Trepanier MacGillis Battina P.A. 8000 Flour Exchange Building 310 Fourth Avenue South Minneapolis, MN 55415 612.455.0500
Trepanier MacGillis Battina P.A. 8000 Flour Exchange Building 310 Fourth Avenue South Minneapolis, MN 55415 612.455.0500

Tips for Preventing, Deterring, and Identifying Employee Fraud

Employee fraud is a long-standing concern among Minnesota business owners. Employee fraud comes in a variety of forms and schemes, all of which can be detrimental to the operations or livelihood of a business and its future prospects. Employers, however, can discover, detect, and deter employee fraud by understanding the variety of schemes employees use, the common red flags associated with employee fraud, and best-practices for deterring employee fraud.

Types of Employee Fraud Schemes
Employee fraud can be categorized into one of the following classifications: asset misappropriation, corruption, or financial statement fraud. These classifications and the schemes therein are not mutually exclusive. Instead, they are often committed in some combination by which one scheme is used to cover-up another in order for an employee to continue to perpetrate frauds against a company. The employee’s combination of schemes may be within one category or overlap between any or all of the three employee fraud categories. As such, it is important to recognize and understand the various employee fraud classifications.

Asset Misappropriation
Asset misappropriation is the most prevalent type of employee fraud, but it is often the least costly on a per occurrence basis. Asset misappropriations encompass a variety of practices, including, most commonly, (i) cash misappropriations, and (ii) inventory and other asset misappropriations.
Cash misappropriation includes theft of cash on hand, theft of cash receipts, and fraudulent disbursements. Schemes include skimming, cash larceny, billing schemes, payroll schemes, expense reimbursement schemes, check tampering, and register disbursements.
Inventory and other asset misappropriations can be sub-divided into misuse of assets and larceny.

Corruption is a fraud category in which employees commit frauds against a company. Corruption includes conflicts of interest, bribery, illegal gratuities, and economic extortion. Conflicts of interests may include purchasing or sales schemes to conflicted parties. Bribery is often characterized by “pay to play” schemes, invoice kickbacks, and bid rigging. Corruption-based frauds fall in the middle of the spectrum in terms of both prevalence and cost per occurrence.

Financial Statement Fraud
Financial statement frauds are least common, but can be the most costly type of employee fraud. Financial statement fraud is characterized by either (i) asset and revenue overstatements or (ii) asset and revenue understatements. As a result, a business may be over- or undervalued to the benefit of certain insiders, while its owners, lenders, investors, officers, or employees ultimately suffer the consequences once the fraud is uncovered.
Financial statement fraud is accomplished in a variety of ways, including: (i) improper asset valuations, (ii) fictitious or understated revenues, (iii) overstated liabilities and expenses, (iv) improper disclosures, and (v) illegitimate timing of disclosures.

Recent examples of financial statement fraud involving Minnesota companies include Denny Hecker’s widespread use of altered or fraudulent financial statements to secure inflated financing and Tom Petter’s creation of fabricated transactions and fictitious documents that supported loans from hedge funds and investment firms.

Detection and Red Flags of Employee Fraud
Employee fraud can happen to almost any business. It is, however, most prevalent in businesses that lack or have easy-to-override internal controls, lack management review, lack respect for management and the business hierarchy, lack competent personnel in oversight roles, lack independent checks or audits, lack employee fraud education, or lack appropriate fraud reporting mechanisms. According to the Association of Certified Fraud Examiners, employee frauds are committed nearly as often by managers as by employees. Similarly, although not occurring as frequently, the cost of frauds committed by business owners themselves tend to be much higher than those committed by employees or managers.

The greatest deterrent to employee fraud is the threat of detection. Detection most often occurs through (i) tips, (ii) management review, (iii) account reconciliation, (ix) document examination, (x) surveillance, (xi) IT controls, and (xii) employee errors.

Red Flags

The following red flags are commonly displayed by individuals committing employee frauds:

(1) living beyond one’s means

(2) financial difficulties

(3) unusually close association with vendor or customer

(4) control issues and an unwillingness to share duties

(5) “wheeler-dealer” attitude

(6) irritability, suspiciousness, or defensiveness

(7) addiction-related problems

(8) complaints of inadequate pay

(9) refusal to take vacation

(10) excessive pressure to succeed from family, peers, or the organization

These red flags, however, should not be used as evidence or even as a presumption that an individual is committing an employee fraud. Instead, employers should recognize that the prevalence of these warning signs may increase the likelihood that an employee may commit an employee fraud.
Detection of employee frauds has increased. This may be the result of an increase in the number of occurrences, or an improvement in their detection. Whatever the case may be, the likelihood of detection is often the greatest deterrent to employee fraud. As such, the following best-practices can lead to early detection, or better yet, the prevention of employee frauds:

(1) regular performance of external independent audits;

(2) regular performance of internal audits;

(3) hiring employees based on defined job standards, experience criteria, or job references;

(4) requiring mandatory employee vacation and/or job rotations (where appropriate);

(5) establishing methods in which employees can report anonymous whistleblower tips and encouraging the reporting of such tips;

(6) establishing supportive employee culture and providing counseling services to support employees going through personal difficulties; and

(7) taking adverse actions against perpetrators, including reporting perpetrators to law enforcement and supporting the prosecution of claims against perpetrators.

For advice on establishing employee fraud prevention practices, employment policies and handbooks, corporate governance, and other issues facing your business, contact the Minnesota business law attorneys of Trepanier MacGillis Battina P.A.
About the Author:
Minnesota business attorney James C. MacGillis advises clients on corporate and business law matters such as fraud prevention, corporate governance, employment law, and employment policies. Jim may be reached at 612.455.0503 or Trepanier MacGillis Battina P.A. is a Minnesota business law firm located in Minneapolis, Minnesota.