Valuation Insights: The Red Flags of Fraud

Business valuations often uncover questions about the choices made by business owners. Unfortunately, sometimes the questions lead to a determination of financial statement fraud.
According to the Association of Certified Fraud Examiners (ACFE) Report to the Nations on Occupational Fraud and Abuse, financial statement fraud is the least common type of occupational fraud. However, it causes the greatest financial impact by far, with a median loss of $1 million.

Valuation ≠ Audit

Under normal circumstances in a valuation, the valuation professional takes the company’s financial statements at face value. In other words, there is no audit, review or compilation involved in a typical valuation.

In fact, the valuation analyst’s “assumptions and limiting conditions” included in the valuation report acknowledge that the analyst has accepted “without further verification” the client’s financial statements and related information. But every now and then something gives the valuation professional a reason to believe the numbers aren’t right. This might include signs of unreported income like:

• A business that continues to operate despite losses year after year, with no real attempt to correct the situation.
• Bank balances and liquid investments that continue to increase annually, despite low profits or losses.
• Unusually low sales for the type of business, or a significant difference between the taxpayer’s gross profit margin and that of the industry.
• A lifestyle that can’t be supported by reported income.

Skimming and Personal Expenses

Among the financial statement fraud schemes most often brought to light in a valuation are skimming and running personal expenses through the business; both of these decrease the value of the business by reducing net income.

Skimming is a scheme in which payment (usually cash) is pocketed before it’s recorded on the company’s books. It is particularly problematic in cash-based businesses like restaurants, bars, taxi companies and repair shops. In fact, skimming is so widespread in these types of businesses that the IRS publishes industry-specific guides to alert agents to signs of skimming.

To address the valuation issues involved in skimming, analysts refer to industry benchmarks and statistics. For example, in a restaurant valuation, the analyst might look at the cost of goods sold and compare that to industry standards. A large variance might indicate that the owner isn’t recording cash receipts.

In terms of personal expenses, it’s not uncommon for owners who cheat on their taxes to have the company pay for everything from club dues to travel, vacation homes and vehicles. Of course, these expenses are not legally deductible to the company, but some owners try anyway.

The Spouse Knows

In many cases, the spouse or business partner is often aware of the fraud and will spill the beans in litigation. This is particularly true in the case of a minority shareholder dispute or divorce. And despite the fact that the spouse or partner may be implicated in tax fraud, he or she is often driven by anger and will tattle out of spite or fear of being cheated out of the “true value” of the business.

Because many businesses are S corporations, business income and personal income are tied together through the flow-through entity. In one case, an angry spouse shared that the soon-to-be-ex had filed a tax return with the IRS showing $80,000 in income, but had shown the bank a tax return reporting $350,000 in income. This is the type of information a valuation analyst can’t ignore.

Because valuations depend on good financial inputs, the “garbage in-garbage out” rule applies. In most cases, the valuation process should be suspended until a forensic accounting investigation can clear up the situation and provide “real” numbers on which to base a valuation.

Our experienced valuation and forensic accounting team can answer your questions about valuation and fraud.