How do internal controls such as separation of duties, redundancy, and centralized processes discourage employees from committing fraudulent acts?

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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

embezzlement 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

because it noticed that the employee was withdrawing large sums of company

funds to pay off her personal credit card account.

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

studied 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.

1. How do internal controls such as separation of duties, redundancy, and centralized processes

discourage employees from committing fraudulent acts?

2. Why are some small businesses more susceptible to employee fraud and theft?

Explain.

3. Given that the ACFE “2010 Global Fraud Study” reported that employee tips were

the most common way that fraudulent acts are discovered, how can an organization

encourage honest employees to report fraudulent behavior committed by co-workers,

supervisors, clients, or vendors?

4. How important is it for an organization to have a code of conduct that defines fraudulent

behavior and what happens to those individuals who commit such acts?

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