Factoring Fraud Risk into a Business Valuation
Business value is a function of risk and return. This is why, when appraising companies, valuation experts are always on the lookout for fraud risks. Although valuations typically aren’t designed to unearth dishonest behavior, experts may expand the scope of their engagement if they spot something suspicious — particularly if they believe financial statements are inaccurate.
A valuator’s fraud risk assessment starts with the subject company’s internal controls. When interviewing management, experts ask about the business’s policies and procedures to protect assets, improve operating efficiency and ensure reliable financial statements. For example, they look for risk-reducing controls such as:
- Physical and digital controls (for example, locks, passwords, cameras and security systems),
- Fraud training programs,
- Job descriptions that call for segregation of duties and job rotation,
- Mandatory vacation policies,
- Background checks, and
- Whistleblower hotlines.
Factors that increase risk include management overrides of internal controls and a lack of regular audits by outside auditors. Certain industries also tend to be more susceptible to fraud than others. Banking and financial services, government and public administration, and manufacturing are more likely to be defrauded according to the Association of Certified Fraud Examiners. What’s more, certain types of valuation engagements — such as shareholder disputes and divorces — can provide a motive to hide assets and downplay income.
When it takes a team
Because business valuation experts rely on financial statements to estimate value, those statements need to be accurate. What if the valuator suspects fraud, based on a preliminary assessment of financial statements? For example, there may be a discrepancy between revenue growth and changes in key assets (such as receivables or inventory) or sudden changes in gross margin.
Some professionals are cross-trained in both valuation and forensic accounting. Others work at large firms that provide both types of services and they may ask clients to expand the scope of their engagements to include forensic accounting services. Sole practitioners without forensic accounting training may refer a company to a separate forensic accounting specialist. This expert can help make the requisite adjustments to accurately value the business — and build a fraud case, if necessary. The valuation expert and forensic specialist will work together to estimate economic damages resulting from fraudulent activity.
Essential component of value
Fraud can strike any business, large or small — which is why valuation experts are alert for signs of criminal activity. If you suspect fraud is affecting your financial statements or harming your company’s value, contact us.