Working Capital Changes in a Free Cash Flow Forecast– Part II

Part I of my working capital related blog addressed the impact on free cash flow of changes in current assets and changes in current liabilities, which are the two components that comprise working capital (calculated as current assets minus current liabilities). The combined impact of changes in current assets and changes in current liabilities equals the impact of changes in working capital on free cash flow. Part II of this blog identifies methods often used by business appraisers when forecasting working capital.

At the core, working capital changes are analyzed and projected to ensure changes in cash are correctly forecast. Merely because a company produces a net profit of $100,000 does not mean the company has $100,000 in cash available to distribute to its owners.

The ratio of sales method is commonly used to forecast the impact of working capital changes on free cash flow in a business valuation where the subject company utilizes the accrual basis of accounting.  This method is readily understandable and can reflect these variations:

  • Use the change (in currency) in working capital from the two years before the valuation date and grow working capital at the expected sales growth rate.
  • Use the ratio of working capital to sales reflected in the year prior to the valuation date to forecast working capital levels needed to support forecast sales levels.
  • Use the ratio of working capital to sales based on a historical multi-year period using a simple average, a weighted average or a median. While this method can smooth out year-to-year changes and allow a complete business cycle to be included, it may not be appropriate for companies exhibiting a consistent downward or upward trend in working capital in the years preceding the valuation date.
  • Forecast working capital using industry average ratios of working capital to sales. This method may be useful when a company has volatile historical working capital and/or is a start-up or in high-growth mode, for example, and the analyst is not comfortable making a forecast based on the company’s historical working capital levels.

Two key caveats are in order. Under the first three methods, the inherent assumption in applying historical average working capital levels is that the historical levels reflect expected future working capital levels. Since a business valuation should reflect expected future cash flows, expected variations between historical and future working capital levels must be considered. Second, if a non-controlling interest is being appraised, the assumption that the company’s working capital levels will be changed to industry averages might not be reasonable if the company rarely reflects industry-average working capital levels and the interest being appraised does not have the unilateral power to compel changes at the company.

Other considerations include:

  • The company’s historical working capital ratios and industry working capital metrics
  • Historical and industry normal metrics of the individual components of working capital (e.g., accounts receivable, inventory, accounts payable, etc.)
  • Comparability of companies in the industry group to the operations of the subject company when the subject’s metrics exhibit a large variance from the industry
    • In the case of very small companies, historical ratios may be more relevant
    • For larger companies that appear to be comparable, further analysis may still be necessary

My next blog will present additional thoughts on forecasting working capital.

If you are interested in learning more about how you can strengthen your case with a business valuation expert or want to learn more about our services and our team, please contact us.

Working Capital Changes in a Free Cash Flow Forecast – Part I

In a business valuation income approach, the income stream being capitalized (in a capitalized income method) or discounted (in a discounted income method) is often the free cash flow generated by the entity being valued. Free cash flow is typically calculated on an after-tax basis, and represents the cash available to a company’s owners after allowing for sufficient reinvestments of cash to maintain the company as a going concern and provide for future growth.

Most free cash flow forecasts used in a business valuation assume that the business being valued will remain in business and continue to grow. Since ongoing investments in accounts receivable, inventory and fixed assets are typically essential to the continued operations of a business, it is common to adjust free cash flow forecasts to reflect working capital changes. Working capital is defined as current assets minus current liabilities, and for this blog we are assuming that the subject company utilizes an accrual basis of accounting. From a simplified standpoint, working capital reflects current assets (such as new inventory) that are not financed by trade creditors (represented by accounts payable) for which the Company must obtain cash to acquire.

Working capital consists of the current assets and current liabilities that a company requires to operate on a daily basis. These accounts can include:

  • Accounts receivable
  • Inventory
  • Other current assets
  • Accounts payable
  • Accrued expenses
  • Short term notes payable
  • Other current liabilities

In a detailed forecast of working capital, the change in each of these accounts is typically driven by the change in a related account or accounts – deemed Forecast Drivers:

Component of Working Capital Typical Forecast Drivers
Accounts receivable Revenues
Inventory Cost of Goods Sold (COGS)
Other current assets Depends on what accounts are included in this category. Look at descriptions and historical trends.
Accounts payable Inventory or COGS
Accrued expenses Often tied to COGS or General and Administrative (G&A) expenses.
Short term notes payable Can be tied to loan amortization schedules or to levels of assets financed such as inventory.
Other current liabilities Depends on what accounts are included in this category.

 

The historical relationship of each of the current assets and current liabilities to the relevant underlying Forecast Driver is typically determined by a rigorous financial analysis of the company’s operations over time.

The faster a company grows and expands, the more cash it will need. During times of growth, companies accumulate additional accounts receivable and inventory at levels that exceed trade financing, requiring additional cash investments. Increased working capital investments impact free cash flow forecasts in ways including:

  • If current assets increase, all else held constant:
    • Working capital can increase
    • Free cash flow can decrease
  • If current liabilities increase, all else held constant:
    • Working capital can decrease
    • Free cash flow can increase
  • If increases in current assets exceed increases in current liabilities:
    • Working capital increases
    • Free cash flow decreases

Under ordinary operating conditions, many, if not most, companies have positive working capital (current assets exceed current liabilities), so forecasted increases in revenues require additional working capital investments, and free cash flow is reduced, all else held constant. It is also possible for a company to have negative working capital (current liabilities exceed current assets) under ordinary operating conditions, such as hotels or airlines that are fixed asset intensive companies with limited inventories and immediately collect payments for services from charge cards. A company in such an industry often reflects a growing negative working capital balance, which effectively can be a source of free cash flow for that company.

A negative change in working capital (working capital forecast to decrease) is also possible in certain businesses and at certain times, such as when a business is experiencing a downturn in its markets. The implications of this assumption in a long-term forecast must be carefully analyzed. While a company may forecast selling off excess inventory or tightening its credit policies, for example, reducing working capital and increasing free cash flow, these sources of cash are not reasonably sustainable over the long-term. At some point, working capital excesses will be eliminated and further reductions in working capital can hamper revenue growth or even the viability of a company.

If you are interested in learning more about how you can strengthen your case with a business valuation expert or want to learn more about our services and our team, please contact us.

The Value of Advanced Data Analytics

A picture says a thousand words – and nothing tells a story better than electronic data. FSS has successfully used advanced data analytics for years to ferret out the truth and bring a story to life through data visualization, from supporting or challenging a plaintiff’s testimony to identifying the patterns and relationships that help uncover a multi-million-dollar fraud scheme.

Although most of us don’t realize it, we all leave an electronic trail of evidence a mile wide on a daily basis. Consider the injured plaintiff who claims their loss of business is related to their injury – most would look to the financial statements for supporting evidence. However, I would suggest a deeper dive. What story does the detailed transactional data reveal? It can often be quite different from what it appears to be on the surface.

It has become common for businesses to use big data for business intelligence, but it hasn’t been adopted widely to uncover relevant facts behind allegations of false claims or whistleblower allegations. The reality is that data holds the answers to many questions, regardless of which side of the aisle you are on in a case. Advanced data analytics can help to isolate and understand details of transactions at the core of allegations such as these.

To illustrate the power of advanced data analytics, I often point to a case that involved whistleblower allegations of underreported revenue to the IRS. FSS was hired to investigate the validity of the allegations. Our investigators analyzed daily sales records, management reports, reports to accountants, financial statements, tax returns and government prepared reports detailing the alleged underreported revenue. These records included electronic data and manual reports. What did we find? The amount of alleged underreported revenue was significantly lower than determined by government accountants. Additionally, we identified significant errors made by the company’s external accountant. Our findings were presented to the IRS, and our revenue amount was accepted as the correct amount of underreported revenue.

Principals of the company avoided substantial jail time because of our work. They also paid significantly lower amounts of fines and penalties. These results underscore the necessity of looking deeper into electronically stored information to reveal critical patterns and insights.

Another prime example is a case from many years ago. FSS was working for a school district with an annual budget of over $11 billion. The school district had a control in place that limited the funds that could be transferred without board approval to $50,000. So, we looked for transactions of exactly $49,999. We found that one of our persons of interest had transferred this exact amount 48 times in 60 days. Thanks to electronic data, this nefarious activity was easily identified among millions of transactions – something that couldn’t have been accomplished with sampling or statistics.

Electronic data allows us to achieve results for our clients in a short period of time. We can relate disparate sets of accounting records, normalize transactions into a single platform for analytics, and conduct data mining to uncover a number of abusive activities. Always remember that the real story is often more complex than it first appears, and electronic data leaves a trail that can be easily followed to find the answers.

Capital Expenditures, Depreciation and Amortization in a Cash Flow Forecast

When valuing a private operating company, an appraiser is likely to use an income approach, either as the main valuation method or in conjunction with another method. Whether the appraiser capitalizes cash flows in a capitalized cash flow (“CCF”) model or uses forecasts of future cash flows in a discounted cash flow (“DCF”) model, they have incorporated both explicit and implicit assumptions into the cash flows used in their model.

There are numerous assumptions appraisers must make when building a cash flow based valuation model. I have reviewed hundreds of valuation models and reports during my career in public accounting.  In some models I have reviewed, it appears that certain assumptions are made perfunctorily. While the intention of the appraiser may not be to mislead users of the valuation, the user (and sometimes the appraiser) may not be aware of the potential magnitude a cursory selection of an assumption may have on the value of a company.

One set of assumptions that must be made in a cash flow forecast is the forecast of normalized depreciation, amortization and capital expenditures (“capex”).  These assumptions appear in the discrete historical periods of the cash flows analyzed for a CCF model, and in both the forecasted discrete periods and terminal value of a DCF model.

The goal of these assumptions is to “normalize” capital expenditures, depreciation and amortization to levels that support the company’s forecast future performance. There are some common errors to watch for regarding these assumptions in a business valuation.

The first thing to know is that capital expenditures always come before depreciation. A company cannot depreciate assets it has not yet purchased! Therefore, if an appraiser is using historical company information to make a simplified normalization adjustment, they should be adjusting depreciation to forecasted capex, rather than the reverse. However, this assumption may be an inaccurate one if the appraiser has not analyzed the historical capital expenditures thoroughly for average useful lives, existence of long-lived assets, and the depreciation methods used. This is also the reason that depreciation should not exceed capital expenditures in the cash flow being capitalized in a CCF or in the terminal year of a DCF.

While amortization is often presented on the same expense line as depreciation in a company’s income statement, “depreciation and amortization”, it should typically be treated differently by the appraiser. Amortization is the term used for the “depreciation” of intangible assets, which are usually created by the acquisition of another company. While fixed assets are systematically replaced in an ongoing, growing business, intangible assets typically are not. Further, the current values of intangible assets are inherently included in the total company value being determined by the appraisal, so subtracting amortization charges based on historical intangible asset values is incorrect. Therefore, amortization should be excluded from the cash flow forecast, and consideration should be given to separately valuing any expected future tax benefit it generates and adding this to the enterprise value.

An appraiser may make a simplifying normalization assumption that sets depreciation and capex to be equal in the terminal period forecasted cash flows.  This assumption is typically only appropriate in zero-growth/inflation scenarios.  If growth is projected in the cash flow forecast, capex should typically exceed depreciation in the terminal period.

If the company owns long-lived assets, such as buildings, it may not be appropriate for the depreciation on these assets to be forecast into perpetuity. Look for an adjustment to the depreciation forecast for these assets and a separate valuation of (or at least a discussion of) the tax benefit overhang.

If you are interested in learning more about how you can strengthen your case with a business valuation expert or want to learn more about our services and our team, please contact us.

25 Years of FSS: Looking into the Past, Present and Future

25 years ago, a dream came true – Forensic Strategic Solutions (FSS) came to life! In October of 1992, FSS was created as the product of a plan to specialize in investigative financial services. We narrowed our scope to the specific field of fraud investigation, while also serving as expert witnesses on complicated financial matters. Many people thought such a niche practice would not be successful, but today, the industry continues to flourish. In fact, back in 1992, few people – especially in the general public – had even heard of forensic accounting. Most folks thought forensic accounting was providing accounting services to dead people!

To celebrate the 25th anniversary of our company, we are examining how the industry has changed, revisiting our most fond memories and forecasting how we predict both FSS and the industry will evolve over time.

What has been the most significant change in the industry since FSS opened?

Until the mid-1990’s, courts of law did not recognize anyone as a “fraud expert” – nor had they heard of a Certified Fraud Examiner (CFE). In the late 1990’s, the Association of Certified Fraud Examiners (which was founded in 1988) and its members were recognized by governmental agencies for their expertise in fraud detection and prevention. CFE then became a recognized brand of fraud experts. Even the television series, “The Sopranos,” identified the forensic accountant as an investigator and expert in fraud! Times were changing, indeed.

In 1997, the American Institute of Certified Public Accountants (AICPA) began requiring certified public accountants (CPAs) to look for fraud in financial statement audits. This was also the year AICPA first used the word “fraud” in any of the accounting professional standards or literature.

In July 2002, as a result of massive fraud schemes in publicly traded companies such as Enron, WorldCom, HealthSouth and Adelphia Congress, the Sarbanes-Oxley Act was signed into law. This legislation was enacted to require reporting companies to implement strong internal controls, enforce management, compel their auditors to make assertions about the reliability of financial statements, and ensure that the companies were free from fraud.

How have the industry and the company evolved over the past 25 years?

The enactment of Sarbanes-Oxley led to industry recognition and growth – consequently, many accountants began to hold themselves out as forensic accountants. To the true financial investigator, however, the industry, while growing, remains very small with only a few organizations and firms equipped with the necessary skills to successfully conduct financial investigations.

As for FSS, in the early days it was much easier to practice solo. As the industry has evolved and technology has exploded, it has become virtually impossible to successfully practice alone. Our firm has found continued growth and success by building a strong team of financial and technology experts whose individual areas of expertise complement and support each of our five integrated practice areas.

What is your most meaningful memory since opening the business?

I have watched, with great pride, as our team has continuously grown to new heights and successfully taken on larger and more complex engagements.

Personally, in 2010 I was recognized by the Association of Certified Fraud Examiners with the Cressey Award, which is the organization’s highest honor bestowed annually on one individual for a lifetime achievement in the field of fraud detection and prevention.

How has technology shaped financial investigation? Where was it 25 years ago, and where is it going?

Data mining and artificial intelligence are significant keys to success in a financial investigation – after all, knowledge is power. These tools allow investigators – and even auditors – to review and analyze all the data in financial records, NOT just test it on a sample basis.

CPAs and auditors have been extremely slow to embrace technology and artificial intelligence as a method to perform their work. Current professional literature touts these methods as new, novel and great ways to change the industry. We have been using these tools for over 20 years, which has been critical to our success in helping our clients to detect and prevent fraud.

Financial data tells a story – data mining, advanced analytics and artificial intelligence allows us to get behind the story and objectively dig out the truth, whether it’s in support of or in stark contrast to the story being told by the party we are investigating – which could be a company, the suspected wrongdoer, or the plaintiff or defendant in a litigated matter – you name it. Technology is one of the key tools in our forensic toolbox.

What do you deem important to the future of financial fraud investigation?

Financial fraud investigation has never been more important than it is today with the proliferation of electronic devices and communication. Bank robbers no longer need to leave the comfort of their homes to steal millions of dollars from banks, organizations and individuals.

Fraud investigators must continuously be trained in all aspects of a financial investigation, yet remain smart enough to know that as the complexity and sophistication of fraud schemes increase, they won’t be able to perform each aspect alone. Staying ahead of technology changes, understanding new fraud schemes, knowing how to legally and ethically conduct financial investigations and building expertise in interviewing are just of few of the critical skills involved in financial investigation.

Where do you think FSS will be 25 years from now? What about the industry?

FSS will continue to be a leader in the financial investigation niche as expert witnesses and financial investigators because of the expertise we possess and the recognition we have received. We will continue to strategically build our team of financial and technology experts. The firm will have double-digit growth for at least the next 10 years.

The need for financial investigators will continue to grow, but the firms providing investigative services will be small, niche firms who have the expertise I have discussed. Our world of real forensic accountants, not those who just claim to be forensic accountants, is limited to those individuals who have very unique skills, intelligence in the field and an undying passion to solve financial jigsaw puzzles.

We are so grateful to our partners, employees and friends who have been by our side throughout the incredible past 25 years. We look forward to seeing what the years ahead will bring!

Trust Your Employees, but Verify Their Actions

Our team recently wrapped up another sizeable fraud examination for a small business whose trusted bookkeeper embezzled hundreds of thousands of dollars. While the names and the faces of fraud change, the story remains the same: the employee you least expect, the most trusted of them all, takes advantage of their position – and you – for their own personal gain.

Chances are, most of your employees would never dream of stealing from your organization. Honest people, however, have been driven to embezzle when faced with perceived overwhelming financial troubles. Perceived financial desperation, coupled with opportunity and constant temptation, increase the odds that even the most honest employee will succumb.

What do you think would happen if you scattered 1,000 one-dollar bills around your company’s break room with a sign that simply asked your employees not to steal? How long would it take for someone to give in to the rationalization that no one will miss just a couple of the one-dollar bills? It likely wouldn’t take long.

If most employees would steal under the right circumstances, how can you possibly prevent embezzlement? The answer begins with you.

Trust, but Verify

All too often, employers have a false sense of security and think they are immune to the risks of fraud, with thoughts like:

“My bookkeeper is the first one in and the last to leave.”

“They’ve been with me for years.”

“But I pay them so well. . .”

“Our accountant gives us a clean bill of health every year.”

Allow yourself to consider for a moment the opposite – that employee theft could happen to you. After all, according to the Association of Certified Fraud Examiners (ACFE), companies lose an estimated five percent of their annual revenue to fraud. Who at your company might have the opportunity to commit wrongdoing and is in a position to conceal it?

The first rule of thumb is to never leave someone in a position to check their own work. Think of a transaction like a circle: no single person should ever be allowed to complete the circle by themselves. You need to segregate duties, especially when it comes to bookkeeping.

Ask yourself these questions:

  • Who has access to the money coming in? Don’t leave them with the authority to post or edit customer transactions.
  • Who has access to the money going out? Don’t leave them in a position to create new vendors or employees – not to mention the authority to sign checks or execute bank transfers.
  • Who orders parts or services? Who opens the mail? Who takes the money to the bank? Who writes the checks? Who mails the checks? Who reconciles the bank statement?  I hope you are getting the picture.

Segregating duties in a small business isn’t always easy, but it can be done. One approach is to find a way to insert yourself into the process:

Cash receipts: Ideally, the employee collecting money and posting payments should not be the employee who bills customers. Only one employee? Don’t provide them with administrative rights to post credits, write-offs or void customer transactions. If you do, be sure to verify the electronic Audit Trail (an invaluable feature of QuickBooks, but most accounting programs have them). Stay informed.

Cash disbursements: When your bookkeeper is the only one able to disburse money and reconcile the bank statement, ensure that bank statements and cancelled checks are delivered to you – preferably to your home – and reviewed before providing them to your bookkeeper.

Debit or credit card purchases: Your bookkeeper is likely paying these bills. Don’t give them authority to increase limits or request additional cards. Place daily and monthly limits on cards and monitor them regularly. Receipts should be submitted and reviewed before the bill is paid.

Fraud is an unfortunate but all too real component of conducting business. By staying vigilant, segregating financial duties and verifying your employee’s actions, you can protect your business from embezzlement.

 

Technology is Changing Auditing

Or… has technology already changed auditing?

The accounting and auditing world is buzzing with talk of how automation and other technologies will reshape the accounting profession. Oh, how slow this world catches on! The reshape should have already taken place, as both technology and automation have far surpassed the capabilities and knowledge of most auditors.

In an article in the Journal of Accountancy, April 2017, Deloitte audit partner Jon Raphael explains how auditors using technology are changing the way audits are performed. “Exponentials” – or advanced technologies – are a driving force representing technological breakthroughs at the intersection of information technology and science, Raphael writes. And Deloitte is clearly at the forefront of using the technology to enhance audit processes and increase value to their clients.

But this technology is not new. It is a technology that has been available for many years, and the use of that technology should have been required by the American Institute of Certified Public Accountants (AICPA) to be used by auditors. Data analytics and data mining have been used extensively by marketing professionals for over 25 years. FSS learned of these breakthroughs over 20 years ago, and we implemented data analytics in the mid 1990’s to investigate, analyze millions of records, and document and prove fraud.

In a keynote speech I made to the National Association of Advanced Accounting and Auditing Technical Symposium (NAAATS) in July 2010, I emphasized to these professional standards writers that we have the tools to catch a Bernie Madoff, Alan Stanford, Enron, HealthSouth, or just name the fraud scheme – we already have the tools. And as I pointed out, there should be standards enacted by the AICPA to require auditors to know and use them.

Raphael correctly states auditors must monitor and understand emerging trends and technologies such as Bitcoin, or digital currency that uses blockchain technology. As he states, these technologies may present new audit-related risks and opportunities. However, I would ask any auditor: If Bitcoin can be used at some of the world’s largest retailers such as Microsoft, Overstock and Expedia and is recognized as an official currency by Japan and others, wouldn’t you consider bitcoin as an audit risk now? And, should you, as an auditor, understand and design procedures “now” to obviate this audit risk with your client’s business in mind?

With all the technology readily available, I can envision a plaintiff’s attorney asking the expert witness this question: “Did the auditor’s failure to use available technology in its audit of this company violate the standard of care?”

And when it comes to keeping up with technology and innovation, where does the auditor’s liability end when it comes to data breaches; and the auditor’s responsibility to identify the liability a company has to protect company data? Even more concerning is the auditor’s liability for data breaches of the client’s records which reside on the auditor’s computer system. We will look at these perplexing questions in future posts on this blog.

Analyzing Assumptions in a Cash Flow Forecast

Forecasts of future cash flows within the income approach to business valuation are loaded with assumptions. During my nearly two decades of business valuation experience, I have reviewed hundreds of valuation reports prepared by other experts that serve as a constant reminder that mathematical accuracy does not always equate to a reasonable value. I have seen erroneous assumptions made by business appraisers that range from illogical disconnects within the valuation to outright errors or unsubstantiated speculation.

Business appraisers must often deal with financial forecasts in their valuation of private companies. Sometimes, the financial forecasts or projections used by the appraiser in a discounted or capitalized cash flow model are provided by management, in which case the appraiser might:

  • accept these forecasts at face value because management prepared them,
  • accept these forecasts, but adjust for questionable assumptions by varying the discount rate used,
  • tweak the forecasts based on the appraiser’s judgement, or
  • come up with his or her own forecasts of the company’s cash flows.

Regardless of the method the appraiser uses, there are numerous assumptions in a cash flow forecast that must be adequately analyzed and supported, the absence of which may cause an overvaluation or undervaluation of the company.

In this multipart blog series, I will point out common issues I have observed in my review of valuation models and reports.  I will focus on the forecasts of:

  • capital expenditures, depreciation, and amortization,
  • working capital to sales,
  • short and long term growth rates,
  • deferred income taxes, and
  • use of future debt.

Look beyond mathematical accuracy. Without adequate analysis and support, the assumptions and related ratios embedded in the forecasted cash flows used in a capitalized cash flow model or in the calculation of the individual forecast years and the terminal value in a discounted cash flow model can lead to an unreasonable value.

If you are interested in learning more about how you can strengthen your case with a business valuation expert, or want to learn more about our services and our team, please contact us.

28th Annual ACFE Global Fraud Conference in Nashville — Like a Fine Wine

Originally published by ACFE Insights.

The premier annual conference for anti-fraud professionals just concluded in Nashville at Music City Center. Nashville has every reason to beat its chest about this new venue — it is just fantastic. It’s as good as, if not better than, any conference center in any major city across the country.

The ACFE Global Fraud Conference just gets better and better every year. The ACFE now has more than 80,000 members, more than 3,100 of which attended this conference. These members allow the conference to grow exponentially each year, making it the place to be for anyone serious about the detection and prevention of fraud.

The world of fraud is rapidly changing, making the ACFE Global Fraud Conference a necessity. For example, nowadays a bank robber can remain in his basement and commit 15,000 robberies through his computer. He doesn’t even have to go to the bank, and he can cover his tracks through the Dark Web of the internet. Internet 2.0 is coming — it looks great and security will be better for everyone, but it will take some time.

Meanwhile back at the ranch, computer hacking, ransomware and theft through the computer continue to grow exponentially. These trending topics and more were covered extensively at the immeasurably valuable conference.

Specialists in the multifarious ways of fraud detection and prevention shared the latest and greatest methods to find and investigate fraud in today’s environment. Anti-fraud specialists know our world functions best through personal networking. The conference gives attendees the chance to connect with peers from around the world. I continue to connect with peers I met more than 20 years ago, as well as those I have met in the last few years. My new connections will be just as valuable as the old ones.

Speaking at the conference is a gratifying experience. The ACFE selects only speakers who can teach and offer valuable insights on their selected subject matter because the members are not timid about offering criticism and feedback. This year marked my 15th year to speak, and I presented two sessions on the auditor’s responsibility to detect fraud. The main takeaway for the presentation was that if fraud is committed and the auditor does not detect that fraud, there is likely a 99 percent chance the auditor will be sued. I shared information on professional standards and the devastating consequences of the auditor’s failure to discover a fraud scheme.

What a treat to attend and speak at one of the most professional, informative and well-organized conferences in the world. I look forward to returning to the conference in Las Vegas next year!

Best Practices for Employers: Conflicts of Interest

In my last blog, I discussed why corruption in the workplace always requires a conflict of interest. Conflicts of interest arise when employees have interests that may make it difficult to maintain one’s duty of loyalty to their company in an objective and effective manner. Unfortunately, conflicts of interest are unavoidable. They exist at all levels within an organization, and are more inevitable the higher you climb the corporate ladder, as well-connected, accomplished individuals tend to hold leadership positions. Quashing all conflicts of interest within businesses would be difficult to conduct; therefore, it is important to know how to reduce the risks inherent in conflicts of interest.

First, it is crucial to train employees on their responsibility of loyalty. Often, employees are simply unaware how outside interests, including friends and personal relationships, could pose a conflict. An additional challenge with conflicts is losing objectivity – as humans, we are often far less objective that we are willing to admit, which is why employees need to be trained on how to recognize the threat of conflicts. It would be wise to give employees examples of what qualifies as a conflict – for instance, is accepting a gift or being entertained acceptable? Or a conflict? Finally, during training help your employees understand that conflicts of interest are not necessarily bad or inappropriate, but they must be disclosed.

In the wake of a flood of accounting scandals, such as the Enron scandal, many companies adopted conflict of interest policies. Your company’s policy, which should encourage disclosure of conflicts as they arise, must be thoroughly reviewed in your employee training. However, your policy should not be forgotten after training – require annual certification that your employees have read the policy and attested they have either reported all known conflicts, or reported they are not aware of any conflicts. In addition, consider an annual questionnaire that asks employees to respond to detailed questions about common scenarios that could give rise to a conflict.

While training is a large, and important, aspect of conflicts of interest, there is another notable component: detection. It’s often said that relationships are hard to discover, but in reality, conflicts almost always leave a footprint that can be detected with electronic data mining techniques. Rather than detecting, it’s more about identifying relationships. Publicly available information, such as social media, business records and public databases can be mined for relationships, and it is wise to mine through emails, accounting records, and employee and vendor lists to identify relationships. For example, data matches can be performed between employee and vendor data files to identify relationships by mining for matching addresses, tax identification numbers, bank accounts or phone numbers.  Also consider vetting incoming mail for irregular contact between employees and vendors.

If you have questions about conflicts of interest, or want to learn more about our services and our team, please contact us.

Quickbooks Audit Trail: Fraudulent Behavior Detection

In our previous blog post regarding the QuickBooks Audit Trail, we discussed what the tool is, what it captures and how to use the tool.

To recap, the QuickBooks Audit Trail (or Audit Log, depending on the version) provides a log of each accounting transaction and denotes any additions, deletions or modifications affecting the integrity of the transaction. The tool captures every transaction from the time it is initially entered into QuickBooks, and tracks changes to the original entry, including transaction type, date, account, vendor/customer name, transaction amount, quantity, and price. The Audit Trail also reveals the User ID under which the entry, deletion or modification was made. The Audit Trail is a report built in the QuickBooks ReportCenter– all you have to do is click a button to generate the report.

One question posed in the blog was, “So, I can use QuickBooks to prevent and detect fraud?” The answer is a definitive yes. Employers can use the audit log to detect warning signs of fraud, waste and abuse.

What are the footprints that could reveal fraud?

–        Transactions with more than one entry in the audit log, which indicate that a change has been made to the transaction after it was originally entered in the system.

–        Name or description changes.

–        Dates that have been changed from the original entry to the last modified date.

–        Changes in check number.

–        Changes in the amount of transaction.

How do we detect fraud with the audit log?

The indicators of fraud, waste and abuse can be identified through the audit log in numerous ways, including:

1.      Export the audit log to Excel. 

2.      Search for the words “deleted” or “void.” If a check was created and then deleted or voided, it will show the transaction as it originally appeared, including the general ledger accounts the transaction was originally charged against. By searching for “deleted” or “void,” we can identify checks that may have been created, deleted or voided from the system but still cleared the bank. After isolating the deleted and voided checks, search the bank statements to verify if the checks cleared and if so, to determine the payee.

3.      Use the Same, Same, Different methodology to search for a change to the payee name. Data analytics allows us to identify all checks that have the same check number but have a different payee. After isolating these checks, we can search the bank statements to verify if the checks cleared and who the payee was on the check that cleared.

4.      Identify changes to a record outside an expected period of time. The audit log includes fields for enter date, last modified date, and the latest and prior dates. By calculating the difference between the enter date and the last modified date we can determine if changes were made outside of a reasonable time period.

For example, a company may have an expectation that no changes be made to a disbursement transaction more than 60 days after a transaction was prepared. By calculating the difference between the enter date and the last modified date, we can isolate all disbursements with changes greater than 60 days.

5.      Look for a changed check number. When a check number is changed in QuickBooks, there are multiple entries in the audit log under the final check number. Each entry in an audit log has a “header record” – typically the check number. We can create a calculated field to find where the check number in the header record is different from the check number in the “NUM” field. Search the audit log to determine if either the original check number or the new check number have other entries in the audit log. After isolating these differences, we can search the bank statements to determine if both checks cleared and who the payee was on the check that cleared.

6.      Isolate transactions to determine which amounts have been changed. We can use a simple calculation to determine changes in amounts. After we isolate those transactions in which the amounts have been changed, we can verify the amounts against supporting documentation and cancelled checks. If a check was issued for more than an invoice, contact the vendor to determine if a refund was issued for the difference. If a refund was issued, request a copy of the cancelled check issued and attempt to follow this transaction through the company’s books and records to determine if the company received the benefit of the refund issued.

Similar to many other red flags of fraud, the footprints of fraudulent behavior found in the audit log of QuickBooks require additional analysis of supporting documentation and corroboration with independent records, such as cancelled checks from the bank and confirmation with vendors. If you are interested in learning more about how our firm can assist you with financial investigations, please contact us.

Why Corruption Always Requires a Conflict of Interest

When it comes to corruption, there is almost always a common denominator: a conflict of interest. A conflict of interest exists when an individual or corporation has the opportunity – real or perceived – to exploit their position for personal or corporate benefit. Corruption occurs when the individual or corporation takes advantage of that opportunity and indeed abuses their position for private gain. The good news is, if conflicts of interest can be controlled, the risk of corruption can be minimized.

Because of this, it is important for management teams within organizations – public or private – to be alerted to the connection between conflicts of interest and corruption. Understanding this relationship can lead to the prevention and detection of misconduct and fraudulent activity. While this relationship can be confusing, a simple way to remember the difference between conflicts of interest and corruption is could vs. does. While conflicts of interest do not always lead to corruption, corruption almost always requires a conflict of interest.

Conflicts of interest are often closely associated with procurement positions; however, it can be anyone in a position to influence the award of business, control payments or abuse supplier relationships. Examples include a purchasing employee who secretively gives business to another company under his control, an employee who gives business to a company in exchange for a gift or other kickback, or an employee who starts a company that provides similar services to the clients or potential clients of their employer.

To prevent conflicts of interest from morphing into corruption, there are preventive steps that can, and should, be taken. Offer training to all employees so they, too, can understand this relationship and the significance of conflicts of interest. Management should be intentional in creating an environment where the staff is comfortable declaring annually in writing any potential, perceived or actual conflicts.  Finally, management should be educated on the procedures for handling conflicts of interest.

If there is an actual conflict of interest, management has options. Sometimes, it’s as simple as removing the conflicted employee from the situation. Other times, it can be more complicated – steps that can be taken include: restricting job-relevant conflicting interests; removing the employee from the conflicted decision-making responsibility; or, if the employee has a business relationship with a third-party, the employee could resign from the position.

Management should remember that the mere act of having a present conflict of interest is not necessarily inappropriate – it’s the knowledge of and response to the conflict that is crucial, and reduces the risk of corruption.

If you are interested in learning more about how the relationship between conflicts of interest and corruption, or want to learn more about our services and our team, please contact us.

Social Media Evidence: Where to Look and Protocols to Follow

As a digital technology expert, it is fascinating to observe how today’s technology-centric world obsesses over anything and everything digital – especially social media. From sharing locations on Instagram and Facebook to live tweeting events, people constantly update their friends – and strangers, if their account is public – on their every movement.

Social media networks are an exceptional method to stay connected with friends and family, but to a forensic investigator social media is a treasure trove of intelligence in a fraud investigation. From the basic share of information, such as a status update or photo, to the searchable metadata connected to social media posts, like time-stamps and geo-locations, the forensic examiner can dive deep to connect the dots. Other publicly available information to aid in the search includes the suspect’s check-ins, comments, reactions (likes or Facebook emotions), re-tweets, locations, photos and friends or followers.

An abundance of information is available on social media that can be useful to an investigation, but two hurdles are important to note: the easily editable format of social media, and the ethics of obtaining the information legally. The volatile nature of social media makes it relatively easy to edit or delete the content. While numerous online archive sites preserve the original content they do not capture all social media accounts.  A letter of preservation is critical to decrease the opportunity for the suspect to delete any evidence.  One or more of the many available tools to capture and authenticate suspicious activities and content on relevant social media accounts can also be helpful.

Evidence from social media should only be obtained ethically and legally, otherwise it may be deemed inadmissible in a court of law.  It is unethical to “follow” or “friend” the suspect or their acquaintances.  Likewise, any information obtained should only be publicly available.  To ensure the evidence is obtained ethically and legally, it is wise to employ a forensic technology expert to assist in the capture and authentication of any sensitive and fragile data.

If you are interested in learning more about how fraud examiners can use social media in investigations, or want to learn more about our services and our team, please contact us.

Adding the Value: Business Valuation Expertise in Divorce Litigation – Part Two

In my last blog post, I explained what an active/passive appreciation study is, scenarios in which it would be conducted and the value that a business valuation expert brings to the table when performing the analysis. As a refresher, an active/passive appreciation study is often required in matrimonial litigation when an existing business or business interest is owned by one spouse prior to the marriage, or is gifted or bequeathed to one spouse during the marriage. Since we have covered the basics, we can now dive deeper and discuss the various phases and steps of an active/passive appreciation study.

The easiest way to digest the steps of an active/passive appreciation study is to think of the process in two phases. The first phase requires the preparation of appraisals of various business interests at different points in time. The variations here depend on when and how the business interests were acquired – if the business interests were brought into the marriage, the business interests are valued as of the date of the marriage, which could require a retrospective appraisal going back decades. If the business interests were gifted or inherited by a spouse during the marriage, the business interests are valued as of the date of each gift or inheritance. Regardless of the acquisition date, the business interests must then be valued a second time as of the date of separation (in some jurisdictions called the date of filing), and then a third time as of the date of distribution (also called the date of trial in some jurisdictions). The final step in the first phase is to calculate the changes in value of the various business interests between the date of marriage, gift or inheritance and the date of separation, and then between the date of separation and the date of distribution.

At this point, after numerous valuations of business interests have been prepared at multiple points in time, the second phase of the active/passive appreciation study can begin. In the second phase, the business valuation expert must determine why the business interests changed in value during the marriage and then between the date of separation and date of distribution. The expert also must differentiate between changes in value due to marital funds or the efforts of one or both spouses versus changes due to external market forces or the efforts of other individuals. Each of the economic, industry, capital market and other analyses performed in appraising the various business interests in phase one must be taken into consideration in determining the factors that measurably contributed to the change in value between the relevant dates. It is crucial for the business valuation expert to always be cognizant that the end objective is to determine the amount and reason for changes in value. Because of this, all of the research and analysis conducted in preparing each valuation must be undertaken in anticipation of doing more with the data than just valuing the business interest at each point in time.

If you are interested in learning more about how you can strengthen your case with a business valuation expert, or want to learn more about our services and our team, please contact us.

The Digital Footprint: Where to Look

The world of technology offers the opportunity for fraud experts to trace the “untraceable.” With technology becoming more popular and present in our lives by the day, people are conducting their lives more digitally, whether through email, texting, social media or Internet browsing. Collecting, analyzing and interpreting the electronic evidence of fraudulent activity is becoming more widespread in the fraud examination world, and will most likely soon become the standard.

Simply because there is no evidential paper trail discovered during a fraud examination does not mean that fraud did not occur. Now, fraud examiners must investigate the alleged fraudster’s digital footprint – but to spot the fraud, they must know where to look.

The answer of where to look is simple, yet complicated – look everywhere. Leave no stone unturned. If you are investigating a company, look through their electronic accounting system, but also comb through employees’ emails, text messages, voice messages and social media accounts, as you can never be sure where they could hide the evidence. Social media might seem like a worthless place to look, but it is often quite the opposite. With people so immersed in the world of social media, they often share more information than either you or I are interested in – but that can be the golden ticket for a fraud examiner. Whether it’s sharing their location or an activity that misaligns with their alibi, or directly lines up with when the fraud is committed, that can be immensely helpful in a fraud investigation. Through social media, fraud examiners also have access to an abundance of metadata, such as timestamps and geolocations.

Through digital technology, fraudsters leave behind their digital footprint, whether by Tweets, emails, logins, downloads or card swipes – and this footprint is exponentially harder to cover up than a paper trail. Deleting or encrypting are not safeguards, and will still provide evidence to the fraud examiner through the mountains of metadata that are available anytime we take an action online. When conducting a digital forensics investigation, always remember where to look, but also remember – there’s more than what you can see with the naked eye.

Adding the Value: Business Valuation Expertise in Divorce Litigation

When going through a divorce, determining the marital value of private business interests can often get tricky – this is especially true if one spouse has a separate ownership interest in a business. An active/passive appreciation study is often required in matrimonial litigation when an existing business or business interest is owned by one spouse prior to the marriage, or is gifted or bequeathed to one spouse during the marriage. The majority of states have matrimonial laws that dictate that the preexisting, gifted or inherited business interest remains the separate property of the owning spouse, however, the marital estate can gain an equitable interest in increases in value during the marriage that are caused by marital funds or active efforts of one or both spouses. Sound tricky? That’s because it is – and that’s why experienced business valuation experts are essential.

It is important to note that an active/passive appreciation study includes business valuations – but it goes much further and it is much more complicated. In an active/passive appreciation study, one must consider the traditionally applied relevant valuation approaches and methods, but along a time continuum, rather than just at a particular point in time. Additionally, the discovery process is more in-depth as there typically is a longer time period for which information must be gathered. This process can include interviews with multiple individuals, even including former employees who left the company years earlier. Through diligent research and analysis, the valuation expert must be able to identify the main drivers that measurably impacted the changes in value and determine the relative impact of each value driver between different points in time.

Divorce attorneys would be wise to bring in a business valuation expert who has deep business valuation experience and training early on in the process to perform multiple valuations that could possibly date back decades. I also recommend that the expert have specific experience in active/passive appreciation studies due to the numerous interacting variables in the company being appraised, as well as the need to be aware of and take into consideration relevant state statute and case law. It is crucial for the legal team and the business valuation expert to work closely together, as many state statutes provide only high-level parameters and limited specifics regarding active/passive analyses. It is the legal team’s role to provide legal guidance to the business valuation expert on the interpretation of the relevant statutory and case law. Teamwork between the legal team and the business valuation expert is essential to the efficient development of a relevant, reliable and defensible active/passive appreciation study.

If you are interested in learning more about how you can strengthen your case with a business valuation expert, or want to learn more about our services and our team, please contact us.

Strengthen Waged-Based Loss Cases with a Forensic Accounting Expert Sooner Rather than Later

I have worked in investigative financial consulting for more than 17 years, and during my tenure I have worked with attorneys in a variety of capacities to provide financial consulting and expert support in a broad range of personal and corporate disputes. One of those capacities includes serving as a forensic accounting expert on cases involving wage-based losses.

For these types of cases, attorneys’ first instincts may be to perform the wage-based losses in-house, as the methodology to calculate seems rather straightforward. However, to avoid overlooking potential losses and increase credibility, I advise bringing in a forensic accounting expert to the case. A forensic accounting expert can provide an objective third-party perspective and financial expertise to the wage-based losses. This expert also can testify in court, adding credence to the basis of the loss calculations.

Damages for wage-based losses typically are comprised of two components:

1. Past Loss of Earnings – the earnings lost from the date of injury to the date of trial
2. Future Loss of Earnings – the earnings lost from the trial through the loss period

Depending on the facts and circumstances of the case, the variables necessary to calculate past and future loss of earnings generally include base wage, employer paid fringe benefits, work life expectancy, life expectancy, mitigation, growth factors and a discount rate.

Recently, I worked closely on a case in North Carolina where three former employees claimed wrongful termination, alleging the reason behind their termination to be their reporting of corruption in their department to state officials.

I was hired by the plaintiffs to perform waged-based losses as well as serve as an expert witness, testifying in court in regard to the damages calculated.

After an eight-day trial, the verdict came in and the jury awarded compensatory and punitive damages to each of the plaintiffs, totaling more than $4 million in damages to the three former employees. The damages awarded were waged-based losses, including past and future loss of earnings, and emotional distress.

If you are interested in strengthening your case with a forensic accounting expert and/or want to learn more about our services and team, please contact us.

The Give and the Take in Charitable Giving

Charitable giving, while good with intent, is not always received as expected. Let’s say you and I give to a seemingly worthwhile charity. You may be surprised at who really takes from the charity – frequently, it’s the fundraisers and executives. Oftentimes the fundraisers and executives are one in the same, since many founders will leave the charity to start a consulting and fundraising business to contract with the charity. This is really where it begins to get out of hand.

The Kids Wish Network gives only 2.5 percent of the funds it raises to the kid’s programs. It was ranked the #1 worst charity in the U.S. by the Center for Investigative Reporting and the Tampa Bay Times. Their rankings of the worst charities are based upon the amount of donations paid to professional “for profit” fundraisers. During the past decade, this charity raised over $141 million, but paid 82 percent of that money to fundraisers and 15 percent for administrative expenses. It’s been this way for over 16 years at Kids Wish Network!

The Cancer Fund of America is even worse. It raised almost $88 million and paid $75.4 million, or 86 percent, to fundraisers. Firefighters Charitable Foundation paid 81 percent of its donations to fundraisers, Breast Cancer Relief Foundation used only 2 percent of its receipts for programs, and the list goes on.

So, what are you and I to do when asked for a donation to what appears to be a worthy charity?

The answer is pretty simple. We need to do our own due diligence for information on the charity. I get the exact name of the organization, then type that name into Google and look at the hits. I also look at Guidestar.org and the Center for Investigative Reporting.

To be qualified as a charity, the IRS issues rules. Each year, the charity must file a tax return on form 990, which is a public document. Available at Guidestar.org, and somewhat difficult to read, the 990 gives a list of executive salaries and its administrative expenses.

To operate, most charities will have administrative expenses and naturally have to pay executive salaries—but these costs of operations must be reasonable. My personal guideline is 90 percent of the funds raised should go to the programs, although there may be exceptions. For example, I have to think twice about a program like Wounded Warriors where only 60 percent of the funds go to the programs – but by spending a lot of money on advertising, a lot of money is raised for a very good cause.

This year, make the most of your year-end charitable giving by ensuring that your funds will go to the deserving programs – not the fundraisers and administrators.

Benefits of Seeking Independent Counsel in an Accounting Malpractice Lawsuit

Most CPAs will never face the underbelly of an accounting malpractice lawsuit. Those who do, however, will say the challenges are something they never want to experience again in their lives.

A malpractice claim against a CPA (I will refer to as you) may arise from several causes such as a business failure, bad advice (primarily regarding tax) and fraud. Regardless, some critical decisions made early in the process can lower the cost and the angst, especially in time and frustration.

Assuming you have malpractice insurance coverage, the matter is not as simple as notifying the carrier, which is required by the policy. At first hint of the possibility of a lawsuit comes the time to thoroughly read and understand the policy. This is also the time to make at least one critical decision: Do I hire my own lawyer or simply rely on the lawyer the insurance company refers?

Allow me to answer the question by stating emphatically, “hire your own lawyer.”

Unfortunately this means you will have two lawyers, but huge benefits are derived. The malpractice insurance policy is a legal contract written by lawyers. In the contract the CPA has agreed to, many key provisions were most likely never considered. Some policies may differ, but you must review your policy to understand.

  1. You pay the retention amount before the insurance company (carrier) pays any expenses. Retention is really the deductible. This includes the initial attorney fees for the attorney hired by the carrier to represent you.
  2. The attorney is hired by the carrier. You don’t get to choose. Even though you have paid premiums and you are the defendant being sued, that attorney’s client is the carrier.
  3. Policy expenses, including attorney fees, are deducted from the face amount of the coverage. For example, if you have a $1,000,000 policy and attorney’s fees after a retention total $300,000, you only have $700,000 of remaining coverage. This balance is available for the carrier to pay to a plaintiff either a negotiated settlement of a claim or a judgement rendered in court. If a court judgment is more than $700,000, you will pay the excess.
  4. Understand that you cannot negotiate a settlement, admit liability, assume liability or incur any claim expense without the approval of the carrier. Furthermore, if you do not consent to a settlement acceptable to the carrier and a plaintiff, the carrier’s obligation to defend you ends.
  5. The carrier’s attorney hired to represent you may have a conflict. Although I would like to believe your interests will be served, there may be some serious concerns here.

Motions, filings, pleadings, discovery, depositions and hearings in court consume an enormous amount of time, and the process moves at a snail’s pace. Until confronted with litigation, most people do not understand the costs and lack of control experienced. The early settlement of a case can seriously limit the cost and resultant fees, plus the headaches, frustration and diversion.

Bottom line, litigation in accounting malpractice is a legal minefield and a tough as nails battlefield. You will have to pay your own legal counsel. Is the cost worth it? I have served as an expert in over three dozen accounting malpractice cases. In my opinion, if you are represented by experienced independent legal counsel of your choosing, who can direct and oversee the whole process for your benefit, your savings will be substantial.

Fraud Suspected in the Workplace? Employers, You Better Read This – Part Two

When you think of fraud within an organization, a newer employee may be top-of-mind, but according to the Association of Certified Fraud Examiners (ACFE), seven percent of perpetrators committed fraud during their first year and more than 53 percent had been with their organization for more than five years.

In my last blog post, I discussed the prevalence of fraud within organizations, costs associated and also provided a few tips to consider immediately after suspecting fraud in the workplace. In this post, I will continue the discussion of best practices, should you have an incidence of internal fraud.

Deal with the Suspected Employee

Naturally, your immediate impulse will be to fire the employee, but acting on this rash impulse could be the worst decision possible and could hinder the investigation. Employees have a duty to cooperate with employers during a lawful investigation, so consider keeping them on your payroll—no matter how hard it might be to keep them around or look them in the eye. Not terminating the suspected wrong-doer can make obtaining records and/or interviews exponentially easier. Once they are no longer employed by you, the chances of gathering information from them becomes a much more challenging process.

Restrict Access

Once the employee has been informed that they are the subject of an internal investigation, immediately restrict them from touching or removing anything from their office except personal items. Any time the alleged perpetrator is on the premises, they should be accompanied and watched closely, then escorted from the office.

The suspected employee must be restricted electronically, as well. Deactivate passwords in order to deny access to company information systems—often, the most dangerous cyber threats do not come from outside the organization, but from within—the company’s own employees. A resentful employee who knows that they are the subject of an investigation has the potential to cause chaos throughout various information systems within milliseconds. If their access is not restricted, they could potentially cover their tracks, encrypt programs to render them useless, steal confidential information or delete incriminating evidence.

Contact Your Insurer

Ensure you contact your insurance provider early on in the investigation—failing to notify your insurer can void coverage, making your losses even greater. The majority of policies have a 30 or 60-day notification provision, beginning from the first day you discover a loss possibly occurred.

Once you have notified your insurance carrier, you will likely have to file a proof of loss within a specific time frame—a time frame that is often too short to efficiently and effectively document a claim. Be sure to ask your insurer if they will grant you an extension to file your proof of loss in order to have adequate time to properly document your claim.

Internal fraud investigations are a lengthy and complicated process, and will sometimes prove unrewarding. Enacting each step I have listed will increase your chances of making a full recovery and will help the investigation move as smoothly as possible.