Pre-divorce Business Downturn Syndrome

Reflecting back on the performance of more than 1,000 business valuations over the last 20-plus years, I have observed the regular occurrence of an economic event in many divorce-related engagements that I have named the Pre-divorce Business Downturn Syndrome (“PBDS” for short). Businesses that otherwise have reported fairly consistent profit patterns experience an unexpected dip in reported performance in the period leading up to the divorce valuation date. Business appraisers, when faced with the symptoms described above, should explore the possibility of an outbreak of PBDS by undertaking additional due diligence.

Manipulating Cash Basis Businesses

Especially for businesses that report their performance on the cash basis of accounting (e.g. many professional practices), there can be a deferral of revenues into the next year and an acceleration of expenses into the current year. Paying all bills by the end of the year for a cash basis taxpayer can be characterized as good income tax planning. However, deferring revenues by holding off on normal billing practices in the last month of the year can cross the line of good income tax planning into the realm of the PBDS.

Accounting Estimate Inconsistencies

Moving away from businesses that use cash accounting, many businesses using accrual accounting can also reflect the telltale symptoms of PBDS. Estimates by company management are regularly required to applying accounting principles to develop financial statements. An example of this would be a construction contractor that must estimate the percent complete of each of its in-process jobs. Backing off on the reported percent complete of in-process jobs can defer revenues and gross profit from the current year to the next year.

Time Can Confirm PBDS

In the simplified examples described above, profits are not removed from the company, they are only deferred. As such, the next accounting period will often reflect an atypical jump in profit. While all post valuation-date profit increases are not necessarily always reflective of PBDS, the business appraiser should further test the period to period fluctuations to determine if in fact an outbreak of PBDS has occurred. Business appraisers must establish a valuation date in a divorce case, and determine the value of the business as of that date, typically based on what was known or reasonably foreseeable as of that date. Care must be taken to not place improper reliance on post-valuation date events, but due diligence should be undertaken to test whether apparent anomalies observed on or before the valuation date are corroborated by subsequent performance.

PBDS Symptoms Can Indicate Other Diseases

While the examples described above can be characterized as aggressive application, or misapplication, of accounting principles, they can also indicate the existence of a more serious issue such as fraudulent financial reporting. An example might include an undisclosed business entity to which business has been shifted. The engaging attorney and the client should be made aware if the business appraiser finds symptoms of PBDS to give the attorney and their client the opportunity to explore the issue further. While the business appraiser might not be engaged (or qualified) to undertake forensic examination of the books and records of a company, the symptoms of PBDS are often recognizable in the typical due diligence a business appraiser undertakes. A referral can then be made by the business appraiser to a specialist in forensic accounting to more fully understand the PBDS patient.

A Lesson on Investigating Fraud from A Fictional Investigator

As a frequent speaker on the subject of fraud, people often ask me, “How do you investigate fraud?”

My answer is always the same: You look for the anomaly. To me, it sounds so simple until I step back and realize that most people cannot see the anomaly, although it is usually right in front of them. They lack or fail to use their power to observe, make logical deductions and, most importantly, they fail to investigate.

Many of the lessons I have learned on investigation over the years have come from the master investigator – the most famous investigator of all time, Sherlock Holmes. Mr. Holmes identifies three traits of a good investigator, outlined is this lesson. Those are:

(1)    Observation

(2)    Deduction

(3)    Knowledge

Deduction as we see relies on the power of logic. And as described by Mr. Holmes, logic gives the investigator a chain of sequences without a break or a flaw. But if there is a break or a flaw, then we have an anomaly.

Take for example Bernard Madoff, who created the world’s largest known Ponzi scheme and bilked investors out of billions of dollars. Bernie’s scheme was simple. Unlike most Ponzi schemes, where the investor is promised huge, unreasonable returns (the anomaly), Bernie’s returns were somewhat reasonable and steady, year after year. So where is the anomaly if there were no promises of outlandish rewards? Madoff had to have a hook to get people to invest.

Through observation, one can see the anomaly in Madoff’s scheme rests in the hook – which is to pay 10 percent to 15 percent returns year after year after year, no matter whether the market is up or down. Logic tells anyone who has ever invested in the stock market or has a retirement plan that no person or organization is smart enough to time the market to get constant returns every single year no matter the direction of the market. Even smart people who recognized the hook as the anomaly chose to ignore or rationalize away the clear warning and obvious flag.

When one observes the anomaly, it is time to investigate, and here is where knowledge is the key ingredient that is either gained through research or is already known. Investigating Madoff is exactly what Certified Fraud Examiner Harry Markopolos did, but not initially as a fraud examiner. Harry is a Chartered Financial Analyst who designs investment products. After being introduced to the illogical returns, Harry attempted to duplicate Madoff’s professed strategy of investing that allowed Madoff to achieve consistent returns.

Harry found numerous fallacies in the Madoff technique and proved that the investment returns, in fact, were impossible to duplicate. Harry Markopolos became a whistleblower and pointed out the fallacies and resulting fraud in Madoff’s scheme to the SEC. Harry made three separate submissions to the SEC, complete with documentation, beginning in 2000. The SEC never investigated, although the fraud was laid out before them in detail.

And today we know the rest of the Madoff scheme that finally collapsed in 2008. The amazingly strange events are well chronicled in Harry’s book, “No One Would Listen.” This book is Harry’s story of incompetent regulators and their failures. Unfortunately, for many investors the failures of the SEC, according to Harry’s account, cost some people their life’s savings (and some their life).