What’s driving M&A deals and how companies can capitalize on the activity

Merger and acquisition (M&A) activity was very strong in 2017 and 2018 has been even more robust. Most closely held businesses have substantially enhanced their balance sheets since the recession and are now experiencing record years for profits and revenue. Many also have excess working capital that can be deployed to acquire competitors and/or key suppliers.

Smart Business spoke with David E. Shaffer, CPA, director of audit and accounting at Kreischer Miller, to get a breakdown of M&A activity in the market, what’s driving it, who is realizing success and why, and how business owners can capitalize on the opportunity.

What are some of the factors driving the increase in M&A activity?

  • Interest rates are still very low, by historical standards. As a result, the cost of capital remains low. Since many believe that interest rates will continue to rise, the cost of this capital could become more expensive in the future.
  • Company balance sheets seem much stronger than they have been historically and owners are actively looking for opportunities to enhance their return on invested capital. There are really only four choices to deploy excess capital: pay a dividend to shareholders, buy back stock, invest in internal expansion, or merge with or acquire another business.
  • Many privately-held businesses lack a succession plan. As such, aging owners may be forced to look at third-party acquisitions.
  • Private equity firms are actively looking for targets to purchase and established companies to sell. During the first half of 2018, private equity completed 2,247 deals with an aggregate transaction value of $263.9 billion.
  • The Tax Cuts and Jobs Act increased expected 2018 cash flows for C-Corporations and most S-Corporations. So, owners are looking for the best opportunities to put this additional capital to work.
  • Technology continues to improve efficiency and profits. Plus, companies with unique technology are especially attractive to buyers.
  • Business friendly legislation and policy changes are reducing the risk to potential buyers.
  • M&A can be an attractive option for owners who want to expand geographically, diversify their customer base, or expand their products or services.

What are business owners currently experiencing in M&A deals?

  • Purchase prices are increasing over historical levels. Larger, well-managed companies are selling at multiples in excess of seven times EBITDA.
  • Companies with unique technologies are fetching higher prices. Anything that provides a buyer with a competitive advantage over other suppliers is highly valued.
  • In most transactions, either the buyer or the seller (or the bank) is procuring a quality of earnings report. These reports are prepared by an independent professional and provide an objective assessment of the accuracy and quality of historical earnings and assets, as well as the sustainability of earnings in the future.
  • Deals that are from a ‘book’ or have gone to multiple companies for potential purchase usually do not get purchased by private companies or families. Instead, a private equity firm will typically acquire these companies, since they are more willing to pay a higher multiple and assume a greater degree of risk.
  • Banks are looking to finance these transactions. Many companies have satisfied their equipment and IT needs, so there is not a lot of loan growth and banks are seeking other ways to deploy their cash in order to maintain profitability.

Successful acquisitions require effective integration, accurate valuation in determining the purchase price, sound due diligence, and a clear understanding of the cash flow risks.

Insights Accounting & Consulting is brought to you by Kreischer Miller

Know your customer and know your competitors

There are many factors that go into growing your business — acquisitions, product or service development and enhancement, geographical expansion, strategic partnerships and more. But before you get to any of these strategies, you must first know your customers and your competition.

Smart Business spoke with Todd E. Crouthamel, CPA, director of audit and accounting at Kreischer Miller, about the importance of focusing on the customer experience and how it leads to success.

What does it mean to “know the customer?”

In order to know your customers, you have to understand who your customers are, what their needs are and what value you deliver to them. Most successful companies have a customer-centric culture. All of their team members are aware of their role in the customer experience and everyone is focused on making the customer experience the best. These are the companies that can often charge a premium for their products or services. Their customers are buying not only the product or service, but the experience from their first contact with the company through follow-up.

To truly understand your customers’ experiences, consider creating a customer experience map. It details every possible way that customers or prospects interact with your brand. It is focused on why, how, when and for how long they interact with you. It enables you to review all of your customer and prospect touch points, determine what they are expecting during that interaction (both technically and emotionally), and how their expectations are met or not met.

Once the customer experience has been mapped, you will have more information as to what the customers’ goals and feelings are for each interaction, and can revise your sales process to ensure that you are exceeding these expectations. Customer experience mapping should provide you with information to make informed improvements to customers’ experiences, leading to increased satisfaction and retention.

How is it that knowing competitors can translate to knowing customers better?

Competitors are often seen as enemies, but if you take the time to learn from them, you may end up stronger than them.

A healthy analysis of your competition is helpful when trying to grow your company. You should not obsess over your competition like you should over your customers, but rather you should know what they offer, to whom, how they deliver their product or service, and how they position themselves in your marketplace.

Useful information can also be found by knowing your competitors’ customers and prospects. If your target prospects are similar, knowing how your competitors reach these prospects can provide valuable insight into how you could be reaching the same potential customers.

It is equally important to understand how your competitors deliver value to their customers and why their customers chose them. What perceived value did customers see when they made the decision to work with the competitor and why do they continue to work with them? The answers to these questions should provide you with additional information to shape your customer offerings, better enable you to tell your story and demonstrate the value that you provide, and differentiate yourself to current and future prospects.

How should companies conduct this research and what should they do with it?

You do not need a spy kit to find the answers to most of these questions. A review of competitors’ websites as well as discussions with their current and former customers and industry participants should provide you with sufficient background to make a meaningful assessment.

To be successful over a long period of time, these key elements need to become part of the culture of an organization. These are not branding initiatives or business development exercises. Rather, these are about building a culture of customer-focused and competition-aware team members who understand their role in the customer experience and work to ensure that all customers are not just satisfied with their experience, but are delighted by it.

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How sales tax nexus, bolstered by the Wayfair decision, affects your business

Sales tax nexus is an area of the law that many businesses would prefer to believe does not affect them directly, though most are aware that the issue exists.

States have become increasingly aggressive in terms of audit techniques, enforcement of existing laws and the enactment of new laws to compel businesses to comply with sales tax collection and reporting requirements. And with the Supreme Court ruling in South Dakota v. Wayfair Inc., there is now a binding legal precedent emboldening states’ efforts.

Smart Business spoke with Thomas Frascella, director of Tax Strategies at Kreischer Miller, about sales tax nexus, how and when it applies, and what the Wayfair decision will mean for businesses.

How is sales tax applied to out-of-state sellers and what are the exceptions?

Most tangible personal property is subject to sales tax unless it is either excluded or exempt from sales tax. For decades, most states were fairly lenient about the collection of exemption certificates. Although state rules require that the exemption certificate be obtained at the time of the sale, most states had historically allowed taxpayers to collect exemption certificates long after the sale had already occurred. Presently, states are beginning to enforce the collection requirement on audit and assessing sales tax if the taxpayer cannot provide an exemption certificate coinciding with the date of the sale.

States are also beginning to more closely scrutinize transactions involving drop shipments. Drop shipments typically involve a scenario in which the seller has a manufacturer ship a product directly to the seller’s customer. Drop shipments can create a sales tax trap for the unwary. Generally, sales for resale are exempt transactions provided a valid exemption certificate has been granted to the appropriate party. In the case of a drop shipment, it is the sales tax nexus of the manufacturer making the delivery that will determine the appropriate state exemption certificate needed.

For example, Seller A is located in Pennsylvania and is not registered in any other state. The manufacturer is located in California and is making a delivery to Seller A’s customer in California. Seller A must provide the manufacturer with a California resale certificate. If Seller A cannot provide a valid California resale certificate, the manufacturer should collect sales tax because it delivered a product that it sold to a location in a state where it has nexus. Some states will allow sellers to use their home exemption certificate or a multistate certificate. Others will not, rendering an otherwise tax-exempt sale taxable.

What effect is the Wayfair decision expected to have on states’ sales tax collection?

The most significant development in the area of sales tax nexus is the U.S. Supreme Court’s decision in South Dakota v. Wayfair Inc. The Wayfair case involved legislation enacted by South Dakota to impose sales tax nexus on remote sellers. The legislation required out-of-state retailers with either 200 or more transactions or $100,000 in sales to residents of South Dakota to register for and collect South Dakota sales tax. Wayfair challenged the constitutionality of the law based on the court’s prior decision in Quill Corp. v. North Dakota, requiring a physical presence in a state to establish sales tax nexus. In a surprising decision, the Supreme Court sided with South Dakota and overturned the long-standing physical presence standard.

As a result of the Wayfair decision, a significant number of states have enacted similar legislation as the law enacted by South Dakota aimed at compelling remote businesses — businesses located outside state borders — to either begin to collect and remit sales tax or report purchases made by residents of states enacting such laws. To date, approximately 22 states have enacted legislation that adopts an economic nexus standard for sales tax purposes.

Today, remote sellers of all sizes that meet these economic thresholds could become subject to multistate sales tax reporting and collecting, and will need to deal with the impact on their businesses. The hope now is that Congress finally takes action to enact a national nexus standard for sales tax purposes that will provide consistency for businesses. Until that happens, businesses will be forced to understand the various state standards and assess the impact on their business.

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Business owners should keep tax implications in mind year-round

Business owners have a lot to think about during the year. Among their concerns are taxes. However, taxes often get the least amount of consideration, though they are arguably among the more important factors impacting their business.

“In a tax year marked by the newly enacted Tax Cuts and Jobs Act, it is vital that business owners recognize the importance of understanding their tax liability and how tax planning throughout the year can benefit them come filing season,” says Brian D. Kitchen, director of Tax Strategies at Kreischer Miller.

Smart Business spoke with Kitchen about the ways in which taxes could affect business decisions throughout the year.

What are some tax incentives business owners should keep in mind?

When business owners are made aware of certain tax incentives during the year, it provides their advisers with an opportunity to explain the benefits of such incentives. It also enables business owners to factor these tax savings into their current year tax calculations.

There are many tax incentives built into the Tax Cuts and Jobs Act for businesses in a variety of industries. These incentives are in the form of tax credits, which reduce tax liability dollar for dollar, and tax deductions, which reduce taxable income.

Some common tax credits include the Work Opportunity Tax Credit, which allows employers to claim a tax credit based on hiring a certain targeted group of individuals; and the research and development tax credit, which rewards companies that innovate and invest in new products and processes. The code also provides for immediate expensing of certain depreciable property, such as machinery and equipment. The new tax bill also introduces a 20 percent deduction on pass-through businesses.

It is important for a business owner to understand the substance and mechanics of the incentives in the new tax law as well as a host of other federal and state tax incentives, as planning might be needed to take full advantage of them.

How might estimated tax payments affect a business?

The income tax expenses of business owners are a cash flow item that requires attention, not only for budgetary reasons, but to mitigate potential interest and penalties on any underpayment of taxes. The IRS and many state and local governments require that estimated income taxes are paid during the year on income that is not subject to tax withholding. This is especially important for business owners of pass-through businesses, those being S-corporations and partnerships, as their pass-through income is not subject to tax withholding.

When the estimated taxes are calculated on a quarterly basis, business owners are able to readily understand the cash flow impact their tax expense has on their business. More importantly, in a year with a dramatic change in the tax code, quarterly tax projections provide business owners with a real-time understanding of how changes in the code impact their businesses.

Why should business owners keep their advisers informed throughout the year?

When advisers are able to meet and communicate with their clients throughout the year, it enables them to provide proactive advice that will not only affect owners’ businesses during the year, but will ultimately provide peace of mind and help prepare for their tax filing the following spring. This approach lessens the probability of surprises in the form of unexpected tax bills, enables a business owner to make more informed decisions where a tax incentive could be utilized and provides for a smoother compliance season as many tax-related items would already have been discussed throughout the prior year.

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The critical success factor within every company’s control

In working with so many private companies, accounting firms get to see it all — different companies, industries, sizes and definitely different performance. Through that experience, some commonalities can be found that directly impact performance, for better and for worse.

Smart Business spoke with Mario O. Vicari, CPA, director at Kreischer Miller, about the differences between top-performing and underperforming companies.

What are the factors that give the best indication of a company’s fitness?

Although there are many metrics one could consider in evaluating a company, there are two that really matter and they are related. The first is net margin, which is the percentage of net profit per dollar of sales. Think of it as how many pennies you keep for yourself for each dollar you sell from operating the business. This is a simple yet powerful concept. The second is the company’s return on invested capital, which expresses how the net margin relates to the amount of total capital deployed to generate the net profit.

Looking across many companies’ performance, most companies are somewhat better or worse than average in different degrees. However, there are very few private companies that have exceptional returns. These are the outliers — the top 5 percent of private companies.

While many factors affect performance, the common denominators among higher performing companies are:

  • They have absolute clarity about the customers, markets and opportunities that fit their business model, and have clear rules around customer acceptance, including the economics that are acceptable to them.
  • Having established rules around customer acceptance, they have the discipline to follow through on their strategy, which means that they will say no to opportunities that are not a fit.

What are the commonalities of underperforming companies?

Companies that are struggling and in need of a turnaround often have poor gross and net margins and low returns on invested capital. Looking into the details of their customer and product mix, often what is found is a hodgepodge of customer and product sales that are widely dispersed and unfocused. These bad results come from a lack of strategy and associated rules around customer acceptance. To these companies every sale is a good sale because they have no established business rules about their target customers and products, or in some cases they have rules but don’t follow them for the sake of getting the sale. This lack of focus and discipline results in low margins and returns. These decisions are often misguided by the belief that growing sales is the goal, whereas it ought to be growing profits.

What are the characteristics of companies that perform well?

In the better-run companies, it can be said that:

  • Everyone in the company knows the company’s focus and what customers they choose to serve.
  • They establish business rules for their sales and customer service people, including pricing, margin requirements, etc.
  • They have mechanisms in place for exceptions and approval, and clear guidance for when the company may vary from its norm. Exceptions have to be approved and are not the norm.
  • The leaders of the company don’t override and break the rules. They lead by example.
  • The company’s incentive programs are designed to reward behavior that is consistent with the company’s rules.

These companies have a point of view about new opportunities that most businesses don’t have, which is why they perform at such high levels. They know that the customer acceptance decision is a two way street and is not only up to the customer. They know that they have a choice about which customers and opportunities to pursue, and which ones to avoid. They know that they don’t have to work with everyone to be successful and have the discipline to say no when the opportunity is not a fit for their business model.

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Understand your company’s risks with an enterprise risk assessment

Business owners are accustomed to dealing with risks. Most, if not all of them, understand the relationship between risk and reward. However, a second relationship is equally important: the relationship between risk and awareness.

“Taking risks is not in itself a problem, but ignorance of the potential consequences is an entirely different matter,” says Mark G. Metzler, director of audit and accounting at Kreischer Miller.

Smart Business spoke with Metzler about the benefits of an enterprise risk assessment.

What are the types of risk?

There are generally four types of risk: financial, operational, regulatory and reputational. If one were to dwell solely on the risks, it is easy to become paralyzed and ignore the rewards of owning and running your own business. Therefore, it is critical that you not only understand your company’s top risks, but also implement processes and procedures to effectively assess, manage and monitor risk. This is commonly referred to as an enterprise risk assessment.

Looking more closely at the types of risk, financial risk refers to safeguarding company assets, which include hard assets like cash and investments, inventories, and property and equipment, as well as soft assets such as customer lists, intellectual property and trade secrets.

Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Because people, systems and processes are not perfect, operational risk cannot be eliminated.

Regulatory risk relates to compliance with laws and regulations, and reputational risk addresses the company’s public image, which may be a company’s biggest and most important asset.

Arguably there is a fifth risk, cybersecurity, that should be included in the list. However, cybersecurity is an element of all the risks previously described and must be considered in any risk assessment.

What is an enterprise risk assessment?

An enterprise risk assessment is a process through which management identifies significant threats that would prevent the company from meeting its stated goals and objectives. It assigns specific responsibility and accountability for developing controls to mitigate risk. It also implements those controls and monitors the controls to verify that they are working as intended.

It is important to have the perspectives of all of the stakeholders in order to perform an effective enterprise risk assessment. This may include the owner, senior management, sales, operations, production, suppliers and customers. Additionally, for certain discussions, involvement of your accountant, legal counsel, banker and insurance broker may be appropriate.

To be successful, contrary views must be encouraged. Surrounding oneself with ‘yes men’ will ensure that bad news is never heard in a timely manner and may result in a decrease in information sharing. Gathering perspectives from individuals who are ‘on the ground’ helps leaders understand what risks could have the most significant impact to the company over the next few years.

In an enterprise risk assessment, the stakeholders share their views of the risks that can impact the business. The findings are then prioritized and rated based upon their risk and probability of occurrence, and potential business impact. A formal action plan is developed for risks falling outside of acceptable levels, and individuals are assigned responsibility for implementing and monitoring risk mitigation plans.

What can a business owner hope to achieve by performing an enterprise risk assessment?

An enterprise risk assessment helps to align risk with strategy. Other benefits include enhancing risk response decisions, creating more efficient operations, providing for proper resource allocation, improving the company’s reputation and possibly lowering insurance costs. Understanding potential pitfalls and developing a predetermined response can decrease the likelihood for negative outcomes.

There is risk associated with every business venture. Without risk, there may be little reward. Business owners therefore need to understand the risks that exist in their companies and how they can minimize them.

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C-level succession planning for middle-market companies

Middle-market companies are more prepared than they might think for leadership succession, but many still have work to do to attract the best talent.

“Many companies have very compelling stories to tell,” says Tyler A. Ridgeway, director of the Human Capital Resources practice at Kreischer Miller. “A successful succession strategy comes down to getting everyone on the same page to develop and execute a plan.”

Middle-market companies, typically run by eight to 10 people, need a plan to attract or develop people who are in line for a leadership position and this critical plan requires the entire organization’s input.

Smart Business spoke with Ridgeway about how middle-market companies can ensure successful leadership transitions.

What tends to stand in the way of a successful C-level succession plan?

Companies may choose to invest in other areas over the years instead of building the executive talent required for the company to excel. Manufacturers, for instance, may invest in inventory rather than upgrading their head of operations, or a sales organization might think having a controller is better than spending on a CFO.

Sometimes business gets in the way, and an unintended consequence of a business expansion is the sacrifice of a training or advancement program. Companies may be attacking challenges as they arise so they’re not thinking 10-20 years down the road.

In other cases, a company might challenge a department head to bring people along, but not provide any structure for that training. Or there’s a plan, but unintended departures derail the effort and put the company essentially back where it started.

What is essential for successful C-level succession planning?

Successful succession stems from a strong company culture, which itself is a product of the C-level team. They need to hire people who are better than they are and provide leadership training to prepare the next-in-line to step into the new role. That takes commitment at all levels of the business.

Compensation is also a major factor. It’s not only about having the right leaders, but also ensuring that they are properly incentivized. Companies that aren’t paying a competitive wage will lose their top talent, so take a close look at the comparable positions and salaries in the market to determine the right compensation levels.

Although salary is important, today people want more than just salary; they want a total compensation package. If a person can trace the company’s success to their desk, they will want to get a percentage of that as compensation. Properly incentivizing the right employees will benefit the company.

How often should a plan be reviewed? What might prompt a company to revise its plan?

It’s good to review the plan quarterly and examine it through the lens of the company’s strategic growth plan. As the business grows, it changes. And when those changes occur, review the succession plan in all areas — where did the company invest, what challenges came with that, are the right people in place to deal with that?

Meetings should involve the department heads with the idea of learning what’s happened. These don’t need to be two-hour meetings. They could be brief checkups to learn whether the departments are on track with their leadership and succession training.

Communication is important, too. Let people know a leadership transition plan is in place and what they need to do in order to move up.

What should companies know or consider as they put together a C-level succession plan?

Companies need someone to champion the cause. This person won’t assemble the whole plan — it’s a group effort — but there should be one person responsible and who can be held accountable for it. And that person needs to have support from ownership.

It’s good to have a strong advisory team help assemble a succession plan. Owners shouldn’t put together a plan alone. Talk with peers who have been through it, as well as bankers, lawyers, accountants and insurance professionals who can bring their experience and knowledge to bear on the succession plan.

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How to execute a successful internal business transition

Business transitions have been occurring more frequently than ever with the aging of America. Some transitions are sales to outside interests while others are internal transactions with family or other key team members.

“An internal transition of leadership in a successful business is filled with opportunities and plenty of pitfalls,” says Stephen Christian, Director at Kreischer Miller. “Navigating this important time in an organization’s evolution requires not only careful planning, but focused execution.”

Smart Business spoke with Christian about factors that can impact a successful business transition that he has observed during his years of advising privately held, middle-market companies.

What groundwork should be laid before turning over the reins to someone else?

First and foremost, the successor to a business leader has to be the right candidate, not only technically and functionally, but also culturally for the organization. The world is changing quickly and the skills needed to run an organization are different today than they were 30 years ago. It’s important to focus on the critical traits that are required of a new leader.

Once this person has been identified, it is important that they get in-depth exposure to all facets of the business — suppliers, customers, professional service providers and all functional areas within the company. In addition, they should start the process of evaluating changes to shareholder agreements and other corporate documents, life insurance and business continuity plans.

What are some factors that provide for a successful transition?

The team members in the organization will be watching the transition closely. It is important to provide for open lines of communications so uncertainties can be resolved. It also is important for the team to understand the agenda and vision of the new leader.

There can be no doubt about the boundaries dictated by the change. Change creates opportunities and the successor should be encouraged to do things their way. There are many ways to succeed in business and everyone has their our own style. With this in mind, it is important for the new leader to build a team of allies and confidants who will provide them with the necessary support.

Describe some fatal flaws that get in the way of an effective transition?

One of the biggest problems is when a successor attempts to change too much too soon. Tread lightly and be aware of changes that may have an impact on embedded cultures within an organization. Focus more strategically than tactically in the early going.

Often overlooked is the need to openly and thoroughly communicate what is transpiring with all stakeholders — internal staff, supply chain, customers and others in the marketplace.

Another issue that arises from time to time is when the new leader does not effectively relinquish the responsibilities of their previous position. It is important to fully transition these responsibilities so that 100 percent of the focus is directed on their new role.

What if the person being replaced is still with the organization?

This situation can provide opportunities, but also problems if not handled properly. Often the predecessor is a founder or otherwise a significant presence in the company and casts a long shadow. The most important thing is to establish responsibilities and boundaries with the predecessor in a constructive fashion, and adhere to these ground rules.

Take advantage of the cumulative knowledge of the predecessor and value the role they have played in the company’s success. At the same time, the former leader needs to be supportive of all new initiatives and be careful not to second-guess decisions.

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Recognizing when the effort to create value outweighs the value created

It’s common that companies don’t focus on value creation until the business owner begins working to generate a meaningful liquidity event as a send-off to a comfortable retirement. But creating value at every stage of a company’s lifecycle in some capacity is possibly just as important.

“At the beginning and during a company’s growth cycle, value creation helps drive growth and increases a company’s competitiveness,” says Steven E. Staugaitis, director of Audit & Accounting at Kreischer Miller. “While the need to increase a company’s value becomes more pressing at the later stages, it takes time to create that value — it doesn’t just happen over the course of a year, it takes several years.”

Smart Business spoke with Staugaitis about creating value in a company, and when the effort to create value outweighs the value created.

Generally, what are the primary ways in which value is created in a private company?

Value is a product of the cash flows a business generates divided by its risk factors. Put another way, companies can influence the value of the business by improving cash flows through increasing revenue, reducing expenses and improving efficiencies; or by reducing risk, which is affected by a variety of factors, including the number and types of customers, recurring vs. project-based revenue, the state of the balance sheet, the depth and strength of the management team, and how dependent the business is on its owner for its continued success.

In what ways can the pursuit of value creation become more costly than the value created?

Value creation becomes costly when the business owner is not thoroughly evaluating the return on the investments the organization is making. Sometimes an initiative starts with momentum and enthusiasm, and then the business doesn’t follow through on it. Instead of making investments that generate a return and add value, the company is just burning through expenses.

How do businesses determine the most economical ways to create value in their companies?

To determine whether actual value is being created, it pays to go back to evaluating what ROI looks like. For example, businesses that are looking to grow their customer base can accomplish this in a number of ways. They can buy another company that already has an embedded customer list, knowing at the time of the purchase what it will pay vs. the revenue it will earn; or look to grow internally by growing the sales team and giving them goals that will present a clear path to the type of return that’s expected. Evaluating ROI is a critical step in determining the most economical way to create value.

How can an accountant help companies in this pursuit?

Accountants have a unique perspective because they work with so many different businesses, which gives them the chance to see how lots of companies handle risks and manage their investment initiatives. They can also participate in or lead strategy sessions with business owners and/or the management team — sometimes it’s good to have someone from the outside who has deep financial knowledge facilitate a discussion or identify flaws in the process.

There are many ways to influence the value of a company. Businesses that do well at this don’t try to tackle it all at once. They take time to identify the key factors, maybe a dozen or so, then they narrow it down and focus on the top two or three initiatives. Less successful companies tend to spread themselves thin chasing too many opportunities, or start and stop and never see anything to completion. As a result, they end up with a lot of activity that ultimately results in nothing gained. Sometimes, when chasing value-creating initiatives, the expression, ‘Done is better than perfect,’ is apt.

Owners should play a role in helping to recognize when they and their executive teams are getting distracted by day-to-day activities that sacrifice time that could be spent working on bigger-picture plans. These plans are vital to the ongoing success of the business and ultimately benefit the business much more in the long run.

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Identifying, understanding fraud is the first step in its prevention

To determine whether a company is at risk for fraud or mismanagement, business leaders need to move their thinking from “outside the box” to “inside the fraud triangle.”

“Recognizing the key attributes and influences of fraud provides a baseline for addressing the risk of fraud in your organization,” says Elizabeth Pilacik, director of Audit & Accounting at Kreischer Miller. “When addressing the risk of fraud, internal controls become more dynamic as the focus is the integrity of the process.”

Smart Business spoke with Pilacik about fraud: its types, the conditions that breed it and how organizations can mitigate it before significant damage occurs.

What are the more common types of fraud?
Fraud exists in various forms, including internal and external, as well as fraud committed specifically against individuals.

Internal fraud occurs when an employee, a manager or an executive commits fraud against his or her employer.

External fraud can be perpetrated by dishonest vendors that bill for services or goods that were not provided, or attempt bribes; or dishonest customers who use false account information or return stolen property for a refund. External fraud also includes health care and insurance fraud. Fraud against individuals is more frequently seen with identify theft, and Ponzi and phishing schemes.

In the financial world, fraud reveals itself through asset misappropriation, corruption and fraudulent financial reporting.

Asset misappropriation is the theft or misuse of an organization’s assets, a type of fraud more easily committed by employees because they have both the ability and access to execute. Corruption exists when one misuses his or her influence in a business transaction to personally benefit — by accepting kickbacks, for example.

The intentional manipulation, falsification or altering of accounting records, documents, and/or transactions is categorized as fraudulent financial reporting. Primarily management or executives commit this type of fraud because they have the authority to override internal controls.

Why does fraud occur?
There are three components, identified as the fraud triangle, that lead to fraudulent behavior. The first component is financial pressure brought on by a financial need such as an inability to pay bills or falling short of earnings or productivity targets.

With a motivation for the crime, the fraudster searches for the second component, opportunity — a chance to solve the financial problem in a way that seems to carry the lowest possible risk.

The third component of the fraud triangle is rationalization, which is the justification for the actions the person caught in the bad circumstance has taken.

What puts companies at risk for fraud and mismanagement?
Potential opportunities for fraud are often more prevalent at organizations that have inexperienced governance structures, financial constraints, IT risks, and weak or nonexistent internal controls.

Management is responsible for the prevention and detection of fraud and error. This is typically accomplished through the proper design, implementation and maintenance of an internal control structure, which includes the organization’s operations, compliance and financial reporting.

For all significant account balances and transactions, management should conduct a risk assessment process to identify, evaluate and estimate the levels of risk involved, and to determine an acceptable level of risk for the organization. The same assessment process is performed for fraud risk — identifying the potential exposure to the various types of fraud and the presence of the components of the fraud triangle.

Who should be responsible for risk management and fraud prevention?
Risk management and fraud prevention are tasks that involve everyone in the organization, but begin with the tone at the top. Management and those charged with governance are responsible for cultivating an anti-fraud culture within the organization.

The fraud risk assessment process needs a proactive, not reactive, approach whereby risks are identified and prioritized. Successfully addressing and potentially mitigating fraud takes awareness, training and communication.

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