Red Flags Of Financial Fraud: How To Detect For Small Business

Financial Fraud affects nearly all businesses, from small businesses to multinationals. Multinationals have the necessary infrastructure to appoint forensic accountants and internal auditors to monitor their systems. They also have the capacity to develop complex systems which prevent fraud, thus reducing the possibilities of fraud, though not completely immunized against this crime. But what about small business owners who neither have the infrastructure nor the resources to detect or prevent fraud?

This article is aimed at small business owners who are not fully conversant with accounting, business processes, and internal controls. Not all business owners are accountants or finance specialists. Let’s identify some red flags of Financial Fraud.

Persistent gaps in inventory – If there are persistent and recurrent gaps in your inventory, and you cannot get to the bottom of this, there are high chances that there is revenue leakage. It does not matter if the gap indicates an excess or a shortage. Any inconsistency is bad, especially when there is no further analysis pointing to its cause.

Delayed cash and bank reconciliation – Many times, especially when a company is dealing majorly with cash, reconciliations are delayed. From my past experiences with several small businesses, this is a matter that should not be taken lightly. If payments and receipts are in cash, and they have been banked in time, reconciliation should never be a problem. Most of the time, serious reconciliation delays have pointed out underlying problems. One of them is teeming and lading. Teeming and lading is a bookkeeping fraud which is basically short banking to conceal theft or shortfalls. Many small business owners have fallen victim to this fraud.

Haphazard record keeping – Those who are intentionally committing financial fraud often develop a system of haphazard record keeping, which over time becomes a norm. There may be more than what meets the eye, especially if you have already had challenges within the finance function e.g. shortfall of cash, unreconciled creditors, lost inventory, etc. This may be a deliberate attempt to break the audit and accounting trail. Be aware of missing documentation and a misguided record keeping structure.

Living out of means – Generally, our lifestyle is guided by the amount of revenue we generate, be it via employment income or business income. If someone is living beyond their means, it is important to consider the possibility of revenue leakages, especially if this individual is in a decision making position. However, it is important to note that it is unethical and against workplace regulations to ask uncomfortable or personal questions to employees even though they are under suspicion. Suspicions must be tackled with tact and the law governing internal investigations must be adhered to at all times.

Document manipulation and duplicate invoices – In the present times, bank statements are received either by email or can be directly downloaded from the banking platform, in PDF or Excel. It is extremely easy to manipulate numbers in Excel. This tactic is used especially by those who are directly involved in banking fraud or are an accomplice. Duplicate invoices can also be manipulated to conceal fraud e.g. if sales invoices are prepared manually (hand-written), then it is prone to manipulation. The original invoices are sent to the customer, the duplicate may be altered to account for the shortfall in cash.

High creditor balances – A review of creditor listing often reveals that the balances result from posting fake creditor invoices. Small businesses that have a sales department, procurement department, and accounts department are susceptible to this fraud if persons from these departments collude. Fake invoices can either be created internally or obtained from a fictitious supplier where the bank account details are linked to personal accounts. These kinds of invoices are often of low values, mostly below the approval limits, and hence can easily pass under the radar.

As a small business owner, it is important to ensure sufficient internal controls are in place regardless of the low staffing. It is also important to hire an external consultant who can assist in strengthening controls and ensuring there is a regular review of these controls. If the company is undergoing expansion, there is significant exposure if there are no internal controls. While business owners dedicate time towards growth, they may fail to monitor the activities of the business and by the time a fraud is discovered, it may be too late.

Prevention is better than cure. Be vigilant, be proactive, and know the red flags.

This is not an exhaustive list of red flags. Please comment and let us know what other red flags you have encountered as a business owner, consultant, forensic accountant, or as an auditor in the comments.