Best Practices for Preventing Internal Fraud

“My employee would never steal from me! He/She has been a loyal employee for 10 years and is like part of the family!”

This statement is the most common rebuttal we hear when an act of internal fraud or theft is discovered. When presented with the evidence, the dealer not only has to process that they have been a victim of a crime but also questions their intuition and how they misplaced trust. Furthermore, the employee is typically a “model employee” that will be hard to replace.

Unfortunately, internal fraud is a serious threat to all business owners and poses significant risks to dealerships. An act of internal fraud can undermine the financial stability of the dealership, disrupt operational efficiency and erode trust among employees while diminishing company culture.

Recent reports indicate that approximately 84% of dealerships experience some form of internal fraud. It is estimated that the typical organization loses approximately 5% of its revenues each year to fraud. Five percent of revenue in a dealership may be unlikely, but 5% of gross profit is not, which still amounts to a significant amount of money. The Association of Certified Fraud Examiners estimates the median loss per fraud incident to be $145,000 before it is discovered. So, how do dealers prevent this from happening? By understanding what it is, why it happens and how it happens, dealerships can put controls in place to minimize the opportunities.

What Is Internal Fraud?

Internal fraud refers to unethical activities committed by employees, such as embezzlement, falsified records and unauthorized transactions.

Why Does It Occur?

The Fraud Triangle is a well-known model that illustrates why an employee may be at increased risk of stealing from their employer. When the three components — pressure, opportunity and rationalization — converge, an employee is at higher risk of committing internal fraud.

• Pressure: Personal lifestyle creep, medical or other financial stresses are common pressures that motivate internal fraud.
• Opportunity: The employee has access or lack of oversight that allows the opportunity to commit the fraudulent acts.
• Rationalization: The employee justifies why they are committing the fraud. Common examples include: no one will notice, the employee deserves it, they are a long-time employee of the dealership or perhaps they see it as a short-term loan that they will pay back.

What Can Dealers Do?

Of the three conditions listed above, the employer cannot exert considerable influence or control over the outside pressure or rationalization components. However, they can control the opportunity component by implementing proper internal controls, oversight and fraud determent programs.

Each department in the dealership faces unique risks when it comes to limiting internal fraud and requires unique controls and oversight.

Accounting Department

The accounting department is a frequent target for fraud due to the inherent risks as employees deal directly with financial transactions. Therefore, internal controls and oversight within this department are essential.

• Segregation of duties: Divide tasks among multiple employees so no single person can initiate, authorize and record transactions. For example, the employee handling cash deposits should not complete the daily cash reconciliations.
• Reconciliations: Conduct regular account reconciliations to identify discrepancies, which should be investigated. For higher risk accounts, we recommend more frequent reconciliations. For example, we recommend reconciling your cash accounts daily.
• Cross-training of employees:
• Cross-training allows for operational efficiencies during employee absences and provides a second set of eyes on critical roles.
• Mandatory vacations: Requiring employees to take vacations ensures their duties are temporarily performed by others, potentially uncovering irregularities.

Sales Department

Internal fraud in the sales department often involves selling phantom products or falsifying loan documents. Controls to mitigate fraud in the sales department include:

• Regular audits: Conducting regular audits of inventory, deal jackets and sales practices to detect irregularities.
• Transparent communication: Ensure customers understand pricing and service options so that they understand what they are purchasing and avoid confusion during the sales process.
• Anonymous reporting: Implement mechanisms that allow employees to report unethical behavior safely and anonymously without the fear of any repercussions. This will cultivate a culture of integrity and self-monitoring.

F&I Department

The F&I department faces challenges such as loan markup fraud, warranty scams and phantom labor charges. Recommended controls include:

• Automated systems: Use technology to flag inconsistent loan terms or excessive markups.
• Ethical compensation structures: Avoid high-pressure sales incentives that encourage unethical behavior.
• Compliance training: Educate employees on regulations and the consequences of fraud.

Service Department

Common types of fraud in service operations include inflated labor hours, theft of parts and duplicate warranty claims. Preventative controls include:

• Segregation of duties: Separate the tasks between the employee who diagnose the service work and the employee in charge of invoicing the customer.
• Random inspections: Conduct random checks of work orders and inventory to detect discrepancies.
• Customer feedback: Encourage feedback to verify services rendered and uncover issues.

Parts Department

The parts department is vulnerable to theft, unauthorized inventory adjustments and inflated pricing. Controls to deter fraud include:

• Inventory reconciliations: Conduct regular internal reconciliations as well as third-party audits.
• Access restrictions: Limit access to inventory systems to necessary employees and require approvals for returns or discounts.

What Are the Symptoms & Indicators of Internal Fraud?

Even with strong controls, fraud can still occur. As an owner, be on the lookout for the below indicators increasingly associated with fraudulent activity:

• Messy accounting: Look for incomplete records, large journal entries by CPAs at year-end or frequent discrepancies during account reconciliations. Pay attention to discrepancies.
• Customer complaints: Monitor for confusion over service costs, billing errors or overcharges.
• Unusual employee behavior: Be alert to employees working odd hours, resisting questions or displaying defensiveness.

How Do I Respond if I Suspect Fraud Is Occurring?

In the unfortunate circumstances that internal fraud is suspected or detected, we recommend a dealer immediately act with the following steps:

1. Containment: Restrict the employee access to systems, freeze suspicious accounts and secure documentation related to the suspected fraud.
2. Contact professionals: Immediately notify your CPA, legal counsel, insurers and local authorities.
3. Quantify dollar impact: Work with the professionals to quantify the dollar impact for insurance reimbursement and potential retribution, as well as potential tax deductions.
4. Review and improve internal controls: Evaluate how the fraud occurred, and review and improve internal controls to eliminate the opportunity for the internal fraud to reoccur.

Creating a Fraud-Resistant Culture

The foundation of fraud prevention lies in fostering a culture of integrity. Dealerships must have internal controls and training, encourage open communication and ensure employees feel safe reporting concerns. By embracing the principles of “Trust but Verify,” dealerships can safeguard operations, protect financial health and maintain trust with employees and customers.