Embezzlement Awareness

by Fraud Expert, Ed Martin

When do people embezzle or abuse the company? Generally, three things have to be present before someone commits fraud or embezzles: need, opportunity, and rationalization. This is known as the “triangle of fraud.”

Need – Direct need is stealing to fund cash needs and is often driven by an addiction – drugs, alcohol, gambling, or an extramarital affair.  Therefore, the next time someone brags about an affair, a warning flags should go up if the handle your company funds.

Opportunity– Defined as the perception that there is a low probability of being detected.  In accounting, we call this “poor internal controls.”  Note:  Management sets the tone.

Rationalization – The employees’ mental process of making the action fit within their personal code of conduct.  In other words, the employees must be able to “talk themselves into the action” — “the ends justify the means.”

Rationalization often results in “situational fraud”

Employees’ propensity to steal or embezzle can be described as a normal distribution curve.  (Do you remember statistics from college?)

1. About 5% to 10% of employees would never—ever—do anything wrong.
2. About 5% to 10% of employees are always scheming.  (I hope you don’t have many such folks working for you.)
3. The real problem is that 80% to 90% of employees who will commit “situational fraud.”
   1. Remember: Who are the only employees who can steal from you?  
   2. Employees you trust.
   3. This isn’t meant to imply you shouldn’t trust your employees, but remain skeptical.  Do not go soft on internal controls because you trust employees.

Here are some warning signs and risks to watch for, especially if they handle company money or assets:

• Employees who are being downsized;
• Employees who are bored and may steal for excitement;
• Employees who make an honest mistake, discover a hole in internal controls, benefit from it, and who intend to “pay it back”;
• Thrill seekers who like bending the rules;
• Employees who are under personal stress: money, divorce, illness (especially spouse or children);
• Employees whose financial problems suddenly disappear;
• Employees with addictions: drugs, alcohol, extramarital affairs, gambling;
• Employees who always have to be number 1 and/or can’t stand not being the center of attention.

Tips on Minimizing Fraud

Minimize risks with a little creativity and by being proactive.

You must segregate duties as much as possible.  Do not allow those who handle money to make deposits, to make entries to the books, to issue and sign checks and to reconcile bank accounts.

As a small business owner, your business generally does not have segregation of duties but you can still be involved:

1. You can have the bank statement sent to your home, not to the company.  This demonstrates that you are paying attention to the statements.  Learn to access you account online and periodically review the balance and checks and deposit slips.
2. I know you are busy, but it won’t take more than 5 or 10 minutes for a review of the bank statement.”
3. When you return to the office – asks questions about several items in each statement.
4. This procedure creates the perception that a theft will probably be detected, thus reducing the “opportunity” and increasing the risk of being caught.
5. Upsetting either side of the Fraud Triangle will help minimizing the opportunity for theft and embezzlement to take place because the perpetrator might “get caught.”
6. To make a change palatable to your long-term employee, have a third party, your accountant, auditor, or CFE, suggest this change.  This will avoid sending the message to the long-time employee that he or she isn’t trusted anymore.

• You need to get the employee (probably a bookkeeper or controller) to ask for the change.
• The third party can say, “You know, you have complete control of everything.  You pay the bills, you make the bank deposits, you reconcile the accounts, and you make entries to the books.  If any money is missing, whom do you think the owner will suspect?  For your own protection, you should get the owner to look at the bank statements and initial the envelope every month.

1. Separate the cash/banking function from the recordkeeping function.  If not possible, then rotate personnel or functions in critical financial areas on a regular basis.
2. Review hiring policies to keep people of questionable background from making it to the payroll.  (Consider employee background checks for employees that handle money and assets.)
3. Restrict access to employee master files to prevent “ghost employees” and improper pay rates.  The owner should review the payroll report.
4. Restrict access to vendor master files with strict procedures for additions and modifications.
5. Protect all check stock (under lock and key) and destroy obsolete stock.

How to react if your suspect fraud and embezzlement

No. 1 Contact the Insurer

The employer’s insurance company should be contacted immediately and your insurance policy reviewed.

No. 2 Contact Legal Counsel

The employer should immediately contact a competent employment lawyer to discuss the situation.

(Consider having your Attorney hire a Forensic Accountant, preferably a Certified Fraud Examiner (Ed Martin, CFE @ 512-659-3179) to help review the detail and preserve evidence (testimonial, documentary and electronic) which will be necessary for your insurance claim, confronting the employee, or presenting to the District Attorney.)

No. 3 Deal with “Alleged” Perpetrator

Once an employee is suspected of embezzlement or even caught, at least three courses of action are possible:

1. Place the employee on administrative leave with pay;

• Do not confront the employee but escort the employee out of the office.
• Limit the employee’s access to the computer network.

2. Proceed to develop evidence by gathering bank records, business records, electronic records, and securing testimony.

• Consider having their computer forensically imaged.
  • Don’t use their computer until the computer is forensically imaged by a qualified computer forensic specialist.
  • The forensic image of their computer will preserve existing evidence and allow the computer to be returned to business use.

3. If evidence of theft is developed then terminate the employee immediately.

Note: Before you contact the Police Department or DA for charges get the evidence and be able to articulate what happened.  The Police have lots of work and embezzlement of your company will not get top priority.

No. 4 Prepare Action Plan

This is a dangerous situation.  Although Texas is an “at will state.”  Meaning that an employer can fire a person at will, wrongful termination lawsuits can result.  Contact an employment lawyer to avoid a mistake.

Consider hiring a forensic accountant / investigator.  Before he jumps into an assignment on embezzlement, he will require preparation and planning.  An embezzlement fraud examination can be complex so organization of documentation is necessary.  Establish a budget for what you will spend on the matter.

A proper plan does the following:

• Identify suspect, co-conspirators, witnesses;
• Preserve evidence both documentary and electronic.
• Prepare for timely interview of the suspect and / or co-conspirator.
• Prepare for timely interview of witnesses
• Unidentified suspected perpetrator – some times the investigation will require “the casting of a wider net” and bring in all individuals who may have had the opportunities and access to commit the fraud.

No. 5 Act Quickly to Stop the Damage

Direct observation rarely catches employee theft.  Usually a tip or specialized audit procedure uncovers embezzlement.

Initially you will be seeing the tip of the iceberg.  The perpetrator’s scheme or schemes likely have been ongoing for months.

No. 6 Know Employer’s Rights and Responsibilities

The employer has a right to conduct a fraud examination and a responsibility to the owners and stockholders to investigate and seek to recover losses by theft.

The complex series of laws dealing with employee rights in the workplace does not necessarily have to hamper the examination.  The rules must simply be followed.  However, the employer must treat all employees consistently.

Inconsistent treatment or an inconsistent track record can later be used against the employer.

No. 7 Know Employee’s Rights and Responsibilities

Review the employee handbook.

Does it outline the employee’s rights in such situations and his or her responsibilities?  Generally, an employee has a fiduciary duty to comply with the employer’s investigation of their possible fraudulent acts.  Failure to do so can lead to termination of employment.

No. 8 Secure Data

The employer must take immediate steps to preserve data.

Fraud deals with issues of “intent” and proving intent is generally through circumstantial evidence.  Evidence that goes to the issue of intent must be gathered and preserved.  Once an employee is notified that he or she is the subject of the investigation:

1. the employee should not be allowed to touch computers or
2. remove anything other than personal items from the office.
3. The employee should be accompanied while in the office and
4. walked from the premises.
5. The timing of such notification is a separate issue.

Do not overlook the employee’s home computer ask for a consent search of the computer and have the employee sign and date the consent.  This consent to search can be executed by a competent private investigator hired by your attorney.  Depending on the matter being investigated, the home computer may be imaged.

No. 9 Perform Background Check of Suspect

Background and credit checks allow the identification of “need” and “greed” as possible motivations for the fraudster.

Provisions of the U.S. Fair Credit Reporting Act require notifying the employee that a check of their credit is being made.

The employee manual should notify all employees that the company may be performing background checks and advise them they have a right to receive copies.

No. 10 Remember Iceberg Principle

Fraud is like an iceberg.

1. What is seen may only be a small part of the whole.
2. Many others may have been involved in the fraud scheme.
3. Often, the toughest frauds to detect are those involving collusion with others within or outside the entity.  For example, a common embezzlement scheme involves the use of fictitious vendors or consultants.  Any employee with the authority to approve payment of an invoice can perpetrate such a scheme.

An admission to the fraud committed follows the 10 percent rule:

A fraudster’s first admission is only a small part of the whole story.  The true fraud (the other 90 percent) may be greater, broader, and longer than you originally envisioned.