How to Deter Employee Fraud

Internal controls

According to the Association of Certified Fraud Examiners’ 2018 Global Study on Occupational Fraud and Abuse, internal control weaknesses are responsible for nearly half of fraud incidents. Setting proper segregation of duties is an excellent first step in strengthening your organization’s internal controls.

When thinking about the number of duties that are involved in accounting, it may seem impossible to segregate them all. This is where the CARR mnemonic can help you remember which duties should be segregated:

(C)ustody of assets
(A)uthorization
(R)ecording transactions
(R)econciliation

For example, if an employee has custody of inventory of fixed assets, that same employee shouldn’t be able to record an entry to write off those assets. An employee also shouldn’t be authorizing (signing) checks, recording those checks in the general ledger, and reconciling the bank account.

Historically, 53 percent of fraud cases have been discovered after a tip or management review. While it may not deter fraud entirely, it may prove beneficial to set up a whistle-blower and/or fraud reporting program in which anyone – whether an employee, customer, or vendor – is able to report an incident anonymously. This may help mitigate the losses to the organization. In fact, fraud losses are 50 percent smaller at organizations with a hotline than at those without one. While management review is critical in any organization, it is especially imperative in smaller companies that cannot maintain the proper segregation of duties.

Employee fraud is committed when three factors are present at the same time: pressure, opportunity, and rationalization. In addition to setting appropriate segregation of duties and taking away opportunity, management needs to know their employees to determine whether there may be any pressure in employees’ lives that could lead to committing fraud. Background checks should be performed prior to an employee hire. Once the employee is part of the team, understanding their personal situation will help you recognize any pressure they are facing. It’s also important to be aware of certain details regarding the employee’s significant other. For example, what is the spouse’s job status? Has the employee or their spouse been diagnosed with a significant illness? Are they underwater on their mortgage?

The reason this is so important is because when an employee commits fraud, it typically starts with pressure in their lives. They see an opportunity to commit fraud, and then must rationalize it. They may do this if they believe they are underpaid or if they see the company being dishonest in other interactions with vendors or customers. Having regular compensation meetings with employees will allow you to discover early on if an employee seems unhappy with their compensation.

Another important area of internal control is setting a tone at the top that demonstrates ethical behavior, including honesty. This tone at the top should include the executive team as well as the board of directors. The board will hold the executive team accountable for their actions, which includes both their competency and their character. The previously mentioned whistle-blower program may also include the board if an employee feels that they cannot approach someone in the management team without retaliation.

Employees observe the actions of the executive team to resolve how they should handle certain situations. For example, if a vendor sends too many items to the company, does the company send back the extra or does it decide it’s the vendor’s mistake and move on? Creating a code of conduct that outlines expected behavior is a great start, but if management doesn’t demonstrate behavior in line with the code, employees won’t take it seriously.

Understanding the fraud triangle factors of pressure, opportunity, and rationalization will help your company take the necessary steps to deter employee fraud.

Katie O. Galaska can be reached at Email or 215.441.4600.

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