Michael Goldman & Associates, L.L.C. - Consulting & CPA Services

Goldman's Critical Support - Fall 2000

Is It Fraud or Incompetence? 

In both bankruptcy and divorce situations, it is common for at least one of the parties to feel that they have been cheated. There never seems to be enough money to go around. Investigations as to why there are not enough assets to cover all of the claims against them are becoming more common, both to return assets to their rightful owners and to place blame for asset depletion.

If you know where to look, you can usually find telltale signs of fraud fairly quickly. The most common place to find evidence of fraud is in the accounting records. Symptoms typically include: 

·         Lack of a sufficient audit trail: unsupported balances or transactions, missing support or documents

·         Transactions not recorded in a complete, timely, or proper manner

·         Significant unexplained or last-minute items on reconciliations

·         Missing inventory, cash, or other physical assets

·         Unrecorded assets or liabilities

·         Overstated or understated expenses

·         Commingling of personal and business assets and transactions

 Unfortunately, those are also the symptoms of accounting incompetence, and are fairly common in small businesses where no intentional fraud is occurring. The typical small business owner has difficulty setting boundaries between himself and his business, works an ungodly number of hours under tight financial constraints, and considers accounting to be something that you do once a year at tax time. When there are poor audit trails, misstated balances, and an inability to determine what was business and what was personal, evaluating whether there was fraud or incompetence must be done within the context of the specific situation. Here are a couple of instructive case studies:

 Case study #1

A valuation engagement in a divorce case became more than dealing with the typical small business accounting problems when I noticed that the expense ratios were way out of line with the industry averages. 

Most suspicious were the commission ratios. The company paid salesmen a percent of revenues, and the ratio of commissions to sales was way too high, indicating either that revenue may have been understated or that expenses were overstated. 

Also suspicious was the fact that the owner had not taken enough money out of the business to live on. In that industry, the owner typically takes about 20 percent of the revenues. I figured there had to be unrecorded revenues and/or payments to the owner. 

Further review of the sales cycle found evidence of refunds being issued to customers for whom no sales had been recorded, and other indications of understating revenues. A transactional analysis also found significant amounts of inappropriate expenditures. This evidence of fraud was instrumental in generating an acceptable settlement for the non-business spouse.   

Case study #2

On the other side of the table, a forensic examination that I performed for the Department of Justice in a bankruptcy case began with all of the apparent badges of fraud. The financial statements were materially misstated and there was evidence of illegal check kiting, mishandling of trust funds, and commingling of business and personal interests to the detriment of outside parties. 

Two factors convinced me that management was grossly incompetent and overly optimistic about their financial future (excessive hopefulness is common among entrepreneurs), rather than malicious. First, there was a clear paper trail indicating that management purposefully kited checks to keep the company alive, but no trail at all indicating that management personally benefited from the scheme. Usually when they're trying to hide something fraudulent they work much harder to obscure all of the trails. 

Secondly, from interviews I conducted with people in and outside of the company, I realized that the people who were alleging fraud had an incomplete set of facts. When more facts became available through my interviews and analysis of the accounting records, management's case seemed more plausible. They had made a number of poor decisions and bad judgments as opposed to purposefully harming other parties. 

After a voluminous presentation of evidence, the parties decided to acknowledge that gross incompetence, rather than fraud, was at play, and they settled the case. 

Auditors often miss fraud evidence

It is important to note that both of the above cases, as well as numerous others that I have worked on, had certified audited financial statements that turned out to be materially misstated. Financial auditors typically do not look for fraud (although they're obligated to report it if they do stumble across it), they tend to trust management or give it the benefit of the doubt, and they typically do not have the business background or experience that would raise their suspicions at irregular patterns in the numbers and transactions. 

Being able to discern the difference between unintentional incompetence and malicious fraud requires the following talents: 

·         Extensive experience in working with both competent and incompetent accountants to understand the differences in their thought patterns

·         An understanding of the entrepreneurial mindset and the context in which it operates

·         The analytical ability to spot symptoms that are out of the ordinary and

·         The business experience to identify relationships, procedures, or events that do not make sense.

Sidebar

If You Suspect Fraud, Look for a Motive

 In a small business, the integrity of the owner and/or manager often plays a strong role in discouraging or encouraging fraud. The following factors may indicate a motivation to commit fraud on the part of an owner or manager: 

·         Tendency to take risks

·         Desire to minimize income tax

·         Personal financial strains

·         Need for outside financing dependent on presenting favorable operating results

·         Hotly contested pending divorce.

© Michael Goldman 2000

For more information, please go to www.michaelgoldman.com 

Editorial material in these newsletters is intended to be informative, and should not be construed as advice. For advice on any specific matter, please consult your financial or legal adviser.

[ Home ] [ Up ]

Send mail to michaelgoldman@mindspring.com with questions or comments about this web site.
Last modified: September 01, 2010