High Tech Can Mean High Risk for Small Businesses

By Ron Klein

As headlines continue to abound on financial reporting and auditing problems in the big-business arena, it is easy to forget that most financial fraud cases occur among small businesses. While Fortune 500 companies are prone to infrequent but more expensive forms of fraud, small businesses are prone to frequent instances of defalcation, or misappropriation of assets, by employees or third parties—crimes that account for 80 percent of all fraud cases, according to the Association of Certified Fraud Examiners (ACFE). The fraud losses of small business occur at a frequency of nearly 100 times that of big business, according to the ACFE.

Unfortunately, new technologies that are sometimes erroneously perceived as “magic bullets” against fraud can actually increase a small business’s vulnerability to theft. The most common defalcation scenario involves a small-business owner who is so busy running the operation that control of financial matters has been entrusted to a bookkeeper with an accounting software program. While the programs make bookkeeping easier, they also enable one employee to do all of the bookkeeping work (posting the books, preparing the checks, reconciling the account). As a consequence, internal controls suffer greatly from the lack of segregation of duties.

Many accounting software packages have major shortcomings, such as making it easier to:

• change the name of a payee, date or amount on a check after the fact, with little or no effective audit trail;
  
• enter a prior period adjustment (even in a closed year), which is harder for the owner to spot until it is too late; and
  
• void extra payroll checks, or fictitious vendor payments.

Frauds usually are detected when the perpetrator is out ill or on vacation and the owner or supervisor notices irregularities, such as extra canceled checks, or disbursement checks made out to unknown entities.

Check fraud has been made considerably easier by new technologies like scanners and graphic design software. Such fraud includes stealing and forging checks, writing checks to fictitious entities, altering legitimate checks and printing counterfeit checks. Between 1992 and 1996, as these technologies were becoming increasingly affordable and commonplace, check fraud grew more than threefold, from $4.2 billion to $13.6 billion.

One can also expect to see more fraud occurring in cyberspace. Internet usage reached 640 million people in 2001, with estimates of usage rising to 1.4 billion people by 2005. As a result, some insurance companies are developing more products to insure against e-vandalism, identity theft and e-signature forgery.

CPAs are often expected to detect and prevent fraudulent activities, and they are frequently held liable for the damages. The Statement on Auditing Standards No. 82 (AU 316.10) confirms the profession’s commitment to detecting and reporting fraud in audit engagements. At the same time, the Statement warns that “even a properly planned and performed audit may not detect a material misstatement resulting from fraud” due to the “concealment aspects of fraudulent activity, including the fact that fraud often involves collusion or falsified documentation.”

Given the difficulties in detection, it becomes all the more important for accountants to help their clients practice effective fraud prevention. Defalcation can go undetected for long periods when it is being committed by trusted employees. There is a natural human tendency to assume that one’s associates and workers are basically honest, and this assumption can lead to a climate of denial in which defalcation is difficult to prevent.

There are several warning signs that a person may be at risk of committing fraud. These include:

• Unresolved financial problems
  
• Living beyond one’s means
  
• Compulsive gambling
  
• Alcohol or drug abuse
  
• Close relationships with suppliers, leading to collusion
  
• Never taking a vacation
  
• Working late all the time
  
• Being secretive about work papers and records

Also, employees who feel unfairly treated and harbor resentment toward their employers often rationalize defalcation as “getting back what they owe me.”

Accountants who alert their clients and provide strategies for lowering defalcation risks do more than reduce the likelihood of lawsuits. They also help their clients avoid the time-consuming, costly and sometimes devastating results of internal theft.