4 Ways to Avoid Small-Business Fraud

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(TheStreet would like to hear from entrepreneurs what made their small businesses successful -- newfangled strategy, clever products or services, tried-and-true management techniques. To do so, please click on this link and follow the directions. TheStreet's readers may soon be hearing about your business.) BOSTON (TheStreet) -- If desperate times can call for desperate measures, small-business owners shouldn't be surprised to learn that an economic recession can lead to employees engaging in illicit business practices.

"With the downturn in the economy, you see an uptick in fraud," says Ken Springer, president and founder of Corporate Resolutions Inc., a New York-based company that investigates fraud reports.

And that can cost. Participants in a survey by the Association of Certified Fraud Examiners in Austin, Texas, credited 5% losses in annual revenue to fraud, or a median loss of $160,000. When applied to the estimated 2009 gross world product, that's more than $2.9 trillion.

TheStreet recently called Springer, who previously investigated fraud for the Federal Bureau of Investigations, to discuss smart practices for small businesses that want to avoid getting fleeced by their employees.

1. Before hiring anyone, conduct a background check.

More than 85% of fraudsters have never been charged or convicted for a fraud-related offense, according to the Association of Certified Fraud Examiners. But a background check, even a cursory one, still can set off red flags that prevent would-be fraudsters.

"In this day and age, no matter who you are, you need to make sure you know who you're doing business with, whether it's a low-level employee or a senior employee," Springer says.

Small businesses that don't want to invest in a full criminal background check should at least check an employee's references to verify employment. And a Google search, while not foolproof, can reveal resume discrepancies too, as well as problematic patterns -- such as a history of filing lawsuits at the drop of a hat. A credit check that reveals a terrible score is another potential fraud flag.

In a recent ACFE study, the most common behavioral red flags fraudsters displayed were a tendency to live beyond their means (43% of cases) and experiencing financial difficulties (36% of cases).

2. Keep an eye on each other

In lean times, when many small companies are operating with skeleton crews, it's all too easy for operations to get compartmentalized to the point where one department doesn't know what the next is doing -- or for one person to be doing the work of multiple departments. This is a recipe not only for overworked employees, but also for fraud.

But employees are less likely to attempt fraud if they know the company is at least trying to prevent it. Occasional audits can help prevent money laundering, and installing cameras in loading zones can prevent property theft. Sounds like common sense, but many small-business owners don't employ common sense.

"Many times the entrepreneur has blind faith," Springer says. "And then the bookkeeper can write expense checks to companies that don't exist."

More than 80% of frauds in the ACFE study were committed by people in one of six departments: accounting, operations, sales, executive/upper management, customer service or purchasing.

3. Invest in fidelity coverage

Most business owners are familiar with insurance fraud. But fewer are familiar with fraud insurance -- aka fidelity insurance -- which protects businesses in case of losses due to embezzlement, forgery, robbery, burglary and so on.

"Sometimes to save money, people won't buy fidelity insurance, but in the scheme of things it costs peanuts," Springer says. "We had one case in which the bookkeeper was the one who said they couldn't afford the fidelity insurance, and it was the bookkeeper who was stealing the money."

4. Enable anonymous whistle-blowing

In a small business, where the whole company works side by side, employees might worry about the ramifications of ratting each other out on fraudulent behavior -- unless they can do so anonymously.

Hire a third-party intermediary to field anonymous tips and help determine whether an accusation is valid or just sour-grape complaining. According to the ACFE, such a system can be even more effective than an audit.

"Staff members are an organization's top fraud-detection method; employees must be trained in what constitutes fraud, how it hurts everyone in the company and how to report any questionable activity," reads a recent ACFE study. "Our data show not only that most frauds are detected by tips, but also that organizations that have anti-fraud training for employees and managers experience lower fraud losses."

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