For many non-financial firms, extending trade credit is an important part of doing business. A challenge for these firms is that, unlike banks, they often lack long experience managing such accounts––thereby opening the door to employee or customer fraud. A recent survey by the Association of Certified Fraud Examiners indicates the typical firm loses 5% of revenues annually to internal fraud. Companies with fewer than 100 employees are most at risk. The typical fraudster has 1 to 5 years employment tenure and no criminal history. “Lapping” is the most common type of internal accounts receivable fraud––a clerk pockets payments to customer A’s account, then uses payments from customer B to keep A’s account current, credits customer B’s account with payments from customer C, and so on. A few simple safeguards can go a long way toward preventing internal fraud or catching it early (which cuts losses dramatically): 

• Segregating and rotating duties that involve receiving or disbursing payments. 
• Requiring all employees to take annual vacations. 
• Training managers to review subordinate work with an eye for possible fraud. 
• Creating internal “hotlines” for employees to report suspected impropriety. 

The last safeguard is particularly important as internal fraud is mostly commonly exposed by employee tips. Large companies are less vulnerable because they can invest more in prevention and detection. But even big firms can get hurt when they leave an opening. Consider a recent case of customer fraud at Lowe’s––a home improvement retailer with over 1,800 stores in the U.S., Canada, and Mexico. In January 2017, federal authorities arrested Kenneth Cassidy of Brooklyn, New York for allegedly opening at least 173 “pre-funded” trade-credit accounts at individual stores throughout the U.S.––each with a different fake company name and counterfeit check. Individual stores sent the applications and checks to corporate headquarters in North Carolina for processing, so up to 10 days could elapse before a check bounced. But, in the interim, Lowe’s extended credit to the bogus company for the full “pre-funding” of the account. By not making sure the checks cleared first, Lowe’s allowed Cassidy to steal over $2.6 million in merchandise. Interestingly, the fraud appears to have relied on marginal analysis. Cassidy recognized Lowe’s had a materiality threshold for investigating scams, so he kept the pre-funding checks under $1,600 to reduce the chance of discovery. Keeping the fake checks small, however, had a “shoe-leather” cost–– the time and energy necessary to apply for accounts in hundreds of stores. By trading off capture risk and shoe-leather costs, Cassidy was able to bilk Lowes from June 2012 to December 2016. The moral: If accounts-receivable policies leave an opening for fraud, some bad guy will find it.

Small firms are frequent victims of internal fraud because (i) the owner knows and trusts all employees and (ii) size makes segregating duties difficult. Careful monitoring through micromanagement, audits, and cameras can reduce vulnerability but at the risk of losing the “family feel” of a small business. How should small firms weight the benefits of reducing fraud losses against the costs of lower employee morale?