• Brett Pittsenbargar

Top Fraud Risks and What Small Businesses Can Do to Prevent Them

Detect Fraud in your small business

Business fraud is nothing new. Enron, the Texas-based energy and commodities company saw its demise in 2007 after authorities found out it had been deceiving the public through falsified financial reports.

And if you thought that corporate America has learned from such high-profile scandal, think again.

Who would have thought that a company as large as General Electric would still be embroiled in "aggressive accounting practices" when it was accused by the Securities and Exchange commission in 2018 for allegedly making overly ambitious projections in terms of its earnings?

No type of business or organization is safe from the risk of fraud committed by employees and even executives. The enormous damage from such activities is a result of an enterprise’s vulnerability to an internal system that has failed in preventing asset misappropriation, corruption and even access to sensitive information.

The fact that deceptive accounting and other illegal business practices still exist today, almost any business can fall prey to the devastating impact of fraud. If Billy McFarland can dupe thousands of people to attend his calamitous Fyre Festival in The Bahamas and Theranos founder Elizabeth Holmes can run a multi-million health technology firm with a bogus product, small-time crooks can also devise their own versions of chicanery. In the end, such activities come with tough consequences - the worst of which is driving businesses to bankruptcy.

Should a company operate at a loss because it had been hit by fraud, having one's head in the sand won’t certainly help. One of the solutions available is to seek the advice of a seasoned expert and turnaround strategist who can help the owner device a concrete, workable plan. In most cases, this includes exit strategies for businesses that are already in financial distress so that they can save money in the process.

Why Small Businesses are Easy Target

Just how vulnerable are small companies to business fraud? According to a 2018 study by the Association of Certified Fraud Examiners (ACFE), small businesses do not have the same capacity as their larger counterparts to detect fraud and thus, prevent it from putting the entire organization in a bind.

Small business fraud cost enterprises $200,000 in 2018 according to the ACFE.

Small business fraud can be committed by employees or the owners who engage in corruption, false billing and reimbursements, larceny and check tampering, to name a few. The cost of such illegal activities? A median loss of $200,000 according to the ACFE.

Owners put the blame on limited financial resources and a small number of workforce who can look into the segregated accounting functions. This is common among businesses of such size where internal controls are lacking despite them being in the industry for decades. Add the lack of a regular audit and you get a recipe for financial disaster waiting to happen.

Others see the lack of a business owner's financial education as the culprit. While he may be an expert in selling his product, it doesn't necessarily mean being adept at understanding financial information.

I, on the other hand, believe that the main problem is complacency. Small business owners are overweening about not being a victim of fraud owing to their company's size. I've met many startups that are too focused on growing their business but never on fraud risk exposure. Some of the reasons that they cite include:

"It's a family-owned business. No one will dare to attempt to funnel money out of the company because it'll eventually hurt everyone."

"We're a tight-knit organization of 20 people. We've come to know each other well for the past five years."

"Only the large companies are targeted by fraudsters. They won't get anything from attacking us."

"Our founder and CEO knows his numbers. He can always support his lavish lifestyle."

The last statement is something that I often hear from unsuspecting employees. This reminds me of a July 2019 report where a janitorial company owner was found guilty of $2 million fraud so he could finance an extravagant lifestyle that included Rolls-Royce cars, home renovations and designer watches. He was sentenced to 50 months in prison for submitting fraudulent invoices for payment.

Remember: Corporate fraud knows no business size. Enterprises, whether large or small, are not immune to high-profile collapses due to fraud. If suspicious activity cannot be identified or flagged early on, it will be too difficult to foil such schemes and will likely result to severe losses. In the end, the owner would have to find a business buyer who can best salvage his company from financial catastrophe.

Who Commits Fraud in Small Businesses

Such complacency among small businesses brings about factors that can lead owners to pull the plug. In such enterprises, fraud can be committed by a staff member who runs errands for the owners, an executive who's in control of financial documents, a family member who cooks the books, or even a CEO who covers up his company's mismanagement problems. The truth is, anyone with connections to the business can be the originator of fraud.

Anyone with connections to the business can be the originator of fraud.

So what motivates them to commit fraud? It's a combination of factors, really.

Excessive Trust

As long as there's excessive trust accorded to someone, the risk of getting caught is diminished. Two professors from the Wharton School even published a paper on this and found a connection on misplaced trust and unethical behavior. As long as unsuspecting people rely on wrong cues in their organization, they'll always turn a blind eye on who takes advantage of their position of power – thanks to opportunistic exploitation.

Insider Knowledge

Employees who are aware of how the company's money is handled can find ways to devise how to exploit the accounting system and cover up their tracks.

An Opportunity Not to Get Caught

Whether one is skimming money off of the cash register or luring large clients into a scam, an individual who's bent on committing fraud is always on the lookout for the right opportunity to execute his or her plan of circumventing a system that lacks internal control. Remember, any relationship with a high level of trust is something that can be abused easily.

A Reason to Give in to Pressure

Some of the reasons why people are highly motivated to commit to fraud include issues in personal finance (excessive debt, credit problems), pressure to maintain a high standard of living, emotional attachment to luxuries such as large homes, vehicles, designer clothing, and vices (gambling, addiction).

Employee disenfranchisement is often a strong motivator for corruption too. They can be urged to exact revenge against a ruthless management when they've encountered issues such as unfair labor practices in the past.

A Lack of Internal Control System

What even adds to the gravity of these white collar crimes is it often takes years before they are detected, often leaving suspicious activities overlooked. As long as someone is bent on making mischief, a business that does not recognize the severity of the lack of checks and balances can likely suffer from the consequences of fraud.

And before everyone knows it, the extent of financial loss has already spiraled out of control.

Types of Fraud in Small Businesses

From devising ways to escape the scrutiny of auditors to processing false customers, small business fraud has become more and more creative in terms of causing damages to businesses. Here are the most common types of fraud in small businesses.

Asset misappropriation

This involves skimming (failure to record sales, understating sales, swapping checks for cash), cash larceny (reversing transactions, altering cash count, removing cash register logs, stealing cash), questionable disbursements (fictitious voiding of product sales, overstating refunds, destroying transaction records, tampering checks).


Small business employees engaging in bribery, accepting or offering kick-backs, entering illegal transactions or illegally contributing to public offices all damage the reputation of their business.

Financial statement manipulation

Falsifying financial statements released to the public include masking embezzlement through double-entry bookkeeping, overvaluing assets and revenue, recording false sales and concealing liabilities and expenses. Concealing the true health of a struggling enterprise is be made to protect a business' reputation.

Misrepresentation of a service or product

Misleading claims are often discovered through false advertising. When customers find out that the information in fine print does not match what is promised in an ad, they can easily divulge a business' deceptive tactics on social media.

In June 2019, The Wall Street Journal exposed the growing number of phony listings on Google Maps. Small business owners mark their business in various locations even though they don't exist in such neighborhoods. So, users end up contacting a number that is then routed to a business' main number. That's easy money for day's work of illegal advertising.

Fake employee claims

Insurance fraud is a common example for fraudulent employee claims. The Coalition Against Insurance Fraud found out that more than 10 percent of small business owners are worried about their employees reporting fake work-related injuries. They can stay out of work but still claim their workman's compensation policy.

Payroll fraud

When a business grows overtime, the payroll becomes more complicated. However, this doesn’t mean that small enterprises are immune from payroll staff who can manipulate the accounting system. Fraud can occur in the form of adding nonexistent employees (or commonly known as "ghost employees") to the payroll, failing to record advances as assets, modifying pay rates or cashing the paycheck of another employee in their behalf.

Vendor billing fraud

This can either be in the form of billing schemes or corruption. In the former, an employee creates false documents to pretend that transactions between two companies have taken place. He may also create a fake company (or shell company) where illegal payments can be forwarded to.

On the other hand, in corruption, an employee can offer bribes to another firm in exchange for personal gains or for the benefit of his company.

Wire transfer scheme

Now that most companies rely on online banking, the risk of having funds subjected to cyber attacks is much higher. Many companies have been victimized by unauthorized wire transfers of their funds without knowledge of where their money ended up in. Small and medium-sized businesses are prone to such because they have less sophisticated IT security measures.

Detecting Fraud in Small Businesses

Preventing fraud begins with identifying red flags in an organization. These can either be employee- or management-related warning signs. Anyone should be aware of these unusual activities that a potential fraud may happen.

Without a clear and organized paper (or electronic) trail, business transactions will be difficult to monitor.

Lack of paper trail and documentation

Small businesses often take for granted proper bookkeeping. Without a clear and organized paper (or electronic) trail, business transactions will be difficult to monitor. Maintaining a ledger and keeping a journal will eventually be beneficial identifying where company money is coming from. These books are used to help people figure out anything suspicious in their financials.

Abrupt lifestyle changes

An executive or employee whose lifestyle is not supported by his or her income can be an indication of fraud. According to a paper by The National Bureau of Economic Research, weak corporate culture and board monitoring are factors that contribute to the propensity of “unfrugal” CEOs and CFOs to live beyond their means (which is evident in their conspicuous consumption). They identified these big spenders to be working in companies where fraud is perpetuated by accounting errors, inefficient systems and a lack of investment in long-term growth but have the gall to dump corporate money into their personal purchases.

For example, commanding top pay is a precursor to managerial entrenchment (how top executives and managers use their firm to further their personal interests). Two professors from Cornell and NYU found out that CEOs’ purchases of large homes and estates are a strong indicator of eventual corporate mismanagement as stated in the researchers' paper. This perhaps explains why Warren Buffett has lived in the same house until now, which he bought in 1958.

Weak IT controls

With only a few people around the office, small businesses tend to share access rights to information systems. When staff are assigned to multi-task, shared login passwords make things easier. However, shared privileges and permissions expose the business to higher risks of fraud, hacking and information intrusion.

Excessive executive control

When small business owners are not capable of performing specific functions in the organization, particularly finance, a point person is tasked to take on such roles. However, the expertise will only be concentrated on a single employee who can circumvent the entire system with fictitious transactions without a sweat.

Unqualified finance head

Small businesses are known to skimp on hiring top talent. However, when an underqualified finance staff gets to rise to the top because of tenure and not on merits, expect things to fall into chaos. Furthermore, because such people would pretend to have learned finance through years of practice, they would be able to pass themselves to company owners as reliable managers.

Employees who show too much dedication to the job and refuse to have someone takeover their post while being away are only under the guise that they’re hardworking.

Employee skips vacation regularly

When a staff, manager or executive refuses to take the time off for a much deserved vacation, there’s a strong possibility that fraud is being committed. This is not to say that the hard workers who put in more hours are to be suspected right away. However, employees who show too much dedication to the job and refuse to have someone takeover their post while being away are only under the guise that they’re hardworking.

In 2007, a trader at French investment bank Société Générale admitted to siphoning off $7 billion. How did he manage to get away with such massive looting?

You guessed it – he didn’t take a single day off for the entire year so that his peers can't access his books.

No oversight and review

Company leaders who have no regard for performing fraud controls through regular book reviews, document analysis and account reconciliations are creating a chink in their organizations’ internal control monitoring procedures. By not accessing files firsthand or having it reviewed by a third party service provider, fraudsters are able to conceal evidence effortlessly.

What Can Small Business Owners Do to Prevent Fraud

When you have already detected red flags or would want to contain the damages that a recent fraud case has effected, keep in mind these action items for your small business.

Perform background checks

Background checks are the first line of defense against potential hires.

Berkshire Hathaway vice chairman Charlie Munger was proud to tell an interviewer, “By the standards of the rest of the world, we overtrust. So far it has worked for us. Some would see it as a weakness.”

Together with his partner investor Warren Buffett, they’ve decided not to have a Human Resources Department in their firm because they trust their employees — a lot.

However, not all businesses can do such thing, especially small enterprises. That’s why background checks are the first line of defense against potential hires who will handle critical positions such as accounting and inventory management. By knowing their employment, criminal and educational history, a candidate can be assessed if he or she can be a good fit to the organization.

Reference checks are also important to verify if the person has resumé inaccuracies or has encountered litigious behavior that he prefers not to divulge.

Maintain record-keeping and organization throughout the organization

Company owners need to track all information in their business through a proper record-keeping system. However, the days of keeping cartons to store documents is now passé. A software or cloud-based computing system, whichever they think is best suited to their operations, can reduce conflicts involving terms of chain of custody as well as develop permanent footprint. All information is tracked and documented, giving business owners peace of mind.

In addition, by implementing an accurate records system, the business can pass audit requirements by government offices and can help them save a huge amount from paralyzing fines.

Never mix personal and business finances

While this is an age-old rule that almost every entrepreneur knows about, many businesses that are backed by personal finances still fail to draw a line between their business and personal expenses. Co-mingling personal funds because owners are too lazy to open a separate business bank account leaves a lot of money on the table.

Furthermore, the IRS is bound to conduct an audit on businesses that deduct personal purchases as business expenses. If proven guilty, the penalty for false deductions plus back taxes (unpaid balance) may put a company in the red.

Business owners must set aside their personal credit cards in favor of a business credit card. This can also help in building a business credit profile, which can benefit the owner in the future when seeking a business loan to expand her business. It would also help if a legal entity for the business is created so that other members of the organization are aware that the owner’s personal assets are separated from business debts.

Hire a credible finance professional

It pays to have someone knowledgeable on the correct process of reporting the company’s income to the IRS. Anybody who is qualified to compute for the business’ tax bill and file the necessary forms and payments must also be adept at correcting accounting data errors. This is especially helpful when the owner is just starting up and does not know anything about accounting, taxation and legal structure.

Owners must faithfully check their books

Business owners need not put too much confidence on their people when it comes to checking the books. Whether they do it by themselves or hire a third-party auditor, the value of having an independent review must always be on their priority list. After all, should the IRS prove that a company is guilty of fraud, penalties can reach as high as 75% on the money it owes on top of the criminal tax fraud charges.

Establish strong anti-fraud policies

Small companies should implement strict measures to reduce their susceptibility to fraud. These include employee programs that remind them of codes of conduct and anti-fraud policies and measures. They should also be able to report red flags to the management while remaining anonymous. Furthermore, regular internal and external audits (surprise audits are even encouraged by experts), risk assessments and financial statement reviews must be conducted.

Finally, business owners must set a schedule to talk and get to know each employee. They can also discuss the grave consequences of fraud in the company and emphasize their commitment to suppressing illegal activities in the workplace.

Fix blind spots right away

Excessive trust on a department head, employees who haven’t missed a working day, executives who devote too much time on their hobbies — all these red flags point to possible fraud. By teaching everyone to observe vigilance and listen to their instincts, organizations can investigate such cases immediately and recognize blind spots that would otherwise put the business at risk if left unattended. By setting up a fraud reporting system, any employee even in small organizations, cannot be intimidated by abusive executives when signs of fraud are noticed.

Rotate responsibilities among employees

For employees working in the same department or account, rotating their duties can minimize the lure of asset misappropriation and skimming anomalies. This deters anyone from monopolizing internal knowledge, customer data and other confidential numbers.

Perform due diligence

Entering contracts can be successful if both parties work their way to a transparent relationship. By performing due diligence through asking questions that can clarify gray areas, one can uncover more sophisticated business intelligence results.

In addition, small business owners tend to form partnerships based on friendship and trust between business partners. While familiarity may be a strong factor in sealing the deal, performing due diligence before and during the transaction should still be part of the process.

Separate personal emotions from business interests

Ever paid for an expensive all-you-can-eat dinner in a fancy hotel? It’s not uncommon to find fellow diners getting a hefty serving on their fourth or fifth plate, which is more than what they could take. Behavioral economists attribute this to the sunk-cost fallacy. It’s natural for people to make the most out of their money’s worth even if it makes them less happier (or in this case, more bloated).

In business, this psychological condition not only applies to money but also to time, effort and even emotions that we have invested. Keeping an incompetent employee under your wing because the company has paid for his MBA, pushing through with a dubious transaction just because the entire team has spent months courting a VIP client, or not letting go of an executive suspected of reimbursing fake receipts just because he has been with the company for more than a decade and has been a top seller too — these are just some of the common examples how the sunk-cost fallacy contributes to fraud.

When business owners stick to something even if it no longer serves them right, it’s time to realize that personal emotions should not get in the way of business decisions. Pursue an investigation to verify if fraud has been committed. Learn to let go of employees who have violated the code of conduct. Rectify the situation as early as possible to prevent digging a deeper hole for the business.


Small business owners are more vulnerable to fraud because they do not have the same sophisticated internal controls as large companies do. Furthermore, they need to be aware of red flags that are present in their organization. When owners are too much complacent on their employees, the risk of having kickback schemes, false customers, ghost employees in the payroll, and executives living large financed by corporate money are just some of the kinds of fraud that may occur.

Detecting these activities early on can help in containing the devastating effects of fraud to the business’ financial standing. Some of the preventive measures include performing due diligence, training employees how to report fraud, separating personal expenses and emotions from the business, and enforcing anti-fraud policies in the workplace.

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Brett Pittsenbargar is a savvy business investor and turnaround strategist dedicated to assisting business owners reach their objective at every growth phase. With a background in business development and investment experience, Pittsenbargar understands that business is much more than written contracts, it is about the people working every day in the business that matter most for small and medium sized enterprises generating $1-10+ million in revenue annually. He invests in, mergers and acquisitions, growth partnerships, cash out purchases and adding shareholder value.

Consult with a seasoned business investor that has decades of experience helping small and mid-sized businesses. A business strategist who can work directly with you in developing exit strategy plans, partnering growth partnership, building shareholder value and organizing mergers is critical for your business. Contact Growth Point Holdings today to arrange a one-on-one consultation with a dedicated business strategist to start building a synergistic long-term business relationship together.

Disclaimer: This article is intended to give you general business information, not to provide specific legal or financial advice. Be sure to consult your attorney, accountant, and financial professionals for any specific questions relating to your business.