How valuators assess the rising risk of fraud

A weak economy provides countless fraud motives: A business in danger of loan covenant violations might overstate asset values or downplay liabilities to keep lenders at bay. A CFO might exaggerate earnings because she feels increased pressure from shareholders to meet performance goals. Or an employee might steal inventory or petty cash to pay his delinquent mortgage.

Assessing fraud risks

The current economic downturn has produced an upswing in incidents of occupational fraud, so it’s imperative for businesses to step up efforts to deter and detect it. An important part of the valuation process is identifying potential risks and gauging whether management has taken appropriate action to mitigate those risks.

Not only does fraud drain company resources, but it also tarnishes management’s reputation, lowers morale, distracts management, results in regulatory actions — and can eventually lead to bankruptcy. All else being equal, companies with higher fraud risks warrant higher discount rates or lower pricing multiples, or both.

The right questions

A strong system of internal controls is one of a company’s most powerful fraud deterrents. In addition, a vigilant corporate culture can make a big difference in deterring fraudulent acts. But neither provides an absolute guarantee against fraud.
Valuation professionals evaluate internal controls and corporate culture by looking for formal codes of conduct, reporting hotlines, antifraud training, and clear channels of communication between frontline workers and their supervisors.

Appraisers also interview management to observe subtler clues. For example, they might inquire about the extent to which managers pressure subordinates at month- or year-end to meet goals. Or they might ask about previous fraud occurrences and how they were resolved. Careful, consistent handling of fraud cases speaks volumes about management’s attitude toward fraud risk.

Risky business

Every organization faces fraud risks, but some businesses are statistically more vulnerable. For example, companies with fewer than 100 employees tend to lack adequate fiscal and human resources. So, fraud strikes small, private businesses more frequently.
In addition, their losses tend to be more costly and devastating over the long run, according to the Association of Certified Fraud Examiners’ (ACFE) 2008 Report to the Nation on Occupational Fraud and Abuse. The ACFE study also revealed that check tampering and fraudulent billing were the most common small business fraud schemes.

The ACFE study reports that financial statement fraud generally tends to be costlier than asset misappropriation or corruption. “Fraud scheme prevalence” on page 2 illustrates which fraud schemes are the most common, according to a recent review of Securities and Exchange Commission (SEC) enforcement releases by Deloitte Forensic Center.

Kinds of fraud

Approximately 38% of SEC fraud enforcement releases from January 2000 through December 2007 involved expense, asset, liability, reserve or accounts receivable manipulation. Also common were revenue recognition schemes, including fictitious revenue, bill-and-hold and falsified return scams.

The Deloitte study revealed that two-thirds of the fraud schemes occurred in two industries: 1) technology, media and telecommunications (37%) and 2) consumer business (29%). Appraisers are therefore more alert to fraud risks when valuing companies engaged in these sectors, including publishers, retailers and distributors.

Appraisers tailor their analyses of fraud risks based on the subject company’s size, complexity, industry and goals. Such risk assessments predict where fraud may occur and who the perpetrators might be, as well as the schemes fraudsters may engage in and how they might conceal their activities.

Extra expertise

Rather than wait for fraud to strike, proactive companies take preventive measures, especially in today’s high-risk environment. Few experts cross-specialize in both valuation and fraud. And even if an expert is qualified to conduct both types of engagements, detecting and investigating fraud is outside the scope of traditional valuation assignments. If you suspect fraud has occurred, consider calling in reinforcements and expanding the scope of the engagement.

Sidebar: Fraud scheme prevalence

January 2000 through December 2007 SEC enforcement releases

Data source: Ten Things About Financial Statement Fraud, 2nd edition, published by Deloitte Forensic Center, December 2008.