Oh, No, You Didn’t! 4 Tips for Preventing Employee Accounting Fraud

What is employee accounting fraud?

Employee accounting fraud occurs when an employee manipulates a business’s financial records to misrepresent the business’s health or mislead others, such as stakeholders or competitors. In many cases, the employee who commits accounting fraud has access to the employer’s financial data with little oversight. A lack of oversight, however, isn’t the only source of employee accounting fraud.

Several factors can contribute to employee accounting fraud, including pressure, opportunity and rationalization — or what is commonly referred to as the “fraud triangle.” Financial stress, such as personal debt or unexpected expenses, can create pressure to commit fraud; weak internal controls or a lack of oversight provide the opportunity. Meanwhile, employees may justify their actions by convincing themselves they deserve extra compensation or that their fraud isn’t really hurting anyone.

How to prevent employee accounting fraud

Implementing safe accounting practices at your small business starts with the policies you enforce and the team you assemble. Here’s how to prevent accounting fraud at your business. 

1. Begin with your hiring process.

Each time you hire a new employee, you’re taking a risk. A successful hiring process is necessary for every business, but you can take steps to minimize the threat of future accounting fraud, such as conducting background checks on candidates.

“A background check for an employee can provide important insight into an individual’s past behavior and potentially be an indicator of future actions,” said David Thomas, CEO of Evident, a data security platform. “However, a background check is just the first step. Validating that an employee or applicant is who they say they are, has the appropriate documents, has the credentials and education they claim to have on their resume, and meets any regulatory requirements needed for their role are also invaluable identity verifications that can minimize the risk of fraud.”

Background checks are not foolproof, and they don’t always provide you with the most recent or relevant applicant information. For instance, Ken Stalcup, senior director at Houlihan Valuation Advisors and a certified public accountant, had an investigation involving an accountant who committed financial fraud. Stalcup’s client ran a background check on the accountant before hiring them, and it came back clean. The accountant had just committed financial fraud in another state, however, and the background check didn’t detect it. The company lost about $400,000 to the fraud.

“In my experience, [background checks] won’t be very effective,” Stalcup said. “It may weed out a few obviously bad prospects with an extensive, documented bad history, but background checks will not guarantee a fraud-free environment.”

The moral of the story? It doesn’t hurt to have an employee background screening system in place, but don’t rely on it as your sole means of fraud prevention.

2. Minimize employees’ access to information.

“In any business, there are a number of ways for fraud to occur,” Thomas said. “One of the biggest opportunities to prevent fraud, especially by employees, is to implement clear processes and controls across the company.”

Thomas advised minimizing the amount of exposure and access employees have to information, including internal numbers and customer data. You can get that level of information control by delegating access among the entire team rather than giving it all to one person. If only one person is responsible for all of the accounting information, Stalcup said, there won’t be any effective internal controls to prevent fraud.

“Generally, the best way to prevent fraud is to establish good internal accounting controls,” Stalcup said. “That means no one person has the ability to initiate, approve and record a transaction.”

3. Establish segregation of duties.

Segregating duties ensures no single employee has control over every step of a financial process, creating a system of checks and balances to reduce the risk of fraud. In accounting, that means dividing responsibilities so one person cannot both initiate and complete a transaction without some level of oversight. The same employee, for example, should not be responsible for approving payments, processing invoices and reconciling accounts.

When multiple people are involved in financial processes, it becomes more difficult for any one individual to manipulate records without detection, ensuring greater accountability and transparency. In a retail business, for instance, one employee may be responsible for handling cash deposits, while another reconciles daily sales records.

4. Communicate fraud policies across the organization.

Fraud policies help set clear expectations. Without those guidelines, employees may be unaware of what constitutes fraud or how to report suspicious activity. A well-documented fraud policy should include prohibited behaviors, reporting procedures and potential disciplinary actions. The policies should be easily accessible in an employee handbook or intranet portal.

Consider regular training to help reinforce the policies, ensuring employees recognize risks and how to report fraud when it happens. An anonymous reporting system, such as a hotline or online portal, can encourage employees to come forward without fear of retaliation. Finally, remember that the policies apply to everyone in the organization — fraud can occur at any level, from tenured executives to newly hired employees.

Types of employee accounting fraud

Understanding fraud categories can help you avoid falling victim to them. These are the most common types of employee accounting fraud:

• Asset misappropriation
• Corruption
• Payroll fraud

Asset misappropriation

Asset misappropriation is usually the first thing that comes to mind when you think of employee accounting fraud. One type of asset misappropriation is the use of company resources for purposes other than their true intention. That could mean taking your family on a business trip and having the company pick up the tab, using the company car and fuel card to run personal errands, or taking home company supplies. 

Taking money from the company before it enters the accounting system is also asset misappropriation. That includes overcharging customers and pocketing the difference, engaging in fake billing schemes and creating fake expenses.

Usually, employees involved in that type of fraud steal small amounts of the employer’s assets consistently, hoping the employer won’t notice the missing assets because they’ve been taken in such small increments. 

That type of fraud, also known as embezzlement, most often involves the misuse of money. Depending on how small the stolen amounts are, it may be challenging to notice this type of fraud when it begins. 

Corruption

Corruption is the second most common type of employee fraud. Although it’s not always directly related to accounting fraud, corruption still hurts a business’s bottom line. Corruption often involves someone in a position of authority and includes bribery, product substitutions and kickbacks.

One typical example of corruption is when an employee offers discounts on products or services to bribe an external source. In another scenario, a manager may agree to hire a contractor to provide cleaning services to the business in exchange for free cleaning services in their home. 

Most people associate corruption with public figures, but it should not be ignored as a costly potential risk within a small business. 

Payroll fraud

Payroll fraud occurs in more than one-fourth of businesses. On a small scale, payroll fraud could include clocking in and then leaving work or forging a timesheet to include more hours than the person worked. On a larger scale, ghost employee schemes are common. In the schemes, employees are on the books and getting paid, but they don’t exist. Instead, the money goes to the person who set up the ghost employee account.

Other examples of payroll fraud include buddy punching, which happens when an employee has a co-worker clock in for them when they’re absent. Another example, which could easily go unnoticed, is when an employee requests a paycheck advance and never pays it back.

What to do if you suspect employee accounting fraud

Take action immediately if you suspect an employee is committing accounting fraud at your business, but proceed with a formal and carefully considered approach. Take the following crucial steps.

Hire an attorney.

If you are suspicious of fraud, act quickly — but not on your own. Don’t approach the suspect with unfounded accusations that could potentially violate the employee’s rights. Make sure there is actually fraud being committed and consult legal experts on how to address the situation. Remember: Be very cautious when gathering details, as falsely accusing an employee of fraud may end in a major lawsuit. 

In the event of possible employee fraud, speak with an attorney immediately to ensure you follow the right course of action. Work with legal counsel to help you investigate, collect evidence and take the proper steps toward legal action.

“You need to build a rock-solid case if you can,” Stalcup said. “Once you have collected enough information, you can confront the employee with the help of an attorney and the HR department. It’s likely you will have one opportunity to talk to the employee before they quit or lawyer up, so you have to be ready.”

Determine whether you wish to proceed with the case.

Once you’ve determined there is a case for fraud, you can decide what course of action to take and assess how it will affect you and your business going forward. Many employers turn to certified fraud examiners (CFEs) to assist in the process. Stalcup, a CFE himself, said CFEs are typically hired after the attorney and client realize there is a loss and want to take additional steps to recover the loss and/or prosecute the offender. 

“Typically, the client and a lawyer will discuss the nature of the fraud,” Stalcup said. “If the client has insurance covering fraud losses, the insurance company might want a CFE to quantify the loss. If the client wants to prosecute the employee, they may have to persuade the prosecutor to file charges based on evidence from a CFE.”

Many clients, however, often “recover nothing and will not hire a CFE or disclose the situation,” he added. “They will just fire the employee and move on.”

Notify the right people. 

Although it’s not advisable to inform the entire staff about the situation, certain individuals should be notified. The individuals include those participating in the fraud investigation; authoritative figures in the company, such as board members and managers; the human resources team; and any other pertinent parties.

Collect evidence.

As a small business owner, you’ll have to provide evidence demonstrating the employee’s deliberate intent, which is most effectively shown through meticulous documentation. Collect and safeguard your company’s financial records, with a preference for original, hard copies whenever possible. Also secure and back up the data on your company’s network, including vendor invoices, bank statements and accounting ledgers.

Restrict employee access. 

Ensure that the accused employee is barred from any company data or confidential information during the investigation, and seek advice from both your attorney and human resources department to establish permissible restrictions. Change all company passwords, and verify that all company-issued electronic devices and accounts associated with the employee are either locked or restricted.

Keep a record of the entire process. 

Document your process, beginning the moment fraud is uncovered at your business, to ensure that you can prove your compliance with the law if needed. Having clear documentation of any communications or steps can also be useful throughout the investigation, since it will likely be a lengthy and complicated process in which notes could serve as a helpful resource.

Establish the consequences.

How a small business responds to employee accounting fraud usually depends heavily on the circumstances of the fraud and the monetary loss incurred. It’s also a good idea to consider how long it will take the business to recover from the incident. Depending on the nature of the offense, fraud can be extremely costly, even for large companies.

To decide the best way to handle employee accounting fraud within your business, determine the extent of the fraud and how it was committed. Employers often choose to resolve more passive forms of employee accounting fraud by terminating the person responsible. The best way to handle extensive fraud, however, may be to take legal action following termination. 

Generally, a loss of less than $500 ends in termination, while a loss of more than $100,000 can lead to hefty fines for the fraudster and even jail time of up to eight years — although it depends on a number of factors. Regardless of the loss amount, of course, the employee responsible will suffer significant damage to their professional reputation.

Sean Peek and Sammi Caramela contributed to the reporting and writing in this article. Some source interviews were conducted for a previous version of this article.