Trust and loyalty are desirable traits in family structures and in business; however, these traits can also leave a family business vulnerable.
In fact, family businesses are especially vulnerable to fraud, according to the Association of Certified Fraud Examiners’ (ACFE) 2016 Global Fraud Study. The study found that businesses with fewer than 100 employees, which are in many cases family-owned, experience fraud at a rate of 28.8%, compared to the 19.8% experienced by those with more than 10,000 employees.
In a family business, trust and security often have an inverse relationship, meaning as trust increases in a business, the quality of internal controls and security is minimized. Business relationships — particularly among family members — can become strained when individuals believe they are owed more money or authority than they receive.
Personal financial pressure and emotional stress outside the business can also create tension within an organization. In worst-case scenarios, family members know there is little risk of exposure, and the perceived benefits of financial fraud outweigh these risks.
When family members are suspected of fraud within the business, they may not be held accountable due to the dynamic of family relationships. Family members are often more hesitant to report relatives to authorities, seeking to save the family member from jail time or the embarrassment that ensues.
Of course, smaller companies suffer more when fraudulent activity occurs. It’s more difficult to control the damage in a $5 million company than in a $250 million company. Misappropriated money often makes a greater impact, and the damage is experienced throughout the entire organization, affecting company culture. While a perpetrator in a large organization may be viewed as a singular “bad egg,” one in a small family business can be viewed as an institutional problem, or part of ongoing corruption to other employees.
According to the study, the median fraudulent loss of $150,000 suffered by small organizations was the same as the fraudulent loss experienced by large organizations. However, in a smaller company, that loss represents a significantly larger percentage of the company’s overall value. The number demonstrates the enhanced responsibility and trust often granted to individuals within a smaller company, leading perpetrators to believe they can take more with little risk of exposure.
Establishing effective controls
When personal and professional interests collide, the best approach to maintaining success and prosperity, from both familial and financial perspectives, is to implement and strictly enforce effective internal controls.
Five ways to enforce internal controls include:
1. Segregate financial duties. Corruption involving check tampering, skimming, payroll and cash larceny schemes are twice as common in small organizations compared to larger organizations. One family member alone should never control the entire business’ finances. A simple solution is to create a three-person system of checks and balances: one person opens the bank statements, one prepares the bank reconciliations, and a third reviews all transactions and canceled checks.
2. Avoid signature stamps for checks. Family businesses, in particular, should consider requiring two signatures for any payment over a certain monetary amount.
3. Establish routine checks of payroll, supplier and vendor lists by multiple people within the company. Seventy-seven percent of occupational fraud is committed by employees working in accounting, operations, sales, executive management, customer service, purchasing or finance. The final payroll list should be reviewed by someone other than the person distributing checks and preparing the payroll. Similarly, the list of vendors should periodically be checked for unrecognized names.
4. Give more employees an understanding of financial reporting. Even if employees claim to not be “numbers” people, it’s important that all staff are aware of financial reporting and are making an effort to understand the business’ finances. To increase transparency and provide another level of security, outsource your financial reporting and ensure someone is monitoring for fraud.
5. Focus on ensuring clear expectations are established for all employees. Every employee — including family members — should understand protocols in a business from expectations to pay rates and benefits. Clear expectations help avoid a power struggle and will clearly define who is double-checking various aspects of the business.
Trust is not an internal control
When confronting fraud in a family business, family loyalties or dynamics must be set aside. Even in small businesses, the most common way fraud is detected is through anonymous tips. Organizations with fraud hotlines are more likely to detect fraud compared to those without, at a rate of 47.3% compared to just 28.2%.
Appropriate punishments should be considered in advance and decided upon by multiple employees. Then, companies must follow through on those punishments. The ACFE study found that 40.7% of companies choose not to involve law enforcement due to either fear of bad publicity or the desire to remain loyal to the perpetrator. Decision makers should maintain a zero-tolerance policy for uncovered fraudsters, as an effective deterrent against copycats.
Another measure a business can take to mitigate the damaging effects of fraud is to work with their insurance provider to ensure their plan includes coverage and protection from employee dishonesty. Outside investigative fees are difficult to estimate due to the amount of layers that could be in play in any investigation.
A business should explore purchasing an insurance rider to cover costs of fraud investigations and potential legal fees, as well as the cost of financial loss incurred by the fraudulent activity. In any case, fraud prevention is a much more cost-effective safeguard than reactive damage control.
Fraud can happen anywhere
The more you believe it can’t happen in your business, the more susceptible you become to it. Most fraud perpetrators are first-time offenders and are well-standing employees in the company, resulting in greater access to controls and the belief they won’t get caught. Family businesses’ increased susceptibility is an essential reason to defend against fraud with multiple internal controls and external resources.
For more tips and resources on defending your business against fraud, contact your local law enforcement agency or financial adviser.
Bill Kowalski (info@Rehmann.com) is a principal and director of operations for Rehmann Corporate Investigative Services.
For your business insurance needs: Scott Lynch Agency