How Internal Controls Protect Your Small Business from Fraud

Feb 16, 2021 | Best of the Best, Read

Big or small, all businesses are at risk of fraud.

Although it’s comforting to believe that small businesses are less likely to experience fraud, research shows otherwise. Small businesses – or businesses with less than 100 employees – actually have the highest median loss due to fraud – $150,000! They’re also four times as likely to have check and payment tampering and twice as likely to experience billing and payroll fraud.

Fortunately, there are internal controls that can help detect fraud quicker and lower or eliminate fraud losses.

What Is Occupational Fraud?

Occupational fraud is when an employee commits fraud against an employer. This type of fraud typically falls into three main categories: asset misappropriation, financial statement fraud, and corruption.

Asset misappropriation is the most common category of occupational fraud and happens in 86% of cases. It involves an employee using their position to steal or misuse a business’s resources. This type of occupational fraud typically results in the lowest median loss at $100,000 per case.

Corruption is the second most popular, occurring in 43% of cases and creating a median loss of $200,000. This happens when an employee (commonly senior management) misuses their position during a business transaction for personal or company gain. Examples include bribery, conflicts of interest, and extortion.

The third and least common occupational fraud category is also the costliest, resulting in a median loss of $954,000. Financial statement fraud occurs in 10% of cases and involves modifying balance sheets, income statements, or cash flow statements. Employees may commit this type of fraud for personal gain, to get loans for the business, or to keep the business in operation.

Financial Warning Signs of Occupational Fraud

The sooner you can detect fraud, the sooner you can stop its impact on your small business. Many different warning signs point to suspect fraudulent cases, such as inventory increases that aren’t reflective of sales growth and reporting unusually high profits and low expenses at the period end that are difficult to explain. Other warning signs include:

  • Gross margins, operating margins, or revenue growth that is inconsistent with industry competitors
  • Unusual growth in the book value of assets, such as inventory
  • Complex disclosure notes that lack clarity on the actual nature of the transaction
  • Failure to record invoices in the accounting system
  • Writing off loans to senior management or other related parties

Besides financial statements, employees themselves can exhibit suspect fraud behavior. Some of them include living beyond their means, having an unusually close association with a vendor or customer, and displaying an unwillingness to share job duties.

Internal Control Examples

There are many different types of internal controls available. All of them generally fall under four different categories:

  • controls to safeguard assets,
  • controls to ensure financial information is accurate and reliable,
  • controls to ensure compliance with financial and operational requirements, and
  • controls to help achieve business objectives.

Knowing which internal controls to set up and where requires an understanding of the various flows of goods and funds within your business. For example, business areas that are more at risk of fraud will require more stringent internal controls. Review your procedures for sales, cash and bank accounts, accounts receivable, and accounts payable to determine whether you have adequate controls in place.

Here are 8 basic internal control procedures to consider:

Close-up of a calculator and dollar bills above a magnifying glass.

Distribute your accounting and bookkeeping tasks

Having only one person responsible for your organization’s finances presents them with an easy opportunity to commit fraud. Instead, task more than one staff with this task or have someone else review the primary finance employee’s work.

If you’re using a one-stop-shop outsourced accounting agency, ask about their internal control policy and how they achieve segregation of duties. If they’re unable to answer, find a different agency that can.

Stay involved with your business

Even if you have staff in financial positions, you still need to closely monitor your company’s finances. Take the time to look over your monthly reports and the trends in your numbers. Educate yourself on your company’s usual expenses and income so that you have a benchmark.

Separate bill entering and bill paying

The same staff member should not be responsible for both entering bills and making payments. Ideally, the payments should be approved by you or delegated to a senior employee in the business.

If your accounting software cannot accommodate this type of workflow, you may need to use a third-party software add-on.

Review bank statements and check for irregularities

Each month, examine your bank statements and look for anything that seems unusual. The staff member responsible for paying the bills should not be the same person who reconciles the accounts and bank statements.

Have an approved vendor list and request regular vendor reports

Having a select number of approved vendors can help prevent an employee from setting up a fictitious vendor (like their friend) and approving fake invoices. Frequently review the list to see if there are duplicate vendor names or any not authorized by you.

Complete regular backup of data

Check that you have a backup in place for your financial data. Cybersecurity is key: If you’re using cloud applications, it may be automatic but be sure to verify.

Ask a third party to look at your finances periodically

Have an outside accountant review your books. You can also hire a fractional CFO to advise on proper internal controls and oversee these functions for you.

Solicit staff feedback

In half of all occupational fraud cases, employee tips lead to fraud detection. Internal audits, customer tips, and management reviews also lead to findings. Employee surveys are another great way to help uncover suspect activity.

The Benefits of Internal Controls

Like any other business system, having internal controls in place doesn’t completely eliminate the risk of fraud. However, KPMG found that 60% of fraud cases occur because a business has weak internal controls.

Small businesses with fraud awareness training or reporting mechanisms such as a hotline experience faster detection and lower median losses. Having adequate internal controls can also reduce the number of employee errors, saving you time and money.

Plants growing from soil heaps with conceptual words of analysis, regulation, control, risk management, secure, minimize, and opportunity written on cards.

The Bottom Line

Having an accountant or bookkeeper on staff doesn’t release you from playing a key role in your company’s finances. Play an active role in minimizing that risk and promoting best financial practices.

As a small business owner, you can never underestimate the possibility of internal fraud. Be aware of the internal control procedures your business uses and check that they’re working properly. Encourage a non-intimidating workplace that encourages staff to approach you with fraudulent concerns and take each matter seriously.

Even though internal controls are the responsibility of all of your staff, you are ultimately responsible as the business owner. Implementing internal controls as part of your financial strategy can help you manage resources, keep operations running efficiently and effectively, and most importantly, keep your business healthy and sustainable.

Many small businesses struggle with understanding their financials and not knowing how to use that information to plan for their business. Schedule a consultation and we’ll help you understand your finances so that you can make better decisions and have a healthy and sustainable business.

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