Understanding Your Business’ Financial Statements Is the First Step Toward Preventing Fraud

Many of my recent forensic and litigation engagements have arisen when business owners (including legal and other professional firms) suddenly learned that trusted individuals within their businesses had perpetrated a fraud upon the business. Most of these business owners had received regular monthly or quarterly financial statements for the business but had failed to read and understand them. Had they done so, they could have caught the fraud earlier or prevented it altogether.

Why does this happen? My experience reveals that most of these business owners had minimal knowledge and understanding of their business’ financial statements, and instead relied upon another owner/partner or trusted employee to handle all of the business’ financial matters. In each case, a careful analysis of the financial statements would have identified that something was wrong. Furthermore, when the economy was booming (as in the early to mid-2000s) and/or the company was growing, the fraud could be more easily hidden. However, when revenues and cash collection slowed down, it became more difficult to hide the fraud.

Let’s look at two examples.

Financial Fraud: Destroyed Cash Sales Invoices and Pocketed Cash

In one instance, the trusted employee in a business that generated a significant amount of cash sales destroyed cash sales invoices (so they were never entered into the accounting system) and pocketed the cash. In addition, at the end of each quarter (when he produced financial statements for the owners), the trusted employee made a large journal entry to increase the cash account balance so it appeared as if the business had more cash than it did. If the business owners had understood the quarterly financial statements, they would have noticed that: (1) the gross margin on sales had begun to decline significantly even though neither selling prices nor purchase prices had changed (because sales costs were entered into the accounting system, but the corresponding sales were not); and (2) the accounts payable balance kept growing significantly (because there was insufficient cash to pay the bills). Also, if any of the business owners had reviewed the monthly bank statements, they would have noticed that the cash balance shown on the bank statements was significantly lower than that shown in the financial statements.

Financial Fraud: Cash Distributions Without Informing Partners

In another instance, one business partner took significant cash distributions from the business without informing his other business partners. Because this business partner controlled the financial matters of the firm, he was able to mask these cash distributions by recording the distributions as increased operating expenses of the firm. If the other business partners had read and understood the financial statements, they would have noted that certain expense balances were much higher than expected, and they would have raised the issue with the financial management partner. (For example, more than $25,000 in office supply purchases in one month for this 10-person company or more than $20,000 in travel expenses in a month when no one in the company had traveled out of town.)

Business owners who regularly read and understand their business’ financial statements can identify warning signs in those statements and stop or prevent fraud from occurring.

Discovery of Hidden Assets

In divorce proceedings and certain types of commercial litigation, counsel may suspect that the opposing side has hidden some assets. A forensic accountant can be of great assistance in formulating discovery information requests and conducting the analysis that will aid in the identification and location of potentially hidden assets.

In order to identify hidden personal and/or business assets, counsel must address his/her discovery requests not just to the known (items identified on the tax return, items of which his/her client is aware, etc.) but also to the potentially unknown.

Upon receipt of this information, the forensic accountant will perform analyses and asset searches that may identify or point to the potential existence of such items as:

  • Income or other payments received that have not been deposited to known accounts.
  • Funds deposited for which there is no documentation as to the source of the funds.
  • Funds withdrawn for which there is no documentation as to where the funds went.
  • Direct wire transfers made to or from unknown accounts.
  • Unusual activity involving the safe deposit box (this could be indicative of cash or other assets being placed in or removed from the box).
  • The existence of previously unknown off-shore bank accounts, or investment accounts or other assets.
  • The substitution of lower value assets for higher value assets (for example, substituting an inexpensive work of art for an expensive work of art)
  • The proceeds of expense reimbursements, loans or advances or other non-payroll payments from the spouse’s company.
  • The existence of off-balance sheet accounts.
  • The existence of intangible assets with a value in excess of the book value.
  • The existence of fixed assets with a value in excess of the book value.
  • Transactions with related parties (this may be indicative of non-arm’s length transactions that could have been used to reduce the value of the company).
  • Unusual company transactions with third parties (this could be indicative of attempts to reduce the value of the company by transferring funds or assets to third parties).
  • Hidden insurance policies for which the defendant is the beneficiary.
  • Trusts for which the defendant is a beneficiary.

Because each divorce or commercial litigation matter has its own particular set of circumstances, it is critical that the review of the discovery request between counsel and the forensic accountant occur as early as possible in the discovery process. The forensic accountant can help identify specific documents that should be included in the discovery request. This will allow the forensic accountant to conduct thorough analysis asset searches to identify or point to the existence of such assets.

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