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Online Exclusive: Accounting Basics for Small Contractors — Fraud Schemes and Internal Controls

Jan. 5, 2015
There are a few ways to forge a check. An employee submits fraudulent invoices whereby the company then pays out checks. The technician will pocket cash and tell the office the customer canceled the call when they got there.

In the last installment in this series, we talked about the leg of the fraud triangle that we can control — opportunity. I also introduced you to the term “internal controls” and why it’s important to have them established in your company.

Let’s take a look at some specific fraud schemes and internal control procedures that could combat each of the schemes.

Forging or Altering Checks

There are a few ways to forge a check. You could make the check payable to a company with a name very similar to an actual vendor of your company. You may have a legitimate vendor called ABC Supply. The perpetrator would create a vendor account with the name ABC Supply Corp. They’d open a bank account under that name and have payments made to the fake company with a mailing address of a post office box. They could also write a check to the fake company or even make it out to themselves directly but not record the transaction in the accounting system. Sometimes checks are altered after they’ve been printed. The perpetrator alters the amount of the check or the name on the check.

You can combat this by establishing procedures to secure and restrict access to the company’s blank check stock. Have the bank reconciliation done by someone other than the person who writes the checks. Also, have the bank mail the bank statement to the owner’s home or a post office box rather than it being mailed to the office. You can also discover unrecorded checks by comparing the canceled checks to the computer accounting records. Also, someone other than person who writes the checks should occasionally compare the vendor list to the check payees looking for discrepancies. Also, carefully review canceled checks or the photocopies of them looking for erasure marks or evidence of correction fluid (“White Out”).

Billing

An employee submits fraudulent invoices whereby the company then pays out checks. The document (bill/invoice) for the check is fraudulent. However, the payment appears to be legitimate. The perpetrator might inflate or double-pay an invoice from a supplier. It takes more effort (because it involves more people) but there have been instances when an employee has recruited a supplier employee to help them steal money from a company.

One control that you can put into place to help prevent this type of fraud is to maintain and occasionally review the company’s approved vendor list. Like forging checks, compare records to see if cleared and voided checks are recorded in the company’s accounting system. It doesn’t happen as often, but you should compare the addresses on vendor checks with the addresses on the invoices or their physical mailing addresses. Make sure an address doesn’t pop up as the address of a company employee.

Like other areas of a business in dealing with fraud, separation of duties is the most effective control you can have in place. Employees responsible for ordering items shouldn’t also be able to approve new vendors, enter invoices for payment, approve invoices for payment or pay the invoices.

Larceny (stealing cash)

There are a few ways I’ve heard contractors being victimized by larceny. One is where a customer will pay a technician with cash on a service call. The technician will pocket the cash and tell the office the customer canceled the call when they got there. They destroy the service ticket and pocket the cash. Or, they’ll cover their tracks a bit more by only turning in cash in the amount of the service call fee and saying that the customer declined the work. They forge the service ticket and, again, pocket the rest of the cash. I’ve also heard stories where the technician asks the customer to make the check payable to him or to cash. It may seem odd but some customers have been manipulated to do this. The technician cashes the check and alters the paperwork. It’s not just technicians that can do this. There are many instances when this happens with office personnel.

A good way to reduce the chance of this happening includes following up with your customers after service calls.  Also, have a second (different) person count all cash receipts that come into the office. It’s also important to lock up all cash and checks received until they’re ready to be deposited in the bank. Again, if possible, the person who fills out the deposit slip and the person who makes the bank deposit should be different people.

Inventory Shrinkage

An employee may take inventory items from the shop or a service truck and not report it. They may use the materials personally on a side job or sell them to someone else. This can be uncovered when the company does a physical inventory count. The counts will come up short, i.e., the inventory “shrinks.” If a physical inventory isn’t done, then the theft may go undetected for some time. Unless it’s a significant theft, it wouldn’t show up on a financial statement as much of a variance. (For example, if $1,000 worth of materials is stolen over the course of a year in a company that has $200,000 in material purchases)

A significant control that you can put in place is physically securing access to materials and equipment. Lock up your inventory. Check your security cameras for unauthorized after-hours access to the shop (assuming your inventory is kept there). You can also establish procedures for ordering materials (i.e., a purchase order system).

These are some of the more common fraudulent schemes that contractors are faced with on a regular basis. Establishing internal controls in these areas of your business should significantly reduce the chances that you’ll be a victim of fraudulent activities.

Michael Bohinc is a Certified Public Accountant in Cleveland, Ohio, and the owner of Keeping Score Inc. He has served as the Chief Financial Officer of Norhio Plumbing Inc., his family’s plumbing company in Aurora, Ohio, since 1988. He is no doubt counting the days until his Cleveland Indians report for spring training in Goodyear, Arizona. He can be reached at [email protected].

About the Author

Michael Bohinc | CPA and CFO

Michael Bohinc is a Certified Public Accountant in Cleveland, Ohio, and the owner of Keeping Score Inc. He has served as the Chief Financial Officer of Norhio Plumbing Inc., his family’s plumbing company in Aurora, Ohio, since 1988. A veteran speaker, he's trained hundreds of contractors in the basics of accounting and on fraud prevention. He also currently serves as the Interim Director for the Service Nation Alliance – Plumbing Group. He's also a die-hard Cleveland Indians fan. You may contact him via e-mail at [email protected].

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