Big frauds start small

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Tracy L. Coenen

Take a look at the frauds in the news, and most of them are huge. Huge frauds make huge news.

As investors and the general public demand more transparency from companies and executives, the issue of fraud is being talked about more than ever. Everywhere we turn, the word fraud is rearing its ugly head.

While fraud is a good thing if you make a living as a fraud investigator, it’s not so good for business and profits. The impact goes beyond dollars and cents, as fraud can negatively affect employee morale, employee work ethic, investor confidence, and customer loyalty.

The sad truth is that almost all frauds started small. They had to start somewhere before they grew to those headline-grabbing proportions. Think about Enron, everyone’s favorite example when discussing corporate fraud.

It’s hard to believe that Enron ever did anything small, but it is true. In fact, the downfall of Enron can be traced back to some fairly minor manipulations in the grand scheme of things. One of the early frauds was a manipulation to boost quarterly earnings that otherwise would have fallen just a little short of Wall Street’s expectations.

This type of manipulation at Enron grew over the years. Add a little extra income here, shave a little off expenses there, and manipulate the accounting rules to boost earnings over there. The small fraud grew, and grew and grew. And the more management appeared to turn a blind eye to fraud (and maybe even encouraged fraud), the bigger it got.

Easy Start

It is eye-opening to trace a fraud back to its roots or to talk to someone who will be completely honest about a fraud she or he committed. You get a chance to see how easy it was to commit that first fraud.

It was small, and therefore easy to rationalize in the mind. Maybe the thief decided it was just “borrowing” or rationalized that the money represented excess funds that no one would miss. Either way, a small sum of money was pretty easy to justify.

Many frauds start with an error, which makes the process of justification even easier. That first fraud wasn’t her or his fault anyway! Someone in a position of trust sees that an error wasn’t caught by the company’s system of checks and balances. Maybe a bank account didn’t balance, but no one said anything about it. Or an accounting entry was made to an incorrect account, but no one ever noticed.

These types of oversights can tempt an employee to take advantage of the weaknesses in the system. The employee typically commits that first fraud, and then looks for opportunities to further manipulate the system where the monitoring is lax.

Other employees purposely try to exploit the system the first time. They test the system with small transactions to see if anyone notices. If someone flags the item, the dishonest employee can claim it was a mistake. With a small dollar amount at stake, no one will think much more about it.

If the manipulation is not caught by a coworker or supervisor, the new thief feels comfortable enough to do a transaction that is a little bigger. Frauds of this type can grow quickly as the employee becomes comfortable with the lack of controls to detect these types of transactions.

Clearly, it is imperative to monitor and improve internal controls to prevent and detect abuses in the system. Yet small frauds, the ones that may be the precursors to bigger frauds, are a low priority to companies. The cost of looking for small frauds seems to outweigh the benefits in the short run. However, that’s not truly the case.

Quick Stop

At a business of any size, it’s important to stop these small frauds quickly. Stop them before they can grow into the big frauds. The key to catching them early is being aware of the signs of fraud and taking quick action. Otherwise, the fraud can quickly snowball, and the company may soon become buried under an avalanche.

It’s hard to catch fraud when it’s small because the fraud is scattered throughout the company. From the expense report abuse by an executive, to a purchasing manager who accepts a personal gift, to the employee who padded her hours, these things can be very small in the grand scheme of things. The mere fact that they’re small makes them hard to detect.

In addition to being hard to detect, small frauds often get a pass from management because they don’t seem worthy of the effort. Even though it may not seem cost-effective to seek out the small frauds, if you look at it in terms of preventing larger frauds, it’s worth it. Halting a small fraud completely prevents that situation from getting out of control. That activity can never turn into a big fraud. That seems worth the effort.

Stopping the small frauds also reinforces a zero tolerance policy. When employees see that fraud and abuse is stopped and consequences are given, that goes a long way toward preventing future frauds. An employee who may otherwise have been tempted to test the system or exploit a weakness may consider the consequences given to other employees who committed fraud.

Know the Cause

Putting a stop to fraud, big and small, demands that we understand what drives the fraud. People have something within their personal moral codes that causes them to commit fraud.

One of the most common factors that I have seen in each fraud I investigate is greed. Not every fraud starts out this way. There are plenty of schemes that started with a need on the part of the thief. Maybe there was a mortgage payment due or an unexpected car repair bill. The thief probably doesn’t think a theft in this situation is related to greed, and maybe it’s not.

But for many who commit fraud, they are just plain greedy. They see an opportunity, and they exploit it — period. For many of these people, there isn’t even a question as to whether or not they’ll steal from the company. If the opportunity is there, they’ll take it. A fraud may grow for this type of person because it is fun or gives the employee a “high.” But to continue to get that “high,” each fraud must be a little bit bigger, a little bit more risky.

For others, greed doesn’t come so naturally, but may still be there. An accounting manager may have started a fraud scheme to pay a few personal bills that were looming. The original intent was to cover those bills, and no more. But as the fraud progresses to three or four or five incidents, the accounting manager starts to develop the greed.

She or he probably wouldn’t immediately recognize it as such. But it’s there. Maybe a desire to buy some nicer shoes, and one more theft would pay for them. What about a nice dinner out? Another theft could fund that. The thief starts thinking about the things that the company could “pay for,” and this is how the greed builds.

Can companies prevent or remove greed from the mindset of their employees? Probably not. However, management can be on the lookout for signs that
point to greed in motion. Management can also make sure that employees are fairly paid, treated equitably, and duly appreciated for their contributions to the company. Doing these things helps stop some good employees from going bad.

Beyond that, the way to manage the greed is to look for fraud and stop it dead in its tracks. Management must make the small frauds a priority, and follow through on them to stop them from becoming big frauds. All fraud is important, not just the big fraud that we see in the headlines.

Tracy L. Coenen, CPA, MBA, CFE, is the president of Sequence Inc., a forensic accounting firm with offices in Milwaukee and Chicago. Coenen can be reached at [email protected] or 414-727-2361.