How Fraud Can Impact Your Company’s Value
There are many negative consequences of occupational fraud, such as financial losses, public embarrassment, and diminished employee morale, but one that is often overlooked is how fraud affects a company’s value. The value of your company can become distorted by illegal schemes involving asset misappropriation, corruption, and financial misstatements. All of these things can make it difficult to get an accurate valuation.
To ensure they come to realistic conclusions, valuators must adjust financial statements when the existence of fraud is known.
Teamwork
Business valuations are derived from financial statements to estimate value. Unless specifically stated in the engagement letter, valuators do not audit financial information or investigate fraud. So if financial statements contain fraudulent numbers, the valuation may be inaccurate, unless properly adjusted.
If fraud is suspected, the valuator will most likely engage a forensic colleague to determine the extent of the issue. This will increase the scope of the engagement but ensure that a proper value can be established.
Importance of internal controls
While a number of factors are considered, size matters when valuators and forensic experts are assessing the risk of fraud. A business that has less than 100 employees tends to suffer the highest median losses, according to the Association of Certified Fraud Examiners.
The internal controls a company has put in place, such as the policies and procedures to protect its assets, improve efficiencies, and ensure financial statements, will tell a valuator a lot about its potential fraud risk. Controls such as a fraud training program and whistleblower hotline are considered to be a good first line of defense against such issues.
There are other examples of internal controls that minimize fraud and protect a company’s value. These include:
- Restricted access to physical assets, including locks, passwords, and security systems
- Formal job descriptions, codes of conduct, and employee manuals
- Mandatory vacation policies
- Duplicate signatures on checks above a preset dollar amount
- Monthly bank reconciliations and physical inventory counts
- Background checks on prospective job candidates
- Annual or surprise audits
Even these do not completely prevent fraud. If a manager is lax in his/her supervision of employees or overrides the system, the environment is ripe for fraud to thrive.
Make adjustments
Valuators will take steps to account for additional risk if fraud or poor accounting practices are known or suspected. If an unscrupulous CFO were to prematurely post unearned or fictitious sales to boost his bonus, this would cause the company’s value to be overstated since the earnings or assets are now exaggerated.
To account for the CFO’s actions, a valuator might increase the company’s specific risk (a component of the cost of capital). By increasing the cost of capital, it has the inverse effect on the valuation.
Valuing a company, building a case
Because valuators typically don’t 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.
Reggie Novak is a Senior Manager in the Audit and Accounting Services Group. As a Certified Fraud Examiner, Mr. Novak can assist you with prevention services, including recommending internal controls and other measures to be implemented to prevent theft or misappropriation. If fraud is suspected, he can investigate and present his findings and recommendations. Contact Reggie Novak at 216.831.7171 or rnovak@cp-advisors.com for more information.
Charles Ciuni is the Chairman of Ciuni & Panichi, Inc. and a Certified Valuation Analyst. Mr. Ciuni can provide the comprehensive and detailed analysis required for a business valuation. He also specializes in litigation support services. Contact Chuck Ciuni at 216-831-7171 or cciuni@cp-advisors.com.
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