Every business — large or small — faces fraud risks that must be factored into its value. Business valuation professionals understand these risks and know which industries and situations present increased fraud risks.
Over time, fraud can impair the value of a business. In addition to stealing assets, employee theft may harm a company’s reputation and lower employee morale and productivity. A company’s owners can also manipulate financial records to artificially increase (or decrease) the value of the business, depending on which serves their financial interests.
Value is a function of risk and return, and one critical risk factor businesses face is fraud. A fraud risk assessment starts with a company’s internal controls. When interviewing management, experts ask about the company’s policies and procedures to protect assets, improve operating efficiency and ensure reliable financial statements.
A business’s first line of defense against fraud is strong internal controls. Examples of internal controls that may help deter fraud are physical and digital controls, fraud training programs, job rotation and duplication policies, background checks, and whistleblower hotlines.
Internal controls can be intentionally circumvented and thus become less effective if managers override policies and procedures or become lax in supervising subordinates. These loopholes undermine a company’s efforts to detect and prevent fraud. The risk of fraud can be reduced if the company’s financial statements are audited by an outside accounting firm — or if the company’s internal audit department conducts physical inventory counts or surprise audits of certain high-risk accounts during the year.
Identifying High-Risk Assignments
Some businesses are more vulnerable to fraud than others. Companies that have weak controls or operate in high-risk industries may warrant a higher discount rate when discounting future earnings or adjustments to pricing multiples derived from comparable stocks or transactions.
Industries that reported the most fraud cases in the Association of Certified Fraud Examiners’ biennial Report to the Nations: 2020 Global Study on Occupational Fraud and Abuse include:
- Banking and financial services,
- Government and public administration,
- Manufacturing, and
- Health Care.
In addition, some types of engagements — such as shareholder disputes and divorces — can motivate owners who control their companies’ books and records to hide assets and downplay income. Experts are particularly mindful of fraud risks when valuing a business for these purposes.
Adjusting for Fraud Risks
Business valuation experts rely on financial statements to estimate value. If financial statements contain fraud, a valuation will be inaccurate unless it’s properly adjusted.
When business valuation professionals analyze financial statements, they might unearth red flags of fraud. For example, an expert may notice a disconnect between revenue growth and changes in key assets (such as receivables or inventory) or sudden changes in gross margin [(revenue – cost of sales) ÷ revenue].
So, what happens if the valuation professional suspects fraud, based on preliminary assessments of the company’s internal controls, industry and financial statements? Some business valuation professionals are cross-trained in both valuation and forensic accounting. Others work at large firms that provide both types of services.
When these experts suspect fraud, they typically ask the client to expand the scope of the engagement to include forensic accounting services. This usually requires a revised engagement letter or an addendum to the existing contract.
Sole practitioners without forensic accounting training generally refer clients to separate forensic accounting specialists. Fraud experts can help make requisite adjustments to accurately value a business — and build a legal case, if necessary. Together, valuation and forensic accounting specialists can estimate economic damages resulting from fraudulent activity.
Beyond the Scope
Business valuations typically aren’t designed to unearth dishonest behaviors. However, valuation experts generally are on the lookout for signs of fraud and may, when necessary, expand the scope of an engagement to achieve an accurate conclusion.
TheKFORDgroup litigation team holds extensive knowledge and experience in expert witness engagements, forensic accounting, and business valuations. Our experts are trained and experienced in the litigation process. We can help you or your client determine an accurate value in your next business valuation case. For more information, please call us at 210-340-8351.
Additional information included in this report was provided by PDI Global / Thomson Reuters © 2021