When Fraud Distorts Value

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Information about When Fraud Distorts Value

Published on February 18, 2014

Author: OConnorDavies



Learn what impact workplace fraud can have when a business valuation is conducted and a company is put up for sale. Discussion on what you can do to reduce the chances of fraud in your company. O'Connor Davies - New Jersey CPA Firm

Viewpoint on Value Newsletter When Fraud Distorts Value: Appraisers Adjust Statements Edited by Ciro Cuono, CPA/ABV/CFF, CVA, CGMA, Partner Among the many negative consequences of occupational fraud — financial losses, public embarrassment and diminished employee morale — one is rarely mentioned: how fraud affects a company’s value. Illegal schemes involving asset misappropriation, corruption and financial misstatements can distort value. Even shady but legal bookkeeping practices, such as delaying revenue recognition to temporarily reduce the value of an owner’s business interest, can make accurate appraisals difficult. To ensure they come to realistic value conclusions, professional appraisers must adjust financial statements when the existence of fraud is known. Ciro Cuono CPA/ABV/CFF CVA,CGMA Partner 914.381.8900 Team of Two Valuators rely on financial statements to estimate value. Unless it is specifically set forth in their engagement letters, valuators customarily do not audit financial information or investigate for fraud. So if financial statements contain fraudulent numbers, an appraisal may be inaccurate, unless properly adjusted. What if management or the valuation professional suspects or knows about specific incidents of fraud? Some valuators are cross-trained in both valuation and forensic accounting. More likely, however, the valuator will bring in a forensic accounting colleague to help make the requisite adjustments to accurately value the business — and build a fraud case. Note that, if the scope of an appraisal assignment is expanded to include fraud work, the forensic expert usually requires the client to sign a revised engagement letter or an addendum to the existing contract. Inventory of Internal Controls When assessing a subject company’s risk of fraud, valuators and forensic experts consider several factors, one of which is a company’s size. According to the Association of Certified Fraud Examiners, businesses with fewer than 100 employees — which often lack comprehensive fraud prevention policies — suffer the highest median financial losses. A company’s internal controls — policies and procedures for protecting assets, improving operating efficiency and ensuring reliable financial statements — can tell a valuator a lot about its fraud risk. Such controls as a fraud training program and whistleblower hotline can be a company’s first line of defense. Other examples of internal controls that minimize fraud and protect a company’s value include: Restricted access to physical assets, including locks, passwords and security systems,

Contact: Formal job descriptions, codes of conduct and employee manuals, New York, NY 212.286.2600 212.867.8000 Mandatory vacation policies, Harrison, NY 914.381.8900 Monthly bank reconciliations and physical inventory counts, Duplicate signatures on checks above a preset dollar amount, Background checks on prospective job candidates, and Stamford, CT 203.323.2400 Annual or surprise audits. Paramus, NJ 201.712.9800 Unfortunately, internal controls can be circumvented by managers who override the system or become lax in supervising subordinates. It is easy for fraud schemes — including falsifying financial statements — to thrive in such environments. Cranford, NJ 908.272.6200 Making Adjustments New Windsor, NY 845.220.2400 In general, high fraud risk equates with lower values. Note, however, that valuators typically incorporate risk into their appraisals of smaller businesses — even when there is no specific evidence of fraud. Wethersfield, CT 860.257.1870 When the existence of fraud or shady accounting practices is known or suspected, valuators take steps to account for additional risk. For example, an unscrupulous CFO may prematurely post unearned or fictitious sales at year-end to boost his annual bonus. His actions overstate the company’s value because earnings or assets are exaggerated. Harrison, NY 914.381.8900 Using the income valuation method, a valuator might increase the company’s risk premiums (a component of the cost of equity) to account for the CFO’s actions. And when using the market valuation method, the appraiser might apply different criteria to pick guideline companies, or adjust median (or average) pricing multiples for differences between the subject company and the comparables. Stamford, CT 203.323.2400 Paramus, NJ 201.712.9800 New Windsor, NY 845.220.2400 Wethersfield, CT 860.257.1870 Often, a subject company with significant fraud risk appears less attractive to potential buyers, especially minority investors. Accordingly, valuators might factor fraud risk into their valuation discounts. But regardless of how they choose to account for these risk factors, valuators must take care not to double-count the effect of fraud risk on value. Otherwise, they risk undervaluing business interests. Appraising a Company, Building a Case Because valuators typically do not look for fraud, be sure to discuss any concerns about the accuracy of financial statements when you engage an expert — particularly if a fraud investigation is already underway. Such information will enable the valuator to make appropriate adjustments and, if necessary, help your litigation team gather evidence and assess possible damages. If you have any questions regarding business valuation, forensic accounting or litigation support services, please contact Ciro V. Cuono, CPA/ABV/CFF, CVA, CGMA, at or 914.421.5671.

About Our Practice: O'Connor Davies, LLP is a full service Certified Public Accounting and consulting firm that has a long history of serving clients both domestically and internationally and providing specialized professional services of the highest quality. With roots tracing to 1891, seven offices located in New York, New Jersey and Connecticut, and approximately 400 professionals including 70 partners, the Firm provides a complete range of accounting, auditing, tax and management advisory services. O’Connor Davies is ranked as number 36 in Accounting Today's 2013 "Top 100 Firms" in the United States. The Firm is also within the 20 largest accounting firms in the New York Metropolitan area according to Crain's New York Business and the Westchester and Fairfield County Business Journals. O’Connor Davies, LLP is a member firm of the PKF International Limited network of legally independent firms and does not accept any responsibility or liability for the actions or inactions on the part of any other individual member firm or firms. IRS CIRCULAR 230 DISCLOSURE: To comply with IRS regulations, we are required to inform you that unless expressly stated otherwise, any discussion of U.S. federal tax issues in this correspondence (including any attachments) is not intended or written to be used, and cannot be used, (i) to avoid any penalties imposed under the Internal Revenue Code, or (ii) to promote, market, or recommend to another party any transaction or matter addressed herein. Our Firm provides the information in this e-newsletter for general guidance only, and it does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind.

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