As forensic accountants, business valuation remains one of the most prominent services CPAs are called upon to provide. Businesses often need forensic accountants to define the financial value of assets in the formation, operation or dissolution of business entities. Attorneys may require business valuation expertise in marital dissolution or in cases requiring the valuation of intangible assets, including patents, copyrights, software or trade secrets. Sometimes, however, a business valuation can reveal big surprises, such as fraud.

In the dictionary, fraud is defined as “a deception deliberately practiced in order to secure unfair or unlawful gain.” While the fraudster’s goal is financial gain, the unfortunate result for the victimized company is often financial loss as well as loss of reputation.

Business Valuation Concepts

In my last article, the definition of Fair Market Value (FMV) was determined and the three generally accepted approaches to the valuation of assets were defined as asset, income and market. While all of the approaches may be used to determine the Fair Market Value of an entity, it is up to the valuator to determine the appropriateness of each approach in the particular valuation engagement. In matters pertaining to fraud, the income approach is often utilized and can be defined as follows:

Income Approach — based upon the principle that value is based upon the expectation of future benefits. It is an indication of value using one or more methods that convert anticipated economic benefits into a present single amount. Value calculations are performed by either discounting future projected benefits to the present or by capitalizing normalized historical benefits.

The Discounted Cash Flows (DCF) Methodology falls under the income approach category and is based on the premise that the value of an entity is based on its projected future cash flow, discounted by risk. This methodology of business valuation was employed in the following case study.

Case Study

A national contractor specializing in commercial fireproofing hired Denver-based RGL, a forensic accounting firm, to determine the value of the company. They requested and received the standard business valuation financial documentation, and then summarized and reviewed the balance sheet and income statement. The company was remarkably profitable with high gross profit and net income margins. Per the DCF methodology, the RGL forensic accountants reviewed the company’s financials to determine future revenues and expenses projected by the company.

As requested, the received documents categorized revenues according to division, location and services. Upon review, the forensic accountants noticed that the Las Vegas operation was substantially more successful and had higher profit margins than the rest of the company’s locations. When this discrepancy was questioned, they were told that the management of that location had several large projects, both federal and private, which enabled it to achieve higher profitability than the rest of the company. They were also told that the general state of the economy and some unique techniques that the Las Vegas office employed in the application of the fireproofing further contributed to its success. This explanation raised several red flags.

Additional documentation from the Las Vegas location was requested, including contracts and job cost reports for each of the federal and private projects. For any construction contractor contract, the key accounting document is the cost report. Upon review of the contracts, it was determined that most of the jobs were time and materials or “T&M” jobs, in which the project owner agreed to pay the project costs, including labor and materials, plus an agreed-upon profit, normally in the form of a percentage. The forensic accountants found this highly unusual since most projects are fixed price, meaning that the contractor agrees to complete the project for a specific sum. These T&M projects were netting the majority of the profits reported by this location.

On reviewing the cost report, including the source documents such as timesheets, invoices, expense reports, they quickly realized that bogus invoices were being submitted and timesheets were being falsified or shifted from one fixed price project to the T&M project. In other words, a complex fraud was in place to falsify records for billings to customers and also to rig the financial statements submitted to the corporate office. It was determined that the local office managers were bribing key employees of their customers in order to gain these T&M projects with huge profit margins. These fraudsters were gaining personal benefit directly from the bogus invoices and also through bonuses based on their perceived performance.

Had the company’s financial performance been taken at its face value and not investigated (the anomaly presented by the Las Vegas location), the fraud would never have been detected. However, a forensic accountant‘s job is to investigate and analyze all available financial information to determine the accuracy and completeness of the disclosures. In this case, upon investigation of various contracts and job cost reports, fraud was identified. No longer was the valuation important.

Conclusion

Forensics can and should, be used when business valuation projects are completed. This article provides an example of how a standard business valuation (utilizing the income approach) can uncover a complex fraud scheme. Future articles will discuss the final two “F’s” of forensics: Fidelity and Forensic technology.

Steven J. Hazel, CPA/ABV, ASA, CVA, CMC, is a Director in the Denver office of RGL — Forensic Accountants & Consultants. With more than 25 years of accounting experience, he is highly credentialed in the area of business valuation.