Imagine you’ve got your eye on a business that seems like an attractive investment or acquisition target. It boasts strong earnings, competitive growth estimates and a clean balance sheet. But this business has a secret: fraud. And fraud can dramatically change the prospects — and value — of a company. That’s why, when conducting business appraisals, valuation professionals keep their eyes peeled for signs that fraud is occurring or could easily occur.

Gauging fraud risk

Business value is a function of risk and return, and one critical risk factor companies face is fraud. So valuators conducting an appraisal might ask management about the company’s internal controls — its policies and procedures to protect assets and ensure reliable financial statements. They may look for particular internal controls that have been proven to help prevent fraud, such as antifraud training programs, job rotation, mandatory vacation policies and whistleblower hotlines. Engaging outside experts to audit financial statements and conducting regular inventory counts and surprise audits also typically reduce a company’s fraud risk.

Of course, some businesses are more vulnerable to fraud than others. For example, the Association of Certified Fraud Examiners has found that banking and financial services, government, manufacturing, and health care organizations experience higher-than-average fraud rates. If a company operates in a risky industry, a valuator might apply a higher discount rate when discounting future earnings or adjusting pricing multiples derived from comparable companies or transactions.

In addition, valuation experts generally are more cautious with some types of engagements, such as shareholder disputes and divorces. In these scenarios, business owners who control their companies’ books and financial records could be motivated to hide assets and downplay income.

Unearthing red flags

Valuation experts rely on financial statements to estimate value. When they 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.

What happens if a valuation professional suspects fraud, based on preliminary assessments of internal controls, financial statements and other factors? The expert might ask the business to expand the scope of the engagement to include forensic accounting services offered by the valuator’s firm. Or, in the case of sole practitioners, the valuator might refer the business to a separate forensic accounting specialist. Fraud experts can help make required adjustments to accurately value a business. They can also help the company build a legal case against fraud perpetrators, if necessary.

Arriving at a valid value

Valuations aren’t designed to uncover illegal activities. And most businesses probably don’t need to worry about fraud harming their value. But if during an appraisal valuation professionals suspect that something’s off, they’ll bring it to the attention of management. That way, steps can be taken to arrive at a valid business value.

(This is Blog Post #1301)