Sunday, May 1, 2011

The Impact of Fraud on Small Business

Businesses of all sizes are susceptible to Fraud but small businesses are particularly vulnerable because they often lack stringent internal controls to prevent fraud. Losses due to fraud in smaller businesses often go unnoticed or are attributed to lower sales. The current recession has led to an increase in fraud as employees supplement their worsened economic situations through fraudulent means. The Association of Certified Fraud Examiners reports in the Report to the Nation on Occupational Fraud and Abuse  that the median loss suffered by organizations with fewer than 100 employees was $200,000, a figure higher than the median loss in any other category including the largest organizations.  

Highlights of the report include:
  • Check tampering and fraudulent billing were the most common small business  fraud schemes.
  • The typical fraud in the study lasted two years from the time it began until it was caught by the victim organization.
  • The most common fraud scheme for businesses of all sizes was corruption, which occurred in 27 percent of all cases. Fraudulent billing schemes happened in 24 percent of the cases.
  • Financial statement fraud was the most costly category with a median loss of $2 million.
  • Occupational fraudsters are generally first-time offenders.
  • Fraud perpetrators often display certain behaviors that can indicate possible illegal activity. The most commonly cited red flags were the criminals living beyond their apparent means, or experiencing financial difficulties,
  • In financial statement fraud cases, excessive company pressure to perform well was a contributing factor.

The implementation of anti-fraud controls appears to have a measurable impact on an organization’s exposure to fraud. Many of these controls may seem like common sense but they are very effective when properly employed.

Steps to reduce fraud:
  • Let employees know you are looking for fraud.
  • Conduct background checks and drug screenings for people handling inventory and money.
  • Maintain strong internal controls.
  • In retail locations use video camera monitoring at cash registers and where inventory is stored.
  • Conduct surprise audits.
  • Use a third-party hotline to solicit tips from employees: customers and vendors are also potential sources for tips.
  • Establish a written fraud policy: a formal fraud policy should be established and communicated to employees through orientation, training, and other ongoing communication. A policy does not have to convey a lack of mistrust towards employees; a more productive approach would be to make employees part of a fraud prevention initiative by making them aware of ways to spot fraud and what to do if they suspect fraud.     
  • Require mandatory vacations.

Useful Links

A company's creditworthiness is determined by what are known as the four C's of credit: character, capacity, capital, and conditions. The components of the 4 C's can be found can be found in the company's credit report.
Character includes factors such as size, location, number of years in business, business structure, number of employees, background of principals, willingness to share information, media coverage, legal history, stock performance, and comments from references.
Capacity assesses the business' cash flow situation which is a measure of the company's ability to pay its bills. It also includes the structure of the company's debt, and the existence of any unused lines of credit. Any defaults must also be disclosed.
Capital assesses whether a company has the financial resources repay its creditors. In general, this portion of the credit report contains the most objective information reviewed by credit analysts. The most consideration is given to information from financial records and statements such as working capital, net worth, and cash flow.
Conditions consider the external factors surrounding the business:  market fluctuations, industry growth rate, political/legislative factors, etc.

 Capacity, Condition, and Capital helps answer the ability to pay question.  However, these three Cs of Credit do a very poor job of answering the more important question of Willingness to Pay. Character does a better job of addressing the question of willingness to pay, which I believe, is the most important "C". The company's overall reputation as well as the history and reputation of the principals are perhaps the best indicators of the company's character.

Useful Links:

How does the extensive use of credit cards by their customers affect small businesses?

For entrepreneurs, the benefits of credit card use by customers includes the fact that credit cards are an important source of financing and have enabled a vast expansion in the market for the goods and services they produce. Credit cards also guarantee payments and have become a critical instrument for helping entrepreneurs weather the economic recession. Credit cards also enhance efficiency for small businesses, and eliminate major costs that they would incur if they had to establish their own credit and billing systems. 

While credit cards have offer many benefits to small business they are not without their disadvantages. The costs associated with credit cards can be a concern, especially if the business is operating on slim margins. Many credit card processing accounts will charge a discount fee per transaction. This is a percentage of the total purchase amount that will be charged to the retailer for processing the credit card transaction. In addition, many will also charge a per transaction fee of 20 cents to 50 cents. Some merchant accounts will also charge a monthly, quarterly or annual fee. Due to the variation in fee arrangements it is a good idea to shop around and find the best credit card processor based on the needs of the business. It is also important to note that many times, the processor will charge for every transaction that is made, including for refunds. Businesses often complain that the charges by the card companies are unfair. A common complaint is that the business owners are the ones paying for the rewards programs advertised by the credit card companies. Business owners also complain that credit card companies use rewards programs to entice consumers into using credit cards instead of debit cards. Since credit cards costs businesses more to accept so business owners are often unhappy with this practice.    


Three Ways for Reducing the Risk of Credit Customers

1. Set Up a Credit Policy
With customers losing their jobs in our current recession and getting behind in payments or even defaulting entirely it's time for small businesses to examine their credit policies. The following simple steps can help improve a company's credit policy and improve the percentage of customers who pay on time.
1. Print out or buy credit applications.
2. Have the applications available at your business, or on your website.
3. Have every new credit customer fill one out.
4. Mail one to every existing customer with a stamped, addressed envelope.
5. Check ALL references.

2. Implement Your Credit Policy
It’s one thing to set up a policy, it can be quite another to enforce the policy. The business owner should decide at the beginning of the process of setting up the policy how they will handle customers who do not pay.
·        Do you want to revoke that customer’s credit?
·        Do you want to freeze until the past-due balance is paid?
·       Will you call the customer or mail a letter?
·       Will you involve the person who made the sale?

It’s important to refer to your policy when answering these questions. Consistency is vital to an effective credit process.

3. Review and maintain the policy. It is important to make sure that you don’t get into the habit of letting your receivables become overdue. Monitor your approved customer and make sure the credit applications stay up-to-date, as well as a credit limit that works well for them and for you. If anyone is past due, take steps immediately to resolve any issues.

Good review procedures include:

·        Reviewing your accounts receivables monthly.
·        Stay motivated to collect as much money as possible.
·        Stay focused; don’t let excuses veer you off track.



    1. Hello Rick,

      I think you have written a very helpful article on things one can do to help prevent fraud, and recognize it if it happens in his business. What surprises most is that fraud is more prevalent in small business than in big corporations. It seems as if it fraud would go unnoticed easier in a big company than in a smaller one. However, regardless of where it happens the most, it is important for a business owner to do all that he or she can to prevent it from happening.

    2. I think there is great impact in the study results from the Association of Certified Fraud Examiners. I appreciated you including the highlights from their report.
      I do have to ask why mandatory vacations would be a way to prevent fraud? Keep employees happier so they don't commit fraud? To change up routine? Montior differences in process when someone is absent? I'm curious!

    3. Mandatory vacations of at least a week in duration can be a good way to uncover fraudulent behavior. Whoever does the job of the perpetrator has a chance of discovering the fraud. Opening mail or bills without the perpetrator in the office also leads to detection. I worked for Wachovia for several years with a mandatory vacation of 5 consecutive business days as a requirement.

    4. Great post. Great ideas to help prevent fraud. I liked the idea of having the employees feel they are part of the fraud prevention process.