Preventing Fraud in the Family BusinessAugust 6, 2013

We’ve all read about business fraud, perhaps even in our local region.  A trusted employee is discovered to have diverted company funds to themselves for years – the results being a loss of tens or hundreds of thousands of dollars, the former employee facing at least public humiliation for the crime, if not jail time, and the shattering of the myth of the business being safe.  But of course this couldn’t happen in a family business – after all, its employees are either family or trusted peers to the family, and everyone there is happy and satisfied with the company.  Right?

Why is fraud different and how is it possible in a family business?  Fraud is most likely in circumstances outlined in Donald R. Cressey’s fraud triangle – in short, 1) the perpetrator has a perceived financial need (e.g., their kid is going to an expensive college); 2) there is a perceived opportunity to take money from the business (e.g., they are the controller and no one else oversees the checkbook); and 3) the fraudster can rationalize the reason for taking money (e.g., they feel they don’t earn enough money compared to others at the firm).  These circumstances can be found in many businesses, including a family business.

There are some unique circumstances in a family business that make fraud very tempting.  The first part of the triangle, perceived financial need, can exist in a multi-generational family business, as sometimes the second or third generations are unaware of the financial struggles of the generation that started it all.  Their perception of money and the manner in which they feel they should live could be very different from their predecessors, and they may feel they need more money to continue a certain standard of living no matter what hardship may hit the business.  As far as opportunity, a belief that family members are the most trusted of anyone in our lives is actually a weakness.  There may be less oversight of family members handling the finances.  Finally, the rationalization needed to take the money could be based on the perception that the family member had to work many more hours to help the business, and they feel that they really “earned” more than they received in their paycheck.

Frequently, in a family business family members are put into a management position that they need to grow into, and are not yet ready to handle.  In this case, financial or sales records may be altered to show greater success than what was actually achieved, and the pressure to do well when unprepared may also cause resentment for being in the role.  Fraudsters may believe there is a lesser chance of being caught or being prosecuted, as family businesses rarely report the crime and avoid any public mention of the problem.  Another difference is that non-family members in a family business may feel the disparity in pay, promotions or respect that could lead to the justification that they should have more money.  It would be foolish for a family business to feel this can’t happen to them.

How the fraud may be committed.  Here are some common methods of business fraud that relate to family business where the employee handles the accounting without oversight:

• Padding their own paychecks or business-expense reimbursements.
• A “ghost” employee is created, and paychecks for this fictional worker are deposited in a private account.
• Easy access to inventory, especially for a family member, makes inventory theft more likely.
• Personal expenses are put on company credit cards.
• The employee “skims” cash, meaning they take it from the cash register before it is recorded in the books.
• Fictitious vendors are created and payments are made to them by check or wire transfer.

Preventing fraud.  Most of these frauds can be eliminated by taking some of the following proactive steps.

• Fix weak internal controls by having a CPA or other professional design checks and balances and put other oversight measures in place.
• Segregate financial duties so no one person controls the books; not using a rubber stamp for checking signing and having two family members sign checks are helpful.
• Don’t be afraid to review procedures and financial records periodically just because you don’t want the family to think you don’t trust them.  Avoiding fraud benefits everyone, and trustworthy employees will have no problem with having vendor and payroll lists reviewed to ensure there are no fictitious names.
• Establish clear expectations of family members for their place in the business, and hold regular meetings where finances are reviewed.

In the long run it is much more cost-effective and productive to prevent fraud than it would be to discover and attempt to recover the proceeds of fraud.  If you eliminate the opportunity elements of the fraud triangle in your family business, you will worry less about it destroying your business or your family.

Contact me at rkvalo@curchin.com or 732.747.0500 with questions about preventing fraud or to receive a complimentary consultation with our family business advisors.