Assessing Fraud Risks

Valuation professionals factor fraud into the valuation equation

When fraud strikes, it can have a major impact on a company’s value. The Association of Certified Fraud Examiners (ACFE) estimates that companies lose approximately 5% of revenues to internal theft and financial misstatement each year, according to the 2016 Report to the Nations on Occupational Fraud and Abuse. Here’s how this statistic relates to the value of a business and how valuation professionals factor fraud into their analyses.

Understand the impact on value

Suppose a company reported $5 million in revenues in 2015. This equates to an estimated annual fraud loss of $250,000 ($5 million × 5%). Assuming a pricing multiple of 1.2 times revenues, fraud implicitly would impair the company’s value by $300,000 ($250,000 × 1.2) based on its estimated fraud losses.

The company’s actual losses could be higher or lower than this estimate, however. And this analysis doesn’t include indirect fraud costs — such as lost productivity, accounting and legal fees, reputational damage, and reduced goodwill — that can also affect business value.   

Identify fraud risks

Fraud takes a significant toll on companies. So an important part of the business valuation process is identifying potential fraud risks and gauging whether management has taken appropriate action to mitigate those risks.

Not only does fraud drain company resources, but it also 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.

Evaluate controls

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, because the internal control system can be intentionally circumvented.

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. They also interview management to observe subtler clues.

For example, appraisers 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.

Customize the assessment

Company size can affect its overall risk profile. That is, small companies are generally perceived to be riskier (and warrant higher returns from investors) than larger companies. One reason is that smaller businesses tend to be more vulnerable to fraud because they often lack adequate fiscal and human resources. They also tend to have fewer internal controls in place to deter and detect scams. So, fraud strikes small, private businesses more frequently. In addition, their losses tend to be more costly and devastating over the long run.

The 2016 ACFE study revealed that corruption was more prevalent in larger organizations, while check tampering, skimming, payroll and cash larceny schemes were twice as common in small organizations as in larger ones. Industry also affects the fraud risk assessment. In the cases reported in the 2016 ACFE report, the most represented sectors include:

• Banking and financial services,
• Government and public administration, and
• Manufacturing.

These findings underscore the need for valuation professionals to customize their fraud risk assessments, depending on the size and industry of the subject company.

When fraud risks materialize

Business appraisers consider fraud risks in every valuation assignment — and many experts are cross-trained in both valuation and forensic accounting. But detecting and investigating fraud is outside the scope of traditional valuation assignments. If fraud suspicions arise, it might be time to call in reinforcements and expand the scope of the engagement.

© 2017