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

Goldman's Critical Support - Summer 2001

Investing in a Small Business? Hold onto Your Wallet!

As discussed in previous editions of this newsletter, small businesses involved in divorce and tax disputes usually understate their earnings. The flip side of financial fraud, overstatement of earnings, is often done to make a business a more attractive acquisition candidate, to cover up embezzlement, to fabricate compliance with financing covenants, or to obtain financing from outside investors or lenders

Fraudulent financial reporting is often driven by a combination of (a) situational pressures on management and (b) the perceived opportunity to commit the fraud.

Pressures

Examples of situational pressures include sudden decreases in revenue or market share, inability or lack of desire to continue owning the business, deterioration in operating performance, and even family or community pressure to succeed. Surprisingly, I have seen excessive entrepreneurial optimism turn many otherwise honest businesspeople into fraud perpetrators; it starts when they miss a lending covenant by a very small fraction of a point due to an operational downturn. Feeling sure that the transgression was due to a temporary and unique circumstance such as bad weather, politics, or some other external factor, they shave the numbers and report that they are in compliance. When the next reporting period comes they are a little further out of compliance, but still sure that the temporary external phenomena will reverse and make the world right again. By the time they realize that they have a fundamental business problem that is going to keep them out of compliance, they may have submitted too many fraudulent reports to feel comfortable admitting to what they are doing, and are therefore compelled to continue the ruse.

Opportunities

Some of the obvious opportunities for committing fraud are the absence of management or board oversight, weak or nonexistent internal controls, unusual or complex transactions, or financial estimates that require significant subjective judgment by management.

Leasing companies are good examples of businesses that have both complex transactions and the requirement for extensive management judgment. Over the past few years leasing companies (with Mercury Finance being among the most notorious) have been imploding all over the financial landscape as a result of financial fraud. In general, small owner-operated businesses usually lack internal control and are dominated by a strong entrepreneurial personality that many bookkeepers find easy to follow down a path to financial fraud.

In 1999 the Treadway Commission published a report entitled Fraudulent Financial Reporting: 1987 – 1997, An Analysis of U.S. Public Companies. The commission’s findings indicated that:

• The most common methods to commit financial statement fraud were (in order of occurrence):

1. Improper revenue recognition, either by recording fictitious revenue or by recognizing revenue prematurely

2. Overstatement of assets – most commonly overvaluation of existing assets (primarily accounts receivable, inventory, and fixed assets), recording assets not owned, and capitalizing expense items

3. Understatement of expenses. In smaller businesses, this is often done by concealing liabilities (accounts payable) or recording them in later periods.

• The Chief Executive Officer was named as the perpetrator in 72% of the cases.

• The majority of the companies involved were relatively small (well below $100 million in total assets).

• The average fraud extended over 24 months.

President's excuse

The implications for potential buyers or financiers of a business can be staggering. The entrepreneur or company president that you are so enamored of could very likely be a habitual offender. In smaller companies, the president's knowledge of proper control and accounting may be so limited that they do not realize what they are doing. However, every business person that I have met who was involved in a fraudulent situation, and who hid behind the excuse that they lacked accounting knowledge, will at least admit to realizing that the business was deteriorating faster than it appeared on paper.  Before putting good money into a bad situation, it is imperative to perform proper due diligence.

Proper due diligence procedures include:

• Vertical analysis. Analyze the relationships between items on the income statement, balance sheet, and statement of cash flows.

• Horizontal analysis. Analyze the changes in individual items from one period to the next.

• Ratio analysis. Analyze the relationships between different financial statement amounts.  For example, is the amount of inventory needed to support a dollar of sales changing? Is the company carrying more accounts receivables per dollar of sales?

• Discussion with management. Evaluate their degree of honesty, the emphasis that they place on meeting quantitative targets, their attitude toward controls, their propensity for taking risk, the amount of concern they express for maintaining the image and reputation of the company, their experience level, and their respect for regulatory agencies.

• Evaluation of the organization. Look for transactions that are difficult to audit or understand, centralization and dominance by a small group of people, use of controls and monitoring, levels of employee turnover, employee attitudes towards authority, etc.

• Evaluation of the company’s environment. Compare he company’s profitability to its industry, determine whether the company is in a period of rapid growth, be alert for the existence of adverse legal circumstances, and measure the company's sensitivity to economic factors.

• Comparison with industry standards. Most importantly, be wary of any business that seems unusual compared to industry or economic norms.

Financial crime is typically performed by an older and more professional population, and may be spurred by jealousy of all the apparent instant millionaires in today’s “new economy” and the trend towards more executives  becoming entrepreneurs in mid-career. Such demographics indicate that financial fraud will be on the rise in the coming years. It will be more important than ever to be thorough when investing in any business as an owner or creditor.  

© Michael Goldman 2001

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: March 31, 2007