Many companies undertake an acquisition using only a financial due diligence process. However, for a greater chance of detecting potential misrepresentations, companies need to incorporate forensic investigative tools into their standard due diligence process.
“Forensic techniques will help point out and isolate areas of potential fraud as well as any irregular or suspicious activity,” says Michael Maloziec, an accountant at Cendrowski Corporate Advisors LLC.
Forensic analysis during the due diligence process can uncover accounting improprieties that could overinflate the value of a target company. Performing these two services together will give increased assurance that projected performance is achievable, Maloziec says.
“Adding in forensic analysis is a crucial step toward assuring your acquisition is successful. It can allow you to see past ‘closed doors’ into areas you might not think to look,” he says.
Smart Business spoke with Maloziec about forensic techniques and their benefits during the acquisition process.
How large of a role can fraud play?
It’s huge. The Association of Certified Fraud Examiners Report to the Nations found a typical organization loses some 5 percent of its revenue to fraud each year. Even though that does not sound like a significant number, when applied to the Gross World Product, this figure translates to a potential projected annual fraud loss of more than $3.5 trillion.
What are some caveats to keep in mind?
Companies will always showcase their business in the best possible light. Managers will ‘polish the apple’ so to speak. Bear in mind the sales numbers might be misstated, which can overinflate the value of the company. Also, companies will not disclose everything, so it is important to proceed forensically during your due diligence process. Always be aware of potential manipulation in reserves and estimates. Reserves are one of the most common areas for fraud to occur because it is under management’s discretion. These caveats will help you recognize and point out areas that raise red flags.
How can you protect yourself from fraud?
One method is to look behind the numbers. You should always carry a certain sense of forensic skepticism and never make assumptions during any part of the due diligence process. Be sure to ask questions that will dig into transaction details and note any instances that provoke uncertainty. Don’t forget about applying simple common sense. Ask yourself, ‘Do the numbers flow with the current business plan that is set in place? Do management’s representations make sense?’ You can also utilize a number of analytical tools to spot any anomalies.
What analytical tests should be performed?
A great way to start would be to forensically analyze the financial statements over the past few years. During analytical testing, it is important to review current and past events in order to isolate anomalies from known events. You can utilize a variety of different ratio analyses, which can be an excellent tool in detecting red flags. Ratio analysis measures the relationship between various financial statement amounts and tracks how past numbers are trending with current results. To gain some perspective, compare company financial information to similar industries that hold the same standards, such as size, geography or sector. There are also numerous computer software programs that will assist in narrowing the scope and provide the capability of recognizing potential fraud.
How should a company approach this issue?
Start by assessing the business processes. Processes provide guidance to employees and assure accurate reporting. Acquirers need to review and understand the capacity and capability of their target organization. As part of the due diligence process, the acquirer should examine the current processes and identify any weakness or holes that could allow for erroneous or unauthorized transactions. A great method to gain insight would be to perform an internal risk assessment, which can help identify industry risks that might not be so obvious. This allows managers to zero in on areas that might be susceptible to potential fraud before they become a problem.
Michael Maloziec is an accountant at Cendrowski Corporate Advisors LLC. Reach him at (866) 717-1607 or firstname.lastname@example.org.
Insights Accounting is brought to you by Cendrowski Corporate Advisors LLC
According to the Association of Certified Fraud Examiners, a typical organization loses roughly 5 percent of its annual revenue to fraud. When applied to the Gross World Product, this figure translates into approximately $3 trillion in fraud losses each year.
Though the economy appears to be on the mend, fraudulent activity remains prevalent in today’s business environment. When a fraud is suspected, a company or its counsel may retain a forensic accountant to investigate the matter.
“Forensic accounting is an important branch of accounting, and perhaps one of the most opaque,” says Walter McGrail, CPA, senior manager of Cendrowski Corporate Advisors. “It is a crucial tool in the investigation of white collar crime.”
Smart Business spoke with McGrail about fraud, forensic accounting and the tools used by forensic accountants in their work.
What is a forensic accountant and how is that person involved in fraud investigations
A forensic accountant is an individual who combines expertise in accounting, auditing, finance and investigations to assist legal professionals. Forensic accountants are typically engaged as expert witnesses, or they employ investigative skills that may require courtroom testimony; these individuals serve at the intersection of business and law.
Fraud investigations, including activities centered on obtaining evidence, performing interviews, writing reports and testifying in a case of fraud, are generally performed by forensic accountants looking to reconstruct historical events leading to the event. Historical event reconstruction is often critical for the accountant to understand the motive for perpetrating a fraud, the opportunity that allowed the fraud to occur in the organization and the rationalization employed by the fraud perpetrator in performing a fraudulent act.
These three elements comprise what forensic accountants call the ‘fraud triangle,’ and each element must be present in order for a fraud to occur.
Where might a forensic accountant begin his or her fraud investigation?
One of the first steps involved in a forensic investigation is to conduct a background investigation on the key players believed to be involved in the fraud. Knowing as much as one can about the individual or individuals in question sets a good foundation for future work that will be conducted in piecing together historical events.
Background checks will reveal if an individual has a history of criminal or civil litigation, as well as whether or not he or she is under financial duress or other pressures. These pressures may provide the rationalization needed for a fraud to occur. Background checks might also shine light on the motives for an individual to perpetrate a fraud.
Can a forensic accountant discern information from tax filings and documents?
Tax matters can become a basis for leads and disclosures on any forensic accounting engagement, and tax professionals are a vital part of any forensic accounting team.
Tax filings and documents are often a great source of information in the conduct of a forensic accounting engagement. These reporting devices are oftentimes generated by third parties. Information included on Forms W-2, 1099, 1098, etc., is typically prepared by third parties and reported directly to the taxing authorities, as well as to taxpayers.
Tax reporting may reflect financial information that is not otherwise made readily available by the target of a forensic examination. Taxpayers that otherwise keep information close to the vest often feel compelled to make accurate filings with tax authorities to avoid running afoul of tax laws. It’s one thing to treat financial information as proprietary and restrict its disclosure to third parties; it’s another thing altogether to misrepresent tax matters to federal, state, or local tax authorities.
Taxpayers also often use professionals to assist with their tax reporting compliance. While tax professionals may serve as advocates for their clients, rarely will independent accountants risk becoming complicit with inaccurate reportings.
How might a forensic accountant use tax returns to deduce information?
Tax filings can often be compared one to another in order to identify forensic financial information. Comparing business returns such as Schedules K-1 to US 1040s and federal returns to state returns and business returns (US 1065 or US 1120S) to business general ledgers often results in financial revelations not otherwise readily available to the forensic accountant. Moreover, there may be tax benefits motivating persons to make full disclosures to taxing authorities. For example, tax refund claims generated by losses or credits which can result in immediate cash flow generally require a fair amount of supporting disclosure and documentation.
By utilizing a forensic accountant, an organization can not only determine how and why a fraud occurred but can use the information gathered in a courtroom against the perpetrator.
Walt McGrail, CPA, is senior manager of Cendrowski Corporate Advisors. Reach him at (866) 717-1607 or email@example.com.