Family businesses are not immune to fraud and can be run to the ground if not properly oversighted.
However, a large majority of family businesses face one kind of universal challenge. They are vulnerable to fraud by the owner/owners.
This can be attributed to the fact that family businesses are synonymous with two fundamental principles.
One is that family business entities more often than not operate on trust. Two is that it is hard holding the principal owner of a family business to account. Family members find it extremely difficult to question the person who built the business from scratch.
Business Today examines some of the loopholes that relatives exploit to commit fraud in family businesses.
If there is something Kenyans should learn from the recent collapse of Nakumatt is that drawing working capital or acquiring loans unprocedurally from a family business is as good as the beginning of the end.
Ex-chief executive Atul Shah and his son, the only directors of the formerly popular retailer drew Ksh1 billion interest-free loans which could not be recovered by the administrator after the company collapsed as the two claimed they were financially distressed.
Drawings are withdrawals of cash or other assets from a business by the business owners.
Drawings, done correctly, are not a bad thing but become a business sin when abused or when not done in the best interests of the business.
Failure to account for/ misrepresentation of drawings is usually the first step down the slippery slope of fraud in family-run businesses.
Perhaps one of the most old school ways of theft in business.
Business owners or rather people involved in a family business might be tempted to manufacture non-exsistent expenses to service their own greed.
Assuming a family runs hardware and one family member has been sent to fetch stock from a supplier but during the trip, the relative in question feels like they need to sleep in a five-star hotel and transfers that cost to the business by inflating the cost of the fuel.
That automatically becomes a cooked expense.
Climbing up the Income Statement
It is profit after tax, typically, from which dividends are paid.
The owner of a loss-making company would have no profit after tax from which to make a dividend distribution.
Such an owner may choose to insert themselves higher and higher in the income statement, by becoming a supplier to the loss-making business at either expense or cost of sales level.
This enables them to extract value before a profit has been realised.
If transactions between related entities are not done at arm’s length, such as if, for example, the related entity supplier to the loss-making business charges that loss-making business a higher-than-market price for its supplies, this could very well represent fraudulent value extraction.
It is a common practice for well-performing family businesses to pay their directors.
However, this should be done professionally in that the salaries paid should be consumerate to work done and reflect the financial position of the business.
In instances where companies with such employment benefits are family-run or owned, the risk of fraud can be higher.
Financial Statement Fraud
All these types of fraud eventually catch up with the culprits.
That leaves them with no other option but to collude with accountants. To cover their tracks, the accountant is asked to bury important financial information or to misstate it which is equivalent to financial statement fraud.
Another way financial fraud is committed is when a family member without the relevant qualifications is put in a senior management position.
This puts the family member under serious pressure to perform. The pressure can force the family member to misstate financial information to cover up their underperformance.
How To Avoid This
Fraud in family businesses can be avoided by
1 Ensuring owners hold regular meetings to strengthen interpersonal bonds, and to ensure that there is agreement on key matters, such as strategy and/or key management personnel hiring decisions.
2 Ensuring family-run businesses are run independently and with professional management advice past a certain size.
3 Ensuring key elements of corporate governance such as an empowered internal audit department that reports directly to the board audit committee, and a strong and well-enforced system of internal controls are established.