How to Lose Control of the Bottom Line
Family firms with lax or secretive accounting practices can lose track of costs and profit margins—and even encourage fraud.
With a ball-point pen and steel nerves, a bookkeeper looted a family owned textile manufacturer. The scam took advantage of trusting employers who saw no reason to update their accounting system.
Here's how the deception worked. To pay vendors, the bookkeeper prepared checks for the company president's signature. As he had been doing for decades, the president and patriarch simply signed what was placed in front of him. He never examined invoices or supporting documents.
The bookkeeper was supposed to mail the checks to the suppliers. Instead, on some checks she covered the names of the vendors with the old-fashioned liquid white-out used to cover typing mistakes. She wrote her name on top of the white-out and deposited the checks in her bank account. When the canceled checks arrived in the mail, she removed the white-out and uncovered the name of the original vendor. Someone who glanced carelessly might believe that the check had been sent to the proper supplier.
Remarkably the seemingly obvious scam lasted for months. The president only became suspicious after he had been forced to increase bank borrowings to cover short-term costs.
While the bookkeeper's brazen technique may be unusual, the conditions that encouraged the theft are not. “Too many family businesses don't have tight financial controls,” says Carl Jenkins, a CPA with Macdonald, Levine, Jenkins in Boston, who straightened out the mess the bookkeeper's scam caused.
Accountants say family operations often lack the rigid financial controls other companies employ. Even when they don't lead to fraud, lax procedures can take a harsh toll. Often family owners have poor cost-control procedures, which prevents quick corrective actions when costs are out of line, and creates difficulty in measuring profit margins and determining whether costs must be cut. An excessive emphasis on tax savings leads to counterproductive behavior like reluctance to move out inventory. Secrecy keeps employees from properly performing their jobs, or finding ways to make operations more efficient; and it's a turn-off to top outsiders whom an owner might want to hire. If the family ever decides to sell the business, potential buyers will be turned away by an operation whose books seem questionable.
Of course, not all family businesses suffer from these ills. But many do tolerate low standards. Writing in the Harvard Business Review almost 30 years ago, Robert G. Donnelley, a member of the family that founded R.R. Donnelley & Sons, a huge, fourth-generation printing company in Chicago, argued that family businesses tend to lack “profit discipline” because they are often forced to choose between competing goals. For example, a family might prefer spending on a civic project rather than on a new computer system. Or it might overpay an incompetent relative. Owners also tend to concentrate on product quality, plant improvement, civic affairs, empire building, and personal relations to excess, beyond what these measures contribute to the long-term profits of the company, according to Donnelley. His points ring just as true today.
Donnelley also noted that when family members view the business as the family exchequer, excessive secrecy over financial matters may result, stifling the development of adequate business controls. He cited the case of a large manufacturing firm in which family managers excluded knowledge of the company's financial position from every nonfamily member, including the company treasurer; as a result, the treasurer was not able to perform even his most basic functions properly.
Some of the most common pitfalls that plague the financial controls of family companies, and expert advice on how to avoid them, are presented below.
Too many family owners succumb to temptation. They deliberately keep financial controls loose in an effort to short-change Uncle Sam. Having labored long years to build up their operations, they resent having to share their rewards with a government that they see as wasteful.
Owners commonly use business checking accounts to pay for personal items. That inflates expenses and shrinks taxable income. Some families even put nannies on the company payroll. Businesses have been known to list yachts and antique cars as transportation expenses. Such creative calculations may enable a family to live lavishly without paying much of a tax tab. But sloppy accounting has its hazards—even if the owners never get caught.
To begin with, it's hard to monitor the business when expenses have been inflated. Say the average profit margin in the industry is 20 percent, and the tax-avoiding company's margin is 15 percent. It's hard to know whether the company is inefficient or if the profits only appear low because of the inflated expenses. Cooked books also complicate any relations the company may seek with outsiders. Bank loan officers take a dim view of low profits—especially if they have been held down artificially. And if the family ever decides to sell, the aggressive tax avoidance may reduce the price the company commands.
Lower profits can make it difficult to hire outside employees, too. Say the company needs to recruit one of the top salesmen in the industry. Family members may have a hard time persuading the star to leave his employer for a chance to join a company that barely shows a profit.
No matter why it's done, tax cheating also leaves a family open to blackmail. A disgruntled nonfamily employee, or an unhappy minority shareholder, could blow the whistle. Angry spouses engulfed in divorce cases have been known to declare in court that their in-laws have been hiding income. Such testimony finds its way back to the IRS.
When the IRS spots fraud, the results can be devastating. And no company is exempt from the temptation. In July the business world was shocked when one of the most venerated business families in the country, lauded as a model by everyone from Ronald Reagan and Tom Peters to the Wall Street Journal, was implicated in tax fraud. Stew Leonard, owner of the legendary Stew Leonard's Dairy in Norwalk, Connecticut, and three associates pleaded guilty in federal court to skimming $17.5 million from sales, in the largest computer tax-fraud scheme in U.S. history. Using a custom-made computer program that automatically altered store records, they systematically siphoned off the money over 10 years, avoiding almost $7 million in taxes. Leonard and the three associates, two of whom are his brothers-in-law, must pay $15 million in back taxes and penalties, and face possible jail sentences of up to five years.
Donald Jonovic, president of Family Business Management Services in Cleveland, says families can become addicted to using their companies as tax dodges. He urges owners to keep their books as clean as possible. Families should view tax time as an opportunity to fine tune their companies, Jonovic suggests. Their accountants should take the occasion to examine all the company's financial control systems.
An experienced accountant can offer suggestions on how to stop employee theft and manage inventory, for example. Jonovic says many owners never think to ask accountants for such advice, and accountants may be reluctant to suggest that their clients should worry about being cheated.
An accountant can help the family develop a monthly budget for the business, too, and analyze problems when revenues or expenses fail to match projections. One area in which an accountant can be particularly useful is in inventory control. Jonovic says few family businesses have top-notch inventory management systems. They order too much, and allow supplies to sit around for years after they have lost value. Some companies don't even assign someone to keep track of shipments from suppliers. They rely on truck drivers to leave the proper amount.
Although the inventory accounting system should be designed with taxes in mind, tax considerations should not blind owners to larger considerations. For example, some families minimize taxes by claiming an excessively low value for inventories. That exercise can become particularly destructive if the family starts believing its own numbers and winds up with more supplies than it needs.
An accountant also can help the company develop a plan for sharing financial data with key employees. Too often family members insist on keeping data secret from everybody, even from those who need to know the numbers. One president of a distributor with revenues of $100 million refused to share profit information with his managers. He kept department heads in the dark about how their units were performing. As a consequence, the president faced a huge burden he never delegated. As the only one in the company who knew what costs really were, he had to judge for himself when expenses were out of line. “If he told his managers some of the numbers, they might have been able to suggest ways to cut costs,” Jonovic says.
To be sure, there may be a good reason for hiding some data. Say the company is earning huge profits from a new product. Then it would be well-advised to avoid notifying potential competitors about the gold mine. But more often, key managers should have a clear idea about the company's profits and losses. If family members are reluctant to share net profit figures, they should at least work with their accountants to develop statements of operating profits that can be relayed to managers.
Many family business owners have been careful not to reveal anything about their own salaries. They may be embarrassed to admit that their take is so high—or so low. While such reticence may seem natural, consultants say key employees should be informed about all phases of company finances, including salaries.
One family owned publishing company refused to fill in the blanks for an outsider who was hired to take a key position and eventually succeed the chief executive. As part of the deal, the employee received phantom stock whose price was set annually by a consultant. Since the stock value rose every year, the employee had some indication of the company's health. But the company president—who earned $600,000—refused to show the complete financial statement. He feared that the employee would demand a higher salary for himself.
Ronald Drucker, president of Drucker and Scaccetti, an accounting and financial consulting firm in Philadelphia, urged the publishing company to show the employee the whole ball of wax—including the owners' take. “If you want that individual to become an effective leader, he has to appreciate everything that's going on,” says Drucker. “Unless he has access to the numbers, he won't feel he has a stake in the company.” Fears that the outside executive will demand a higher salary may be unfounded. A sophisticated businessman should understand that the family's high incomes represent owners' profits, not just salaries.
While owners may not provide employees with key information, they often put too much trust in employees. Lax financial controls go a long way toward encouraging employee theft. Loose controls also permit well-intentioned employees to run far afield. After serving a family business for years, one bookkeeper cared more about the health of the family patriarch than the patriarch's profits. When the business was struggling, she decided not to trouble the old man with bills. Instead, she tucked them away. The unpaid bills mounted and nearly bankrupted the company before the owners discovered the debts.
To avoid such problems, consultant Jenkins suggests following the classic advice financial textbooks preach: No matter how trusted the employee, the tasks of bookkeeping should be divided so that one person can't control the flow of money into and out of the company. If a clerk mails out checks, someone else should receive canceled checks and make sure bank accounts balance. Someone who makes purchases shouldn't be able to sign checks.
Payrolls present big opportunities for errors and fraud, as one family owned parts distributor discovered. The company periodically hired groups of employees through a temporary service agency. When a big order arrived, the temps would pack and ship the parts. The shop foreman who oversaw the operation would request 30 temporary employees and paid the agency directly for their services. But only 25 employees would actually show up. The foreman and the temp agency split the salaries of the phantom employees. The scam went on unnoticed for several years, because higher executives never bothered to count heads.
Jenkins suggests placing one senior staff member in charge of payroll. In a small company, that person should personally hand a pay check to each employee. That way, there will be a face attached to each check.
While family businesses should strive to achieve the tight financial controls of well-run companies, consultants concede that many families fall short of the ideal. Even enormously successful businesses cut a few corners.
Still, consultants say it's important to keep records as true as possible. “If you insist on giving family members rich perks, or cutting corners, your business won't necessarily go down the drain,” says Jonovic. “But you should talk about what you are doing and be clear about why you're doing it. Otherwise things can get out of control quickly, and you'll wind up with the sort of disputes that tear businesses apart.”
Stan Luxenberg writes about family business from New York City.