Red Flags of Fraud in Family Businesses

Importance of Fraud Deterrence in Family-Owned and Small Businesses:

Family-owned businesses often lack the resources to dedicate toward fraud deterrence and detection and often do not implement preventative controls or measures, and unfortunately, their personnel often lack the technical accounting knowledge to detect falsified transactions or events.

Establishing trust with family members can be both advantageous and harmful. Despite family being the most trusted individuals, opportunities, pressures and rationalization of behavior are factors that could indicate the existence of weaknesses within the business. For instance, a family member could be going through financial pressures such as medical costs, children’s expenses, loss of a loved one, etc.  These types of pressure could ultimately lead an individual to alter their judgement and rationalize fraudulent behavior. The impact of fraudulent activities can extend beyond financial losses, tarnishing relationships and jeopardizing the very foundation of these businesses.

Common Types of Fraud in Family-Owned and Small Businesses:

The most common types of fraud prominent within family businesses are embezzlement, financial statement fraud and asset misappropriation. Each fraud can overlap and ultimately lead to another. For instance, if an employee steals inventory and inflates the inventory count for the stolen item, this is a form of financial statement fraud, leading to falsified records. Understanding each is the first step to preventing such frauds from occurring.

Embezzlement

Embezzlement involves the misappropriation of company funds where an a trusted employee is responsible for the maintenance of financial records and also authorized to access funds. Fraud is often perpetrated where the roles and responsibilities are often blurred and overlap. Embezzlers may exploit the lack of oversight, clear responsibilities, and obtain a position of authority, eventually leading to substantial losses.

Financial Statement Fraud

Financial statement fraud is known when management and those responsible for recordkeeping manipulate the financial records and statements to portray a more favorable position of a company’s financial health. This is often perpetrated for many reasons, however, most commonly a perpetrator of fraud would want to ensure that no indication of such losses were present on the financial statements. However, family owned businesses may also want to attract new investor and creditors and therefore inflate assets and deflate liabilities. The deception is to mislead investors, creditors, and even family members about the business’s true performance.

Asset Misappropriation

Asset Misappropriation, similar to embezzlement, requires that an employee steal and divert tangible assets away from the company. This could be ongoing theft of tangible assets that are either kept or sold to the perpetrator at far below market prices. An owner may prevent such fraud and abuse by installing physical controls such as cameras and locks, as well as performing ongoing inventory counts, either scheduled or random.

As we proceed, we will uncover red flags associated with these types of fraud, providing practical insights for detection and prevention.

Red Flags in Financial Records

The following is a general list of red flags to be aware of while considering the existence of fraud:

Embezzlement

• • Unusually large outstanding receivables;
  • Bank Reconciliations are not completed on a timely basis;
  • Transactions within the bank accounts are not supported by invoice and receipts;
  • An authorized vendor list has not been maintained and such vendors are unknown;
  • Credit card reimbursements are not regularly reviewed.

Financial Statements

• • Revenues recognition does not follow accounting procedures, recognizing income early or late;
  • Liabilities are not updated or are “off-the-books”;
  • Inventory counts are not regularly performed;
  • Positions controlling and recording cash do not have appropriate oversight;
    • Even with segregation of duties, collusion may bypass such controls.

Cash

• • Unknown withdrawals and transfers are recorded within the general ledgers;
  • Invoices do not appear to be from the Vendor (check and call directly);
  • Receipts are not presented for reimbursement and such policies are not adhered to.

A significant weakness however is the Lack of Segregation of Duties. This concept requires that one individual may not control a complete cycle of events such as the recording of cash, receipt of cash, authorization of payments. Unfortunately, many small businesses most likely are not able to hire additional positions, therefore, management must provide an anti-theft culture and review the financial statements regularly to prevent embezzlement and collusion.

As you consider the above, please feel free to consult with our team on implementing the appropriate internal controls for your business, inquire about a financial review, and if you detect fraud we can refer you to our network of attorneys.