal controls. However, neither tops the list of how fraud is detected. The ACFE found that almost 40 percent of fraud is discovered through tips, the majority of which come from employees. Customers, vendors, and anonymous callers are also good sources. Another mechanism for controlling employee fraud is to institute careful hiring practices, although this approach is less effective than strong internal controls or a forum for tips. Unicru, a company that specializes in helping other companies recruit and hire employees, has found that 70 percent of “internal shrinkage,” or theft by employees, is carried out by people who are on the job for less than 30 days. Eliminating job candidates who have a track record of holding prior jobs for fewer than 90 days is one way to limit exposure to shrinkage. Checking job applicants for criminal backgrounds makes good business sense. However the ACFE found that only 15 percent of the fraud-committing employees had a previous conviction. In addition, employment-screening processes may vary from country to country, which can be challenging for large, multinational firms. Weeding out bad apples is important, but not nearly as important as setting up internal systems to discourage fraud before it begins.