Financial Matters

by Steve Davis

last updated 23/07/2009

Steve Davis is a security consultant who has advised clients in the US, Eastern Europe and Australasia. He is a consultant to the NZ Retailers Association and works with franchisors and franchisees throughout New Zealand.

Keeping Your Business Safe From Fraud - Part One

by Steve Davis

last updated 23/07/2009

Steve Davis is a security consultant who has advised clients in the US, Eastern Europe and Australasia. He is a consultant to the NZ Retailers Association and works with franchisors and franchisees throughout New Zealand.
Fraud is very much in the news in franchising right now. Steve Davis looks at common types of fraud which can affect both franchisees and franchisors and suggests ways of preventing them

Fraud is a topic that most business owners don't like to think about too much. Considering the possibility of fraud in your own business smacks of distrust and suspicion of the people you employ and rely upon to manage or operate your business. They may be people whom you hold in close regard, apparently hard-working and honest, people you socialise with sometimes and believe you know well. Thinking about them cheating you - stealing from you - just doesn't seem right.

But common prudence, good management and, above all, the sheer prevalence of fraud in New Zealand business dictates that it is something every business owner must think about. Consider the following statistics:

  • According to KPMG's 2006 Fraud Survey, 53% of New Zealand businesses have experienced at least one case of fraud. The average loss was $479,000. These are only the detected frauds; many experts consider that maybe only one out of every fifty frauds is detected.
  • 63% of reported single fraud cases involved sums greater than $200,000. In 42% of major frauds, none of the money or goods stolen was recovered. 
  • 14% of employees engaging in fraud had a history of dishonesty with other employers. Good background checks might have prevented the hiring of these employees.

If those figures seem startling enough, consider this: according to an Otago University study, out of a sampling of 12,500 employee theft and fraud incidents, only 3.3% of cases were even referred to police. The real problem is many times larger.

  • 39% of business respondents believed fraud was ‘really only a problem for larger businesses.'  
  • A ‘no-names' employee survey published by Southern Today magazine in July/August 2006 found that 79% of employees admitted anonymously that they steal from their employers, either in the form of straight theft or fraud, or are willing to steal if given the opportunity.

Small business owners often believe they couldn't fail to notice an employee making off with $200,000. However, this is highly possible. Most frauds are carried out by long-term employees who are sufficiently experienced, knowledgeable - and trusted - to get away with it for many years. While most small business frauds are in the $30-70,000 range, in two Christchurch cases single employees stole $300,000 each - one from a fruit and vegetable shop, the other from a rural dairy. Fraud can be - and probably is - a problem for any business.

The Causes of Fraud

Fraud can have many causes. The number one motive is obviously simple greed, the desire to enjoy a better lifestyle at someone else's expense. The second-ranking motive is financial pressure, often due to living beyond means and overuse of credit. Other reasons include gambling addictions, drug usage, revenge-based motivations and even just a desire to ‘beat the system.'

But fraud is not just about the criminals - it's about the companies they work for, as well. KPMG observed in their survey that a common factor in frauds was a lack of senior management commitment followed by a poor ethical culture within the organisation generally. If management is seen by employees to harbour any dishonest inclinations, such as overcharging clients or other dishonourable practices, then this makes it easier for any dishonest employees to rationalise their own frauds against the business.

Another factor that abets fraud is a frequent absence of fraud awareness and controls by management. Post-mortem analysis of internal frauds usually reveals (in painful clarity) just how easily those frauds could and should have been prevented by more alert management, improved procedures and controls, and closer monitoring of critical accounting and operational processes.

Typical Frauds

Many frauds revolve around accounting systems and banking. One restaurant owner discovered that over a period of two years, there had been a series of ‘discrepancies' between the daily till totals and the banking deposits to the tune of around $60,000. The absentee owner had trusted his manager and only read their weekly reports of sales and bankings. He had never received the original till tapes or deposit slips so as to be able to audit and reconcile them.

Frauds may also be committed against the business by outsiders (often customers, contractors, and suppliers), on the company's behalf (as with managers defrauding their own clients and investors) or by others such as franchisees - the under-declaring of sales in order to reduce royalty payments is as much fraud as any of the above. However, the majority of commercial frauds are committed by those within the business.

There are many types of fraud. Some of the most common involve payroll (‘ghost' employees or falsified hours worked); travel expenses; sales commissions; collusive fraud (by managers or purchasing officers receiving kickbacks from suppliers); retail POS and credit frauds; computer frauds; petty cash; ‘foreign orders' (where an employee uses company time, equipment or materials for ‘on-the-side' jobs); abuse of company accounts/credit cards; conflict of interests (employee diverts work/product deliveries or reduces debt balances to benefit relatives or friends) and many more.

False invoicing is common - who has not read news stories of long-term secretaries of some sporting club found paying bogus invoices to dummy companies and diverting the money into their own bank account? When the owner of a mini-supermarket was away on other business, the manager frequently paid her brother-in-law for emergency refrigeration repairs and maintenance that never happened.

In a recent accounts payable fraud in a large bookstore, the accounts girl would wait until the manager was just rushing out the door then accost him with a fistful of cheques to sign. Included in the cheques would be one for an office supplies/machines and furniture warehouse - a regular supplier. The clerk would then personally go down to the supplier's store, select items to the value of the signed cheques, take them home and sell them at discounted prices to friends and on auction websites.  This went on for two years and $14,000 worth of products until the supplier advised the manager over a faulty product recall for an item the bookstore did not have.

Inventory fraud is often committed to mask theft of product, supplies, merchandise, etc. In one retail hardware store, an easy-going and somewhat timid manager was unable to control rampant shoplifting and employee theft. Fearful of losing his job, he consistently manipulated and falsified the store's annual stock-takes to hide the huge stock losses.

Security reviews of retail operations almost invariably reveal that they are at much greater risk of retail fraud than they realise. Frauds and manipulations at point-of-purchase are widespread and it's going on right under the noses of hundreds of franchisees as you are reading this article. Modern POS systems often have ‘fraud loopholes' that actually make manipulation easier in some ways. However, most systems usually provide summary data and exception reports that, if reviewed discerningly by owner-managers, can at least ring an early warning bell to cashier manipulation.

Indicators of Fraud

When internal theft or fraud is committed, the money or merchandise must be transferred in some way. As this happens, some deviation from normal patterns also frequently occurs. This may be a small irregularity, discrepancy, omission, a curious ‘white-out', a figure written over an erasure, a larger-than-usual payment to a supplier, a different-looking signature, a computer log-on or a register void at a strange time. Alternatively, it may involve uncharacteristic behaviour by someone, something ‘out of sync' or something that simply arouses curiosity. In hindsight, there are always clues.

These clues may be obscured amongst paperwork or in a computer, with the thief counting on them going undetected on the basis that no-one audits those figures or has the time or inclination to follow them up. Detection in manual systems is actually easier, as a physical trail of documents, signatures, cash records and inventory is less able to be altered or erased. Look for:

  • Missing files or documents, or items so badly mis-filed that error is unlikely;
  • Documents, disks or logs which mysteriously turn up later;
  • Documents where original and carbons do not agree;
  • Product type or quantity errors;
  • Obsolete documents used, or documents with no or out-of-sequence control numbers;
  • Unexplained alterations in inventory/shipping/accounting or other records;
  • Illegible signatures or possible forgery;
  • Excessive numbers of voided or substituted documents;
  • New or apparently unwarranted or increased purchases, or altered arrangements or terms with certain suppliers;
  • Payments to new or unknown service contractors;
  • Sudden rise in bad debts, collection costs or unusual expenses.

Indications may also arise through a wide variety of incidents or conditions, often connected with merchandise, documents and records, sales transaction data, inventory or financial data, personal behaviour and employee activities, customers and suppliers. A few common and typical examples include:  

  • Unusual rise in inventory shortages/variances;
  • Reserve/stockroom merchandise missing/found in wrong box;
  • Goods or packaging materials discovered hidden or in unusual places (near exit doors, in toilet, concealed location, found with trash, etc.);
  • Over-age goods left in receiving area;
  • Frequent mis-location/mis-stacking of high-value or desirable items;
  • Rise in short-shipments/damages from certain suppliers;
  • Rise in ‘errors' or ‘confusion' in goods received/shipped records;
  • Increase in complaints from customers;
  • Extra goods found wrongly placed in out-going orders;
  • Mislabelled shipping orders;
  • Company delivery/service vehicle odometer readings do not tally with claimed runs or jobs;
  • Production figures do not tally with raw material consumption;
  • Rumours of your merchandise being sold elsewhere at bargain prices.

Changed or unusual personal behaviour can also be an indication of fraud. Some things to look for are employees who: 

  • Complain about/frequently violate/shortcut house or security procedures and rules;
  • Appear to be living beyond known means;
  • May have drug/alcohol/gambling/financial problems;
  • Try to take advantage of suspicious damage to desirable/high price items;
  • Have unusual interaction with certain customers, delivery drivers or supplier's reps;
  • Have out-of-character relationships with other employees (not evident on the job);
  • Have outside relationships with potential for conflict-of-interests;
  • Resent/stall/evade supervisory oversight/checks;
  • Make every effort to work alone or ‘mystique' their work;
  • Always work late/take work home/never take vacations;
  • Make frequent errors or never make errors;
  • Try to observe others' passcodes/words;
  • Show unwarranted attention in areas not concerning them;
  • Exhibit abnormal behaviour patterns.
Where cash is handled, look out for cashiers who:
  • Have too many errors/inconsistencies in balancing (or are too perfect or consistent);
  • Seem to keep private notes/jottings/tallies/small objects (coins, paper clips, etc.) around register or keep coins in wrong till compartment;
  • ‘Forget' to give customers receipts or to return bankcards;
  • Block/turn register terminal displays away from customers;
  • Make adjustments after a sale;
  • Have above-average numbers/values of voids/refunds/No Sales/other irregular transactions;
  • Process voids too long after the original sale;
  • Make excess/unauthorised cash-counts;
  • Make unusual ‘lapses' in other transactional/sales procedures;
  • Often drop cash or items on floor during sales;
  • Exhibit strange shifts in behaviour when transacting with certain customers;
  • Process sales for known/suspected friends/family members.

These are only a few of the indicators and many more exist in every type of business enterprise. Obviously, not every such condition or action is indicative of crime, and hasty judgement should be avoided. Many will be due to genuine error, carelessness or idiosyncrasy. However, in many other cases, these circumstances may well be the first warning signs that something is going on and therefore deserve closer investigation.

This Thing Called Trust

In order to minimise the risks of fraud within your business your employees must know that checks and audits can and do happen at any time, that they are serious and thorough, and that you will closely query any irregularities. This will apply no matter how long they have been in the job and no matter how much you may feel you trust them. It should be made clear and reiterated that this is not a sign of any specific mistrust of them but just a routine part of good management practice which helps to protect them as well as you. Such checks should be applied regularly but at random - do not be discriminatory or selective but apply them right across the board.

Never become complacent and believe that ‘It can't happen to me,' because the statistics show that it probably will - and may already be happening. Every year, dozens of businesses suffer severe damage and often fail because of serious fraud - most usually committed by someone who was completely trusted. It is a sad thing to have to say, but the Number One pre-requisite for successful fraud is trust.
New Zealanders tend to be a trusting lot and that is a laudable virtue. In a business context, however, blind trust or over-trust can also be a major risk factor. Remain objective and develop and monitor your controls to the point that the reviewable facts and figures continue to confirm that your trust is well placed. In the next issue of this magazine, I will suggest some specific procedures and controls that you can use to prevent your business being the victim of fraud.

There is an old Middle Eastern proverb: "Love and trust your brother, but still keep your camel close to your tent." Let that be your guiding principle in preventing fraud robbing your business of the funds it needs to succeed and you of a fair return on your investment.

This article was first published in Franchise New Zealand magazine Volume 17 Issue 1. Read Part Two here .

Steve Davis is a security consultant who has advised clients in the US, Eastern Europe and Australasia. He is a consultant to the NZ Retailers Association and works with franchisors and franchisees throughout New Zealand.
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