Why Fraud is Fatal To Family Businesses

The relationship between trust and business longevity is inverse: Best practices indicate that the more a management team trusts its staff, the less likely the business is to enjoy continued success. Family-run businesses are no exception to this rule, and fraud is a quick way to seal the fate of an organization.

Although it’s difficult to pin down fraud statistics specific to family business, research by the Association of Certified Fraud Examiners (ACFE) highlights fraud as the leading cause of collapse among small organizations, many of which are family-run.

A 2016 ACFE global fraud study found that smaller businesses—those with fewer than 100 employees—were the most common fraud victims among the organizations in the study. These businesses accounted for 30% of the fraud cases in the ACFE study, whereas large organizations—those with 10,000 employees or more—accounted for the fewest cases (20.5%).

It’s worth noting that the losses these businesses experience aren’t proportional to their size. The study points out that both small and large organizations suffered a median loss of $150,000, and that a small organization would likely feel a greater impact from a loss of that size.

The ACFE study was based on 2,410 responses from Certified Fraud Examiners that were submitted from July 2015 to October 2015. Respondents were asked to detail the single-largest fraud case they had investigated since January 2014.

Detecting in-house breaches of trust can create challenges on two fronts. On one hand, the manner in which employees make off with company cash varies greatly from case to case. A 2014 ACFE report identified a minimum of 10 different fraud schemes to which small businesses fall prey. The schemes range from corruption and billing ploys to check tampering, skimming, and expense reimbursement scams.

On the other hand, the profile of a fraudster does not usually fit the stereotype that higher-ups expect. While many managers look to younger, newly-minted employees as prime suspects because of their perceived immaturity or impulsiveness, the ACFE studies indicate that the typical culprit is actually a middle-aged employee who has worked for the company for many years.

Despite uncertainty surrounding sources and methods of fraudulent behavior, the rationale behind this kind of misconduct is generally straightforward. Following what has been dubbed the “fraud triangle,” dishonest employees tend to exhibit three critical factors when carrying out fraud schemes:

  1. They succumb to financial pressures such as a personal financial need or a workplace shortfall.
  2. They rationalize their behavior.
  3. They ultimately capitalize on a perceived opportunity, meaning they can commit fraud without getting caught.

Perceived opportunity, research shows, is critical in determining why fraud rampantly plagues family businesses. “Blind trust” often pervades family businesses, given the extent to which the employees are familiar with one another. Managers and executives tend not to enforce systems of checks and balances for fear of offending a relative or lifelong friend, but they end up leaving the door wide open for an employee to take whatever they feel entitled to.

Small family businesses are also at high risk of fraud because of their inability to establish and enforce punishments that deter illegal activity. The 2016 ACFE study revealed 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. When those within an organization know fraud will likely go unpunished, it gives rise to two negative dynamics. On one front, would-be scammers are emboldened knowing that there will be no repercussions for their actions. On the other, employees who could have been useful as whistleblowers fall silent, understanding that any information that they provide will likely be ignored.

In light of these risks, a few fundamental best practices can go a long way toward preventing or, at the very least, lessening fraud incidence in businesses.

Separating responsibilities is critical to eliminating temptation to commit fraud among employees. For example, because most fraud originates in financial departments, companies should have a payroll list reviewed by someone other than the person distributing paychecks to prevent skimming.

Although thorough checks and balances discourage some employees from committing fraud, others will remain undeterred. Fraud literature highlights the fact that organizations usually detect fraud through tips from other members of the business. An effective, anonymous whistleblower hotline can be a key mechanism for companies looking to curb violations. Companies can go one step further by implementing regular third-party audits to create an internal and external “no-fraud” culture.

Avoiding blind trust can be the toughest change for businesses to implement because it implies that they can’t trust people they’ve known their entire lives. In fact, it’s often the individuals in whom businesses place the most trust who are most likely to abuse it. By explaining their internal controls as best practices and establishing policies that apply to employees across all levels of the company, firms can avoid offending individuals while establishing a fraud-proof system. Ultimately, trustworthy individuals won’t have a problem with the controls, and those who do probably shouldn’t be trusted.

 

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