Part 10 of 10, Fraud Inoculation by Paul Updike, certified fraud examiner

Part 10 of 10, Fraud Inoculation

Other Possible Areas of Fraud

One of the areas of possible fraud, despite the above level of monitoring, includes employing the assets for personal use and not reimbursing the firm. Another is stealing either assets or inventory. Unless there is a 100% physical inventory every day, inventory remains vulnerable to fraud. Therefore, walking around can help.

The cash registers are another area open to refund fraud, etc., though daily cash register balances are reported to accounting and physical scanning and reconciliation of cash register tapes several times a week restrains this potential avenue. Credit card fraud is possible too, though any significant drop-off of credit card deposits is quickly picked up in the weekly cash forecast to actual comparison as well as monitoring daily bank balances.

As stated in Part 1 of this 10 Part post, there are creative ways to commit fraud that have not yet been invented. However, if a firm really wants to drastically reduce the likelihood of material fraud from happening to their firm, then the combination of the detailed fraud inoculation/monitoring plan outlined in these ten parts, along with implementing the good suggestions garnered through a Fraud Risk Assessment, will help immensely.

Other anti-fraud techniques found on my web site include implementing an anonymous Tip Hotline. Communicating with employees and vendors better is also essential. One of the best ideas I have heard is sending around to all employees email stories of local fraudsters who have been caught and prosecuted, along with their prison terms. These are actions which can help maximize the perception of detection of fraud, which perception of detection is critical to deterring future fraud.

The bottom line is that if you balance your cash daily, your chance of business success for your small business increases dramatically while your likelihood of material fraud drops to near zero.

Part 9 of 10, Fraud Inoculation

Part 9 of 10, Fraud Inoculation

The Payoff for this Intensive Monitoring

The owner of the firm that suffered this large-scale embezzlement never wants to be materially defrauded again. He has the cash balance in his head, every day. In effect, by going over the cash flows in and out regularly, and having a reporting system that carefully tracks and matches monies in and out in all areas of his business, he thoroughly checks for material fraud every week and every month. No more surprises, ever.

Is the daily/weekly/monthly cost worth it? If one includes the extra burden of regular monitoring, the owner’s extra time may only average an hour extra per week. Because the fraud trauma cut so deeply into his personal psyche as this is the only company he has worked for in his 30-year career, the extra time spent by him is simple prudence. While the accounting department probably spends several more hours per week generating the reports and the information and the cross checks required.

No, there are really no guarantees that material fraud will not happen again at this firm, but such an unhappy event is highly unlikely. Why? Because the owner is continually auditing his firm, comparing the reports and information the accounting department generates with the cash balances in the bank. Either this comprehensive information approximately matches or there is an error in the calculation.

In addition to fraud avoidance, there are other less obvious, even unspoken benefits as the accounting information is now robust enough that internal accounting will not be the cause of restraining future growth, as often happens in small businesses. Another benefit is that this business survived a potential killing blow, which survival status allows for the employees to feel an atypical sort of loyalty and a camaraderie  which contributes to employee long-term efficiency.


Part 8 of 10, Fraud Inoculation

Part 8 of 10, Fraud Inoculation

Fraud Inoculation

May I put approximate time requirements on the necessary monitoring activities? First of all, to start such a comprehensive program requires a 100% physical inventory, perhaps involving every employee for one day. Setting up this forward-going scenario would require a one-time investment of time of 10 to 40 hours, depending on the complexity, the size and the numbers of items involved, plus perhaps a day in the life of all the employees. And of course the tickets used to count the inventory has to be audited by an outside auditor.

Taking a look at each and every check face as checks are cut and payrolls paid, might require ½ hour per week, while carefully reviewing all bank reconciliations monthly, might add another hour per month.

Scanning/watching all receipts of weekly inventory in (including drop shipments) might require another ½ hour per week. (Spreadsheet macros could be written to catch the salient information, but walking around is needed too.) Each vendor must be known, though most small business owners already know all of the vendors. This re-acquaintance might require a one-time 2 to 4 hour time allotment. Likewise, each customer who is granted credit, becoming an A/R, needs to be known before being added.

Then, as vendor checks are written and receivable checks are received and posted, both the AP and AR aging reports can be carefully scanned every week to match the increase or decrease of check amounts in or out to each account. Again, spreadsheet macros can be written to track and somewhat explain any non-matching issues.

Before too long, the scanning of aging AP and AR reports does not take much time, while scrutinizing the spreadsheet information becomes the focal point, because those spreadsheet macros track and match all cash flows in and out to AP and AR every week.

Ditto with every employee, as every check written to an employee matches only employees known to be on the payroll paid a known periodic amount. Again, spreadsheet macros can be written to track and explain any non-matching issues.

Finally, every checking account, credit card account, (as well as Petty Cash) needs to be independently monitored. This might take 2 to 4 hours per month. Again, spreadsheet macros can be written to track and explain any non-matching or unusual issues each month.

The meaningful issue here is to know the actual cash flow in and out, perhaps within $500 at any point in time. This knowledge requires a weekly cash flow forecast which clearly reflects the cash cycle for this specific business with changing cash expectations built into every weekly forecast. Then the spreadsheet macro reports on all the flows in and out are reconciled both on paper and in the owner’s head with what the cash balance is now and what the cash balance is expected to be in the near-future.


Part 7 of 10, Fraud Inoculation

Part 7 of 10, Fraud Inoculation

Fraud Risk Reduction

Because material fraud rears its ugly head mostly over cash issues, we need to identify cash activities, thereby identifying the fraud risk candidates.

The main areas of cash flow out, in small businesses are:

Payroll checks

Vendor checks

Cash register refund transactions – checks/cash/credit cards

Loan repayment plan checks

Auto pays in checking account

Pension/401k payments uploads

Unusual checks

Inventory product checks

Asset purchases, asset payment plans

Credit card charges

Petty cash out

Unusual/manual checks out

Postage machine/shipping charges

The main areas of cash flow in, in small businesses are:

Account receivable checks

Cash register transactions – checks/cash/credit cards

Employee COBRA checks

Loan/equity proceeds

Auto deposits in checking account

Asset sales

Credit card credits

Petty cash in

Unusual checks/cash in

If all the above avenues of cash flow in and cash flow out are monitored tightly, assuming such a scenario is possible, then only the cash-flow monitor has opportunity to commit material fraud. And if the owner, the monitor and the largest stockholder are all the same person, and he or she reports to the board of directors on a monthly basis, then his or her fraudulent opportunity could decrease to near zero.

Part 6 of 10, Fraud Inoculation

Part 6 of 10, Fraud Inoculation

Cash Flow Forecast

Of course one large contributor to survival was reducing the workforce. From the date of the fraud discovery to three and ½ years later, sales have decreased by almost half, yet payroll expenses have been reduced by more than 50%.

With the small monthly repayment plans in place, the firm now operates slightly above break-even, eking out a small operating profit during the majority of the months.

One large reason for being able to operate profitably, most months, is that every week we revise and create the new Bible – in the form of a Daily Cash Flow Forecast six weeks into the future.

This cash flow forecast includes AR in, AP out, occupancy expense, sales tax expense, checking account balances, 1099 expense, cash in through the retail stores, cash out to fund 401k agreements, auto-pays in the checking account, vendor and creditor agreement payments, shipping expenses, etc., whatever is needed, all on a daily basis. And we fit all that information into a one-page report.

Then we balance the checking account, materially, every day. Both the accounting clerk and the owner know every day what the checking account cash balance is as well as the net balance, assuming all outstanding checks had cleared, including which checks are outstanding and likely how long before they clear.


Part 5 of 10, Fraud Inoculation

Part 5 of 10, Fraud Inoculation

Working Capital

Inventory replenishment became an intricate chess game as on-the-shelf inventory value in the warehouse quickly dropped from well over $1 million to less than $500,000, causing the purchasing manager major headaches. Many stretched vendors began to do business with this firm on a cash-on-delivery or paid-in-advance basis.

The purchasing manager and the owner made new deals with different publishers to intentionally raise costs by sharing part of the rich margin of regular new publishing with them, entreating them to make units for us in bulk, then holding on to our inventory, doling out product to us as they were paid in cash.

This inventory process is a kind of ‘just-in-time’ inventory, available whenever cash is fronted, yet we begged and pleaded for these terms instead of dictating them. All the risk for inventory overruns is ours as well, at these new publishing houses. The only real risk faced by these two long-time, friendly suppliers is our bankruptcy, which the regular publishing of new inventory renders increasingly unlikely.

Payroll expenses were trimmed again and again in to reduce the bi-weekly consumption of cash in order to maintain sufficient cash for new inventory acquisition. Occupancy expenses followed payroll expenses as the second largest expense line item, so three locations were consolidated into two. Payments to landlords and leaseholders were renegotiated to smaller amounts as the credible threat of filing for bankruptcy (though decreasing over time) became a weapon to extract concessions.