Red Flag Series (3 of 5) – Red Flags in a Small Company

When I think of a small company, I think of the “mom and pop” business. This type of company usually starts as an idea and grows enough to sustain the income of the owner(s) and their family members. They grow from a few hardworking individuals, usually just the owners, to eventually hiring employees to help run the company. They treat their employees like family, and in some cases, they are family. These companies and their employees are a huge part of the United States economy.

In the U.S., small businesses (less than 100 employees) employ over a third of the private sector’s workforce and pays almost 28 percent of gross payroll, which translates to over 40 million people and over $1.5 trillion in gross payroll.[i]

With regard to fraud, these same size companies experience median losses of $150,000, which is the same for all cases reported with the ACFE’s Report to the Nation.[ii] However, the impact of the losses is greater because the revenues generated by the smaller company are usually less than a larger company, making recovery harder.

This post will provide some key red flags to help identify a potential fraud in smaller companies or entities with “mom and pop” cultures or characteristics. In these cases, the entity only has a few people involved in the accounting function, which makes implementation of segregation of duties near impossible as there is usually only one employee involved in the accounting for a transaction. The following red flags should not be ignored:

• Hardworking, focused business owner – This is a characteristic of almost, if not every, small business. However, the red flag would be associated with the business owner’s lack of engagement in the accounting aspects of the business, which exists more often than it should. These owners either discount the importance of the accounting function or simply do not understand it, which leaves a huge opportunity for someone to take advantage of this business owner.
• Declining cash flows – This one can be a little tricky because there are times when a business can experience reduced cash flow from growth. Generating an increase in the need for cash from the timing difference between the expending of funds and collection from customers. However, most experienced business owners know how to manage this through lines of credit or other means. The red flag comes into play when the decline in cash flow cannot be explained or the explanation is illogical. Past due notices from vendors, increasing credit card balances or lines of credit growing are all signs that you may have a problem.
• Long-time employee – We all know someone who would fit this description and in most instances, it is the office manager. The owner usually trusts this person implicitly—they have a lot of responsibilities and call almost all the shots. These are good people, but they may commit fraud under the right conditions. See the first blog in this series.
• Customer or vendor complaints – Complaints are a part of every business, but they can also be an indicator of potential fraud. In most small businesses, the complaints are routed to the person who is most likely to commit the fraud. If this person is committing fraud, they can address the complaints by building up the web of lies that cover their tracks.

These red flags are oftentimes ignored until it is too late. If one or more of these red flags are identified or if there are other suspicions, you should discuss it with someone outside the organization. These red flags may also be present in large companies or a government entity because there are also plenty of entities that have “mom and pop” cultures. In next week’s blog, we will cover the red flags within larger companies. 

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[i] http://www.census.gov/econ/susb/

[ii] https://s3-us-west-2.amazonaws.com/acfepublic/2016-report-to-the-nations.pdf (page 32)