Beneath the surface: The hidden role of employee fraud in business failure

Employee fraud is a growing threat to businesses worldwide – and smaller businesses are among the hardest hit.

According to the Association of Certified Fraud Examiners’ (ACFE) 2024 Report to the Nations, organisations lose an estimated five per cent of their annual revenue to occupational fraud, with most schemes remaining undetected for around 12 months. For smaller businesses, fewer resources and weaker internal controls can create the perfect storm, quietly weakening the business long before anyone suspects something is wrong.

While employee fraud rarely causes a business to fail on its own, it can accelerate financial decline by draining working capital, distorting financial records and reducing the assets ultimately available to creditors. When a company enters external administration or liquidation, closer examination of the financial records can reveal that employee fraud played a much greater role in the business’s decline than first appeared.

Poor trading conditions, rising costs and cash flow pressures are often the primary drivers of business failure. However, insolvency investigations can sometimes uncover a more complex picture, where financial misconduct has quietly compounded those challenges for months, or even years, before the business reaches breaking point.

When fraud and financial distress collide

This is where forensic accounting becomes invaluable. By analysing financial records and tracing transactions, forensic specialists can determine whether employee fraud contributed to a company’s decline, quantify losses and identify assets that may be recoverable.

Forensic accounting is not about assuming fraud has occurred. More often, it confirms a business failed because of genuine commercial pressures. However, where the financial records don’t align with the commercial reality, forensic investigations can establish what happened and identify opportunities to recover assets.

Employee fraud can:

• quietly erode working capital;
• conceal a company’s true financial position;
• delay directors from recognising financial distress;
• reduce the assets available to creditors; and
• create additional legal issues once formal insolvency appointments commence.

Employee fraud often remains undetected until an independent review of the financial records is undertaken. By then, losses may have accumulated for months, making recovery considerably more difficult.

Understanding why fraud occurs

The “Fraud Triangle” identifies three conditions commonly associated with occupational fraud:

• Pressure – financial hardship, personal debt, gambling or lifestyle pressures.
• Opportunity – weak internal controls, inadequate oversight or unrestricted access to company funds and financial systems.
• Rationalisation – believing they are simply “borrowing” money, are underpaid or deserve additional compensation.

Businesses experiencing financial pressure can unintentionally increase opportunities for fraud by reducing staff numbers, consolidating responsibilities or relaxing internal controls.

Employee fraud can take many forms, from payroll manipulation and false supplier invoices to duplicate payments, diverted customer receipts, expense reimbursement fraud and procurement kickback arrangements. Individually, these transactions may appear minor, but collectively they can quietly erode cash flow while masking a business’s true financial position.

Warning signs accountants should watch for

Because accountants regularly review financial records and trends, they are often among the first professionals to identify anomalies that warrant closer examination.

Common warning signs include:

• unexplained reductions in profitability;
• supplier expenses increasing without corresponding business growth;
• duplicate vendor details or changes to supplier bank account details;
• round-dollar transactions;
• missing supporting documentation;
• unreconciled balances;
• unusual journal entries close to reporting dates;
• repeated overrides of financial controls; and
• employees who refuse to take annual leave or insist on maintaining complete control over financial processes.

While none of these indicators proves fraud, a combination of red flags should prompt further investigation, particularly where a business is also experiencing cash flow pressure or mounting creditor demands.

Looking beneath the surface

Strong governance and internal controls remain the best defence against employee fraud. Segregating financial duties, requiring dual authorisation for payments, independently verifying supplier details, enforcing mandatory annual leave and regularly reconciling accounts can all reduce risk.

When businesses encounter financial distress, forensic accounting can determine whether employee fraud contributed to the company’s decline, identify recoverable assets and provide creditors with a clearer understanding of what happened.

Like an iceberg, the true causes of business failure are not always visible on the surface. Sometimes, the most significant factors only emerge once the financial records are examined more closely.

Peter Moore
Partner
Jirsch Sutherland