Another post of mine about “Forensic accounting in real business conduct” provides basic description of forensic accounting. In fact forensic accounting inter-related with many other fields in the accounting and business field—works hand-in-hand with financial accountant, management accountant, even with lawyer in certain instants.

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Among those fields, forensic accountant is closely related to business valuation activities. The chief job of many forensic accountants in valuation assignments is to reconstruct income and/or identify the ownership of various assets — most often, its illegal path into the wrong hands inside or outside an organization.

This post discusses the link of forensic accounting with business valuation. How close they are, under what case—or specifically under what situations forensic accounting work best in business valuation activities. Read on…

In some cases, forensic accountants use existing information, such as public-company data or industry benchmarks, but often, they need a subpoena to access needed information. Following are some typical situations that unite forensic accountants with valuation assignments:

1. Mergers and acquisitions – Forensic accountants may make appearances on due diligence teams in a host of deals. Involving a forensic accountant is a good thing to consider in most due diligence situations. Investment banks and other lenders also bring in forensic accountants to safeguard their interests. Besides scrutinizing numbers, forensic accountants question human beings in the process and do onsite inspections of the facilities being sold to verify the pricing in the deal. Fake or inadequate assets listed as being a major part of a deal may be found by any valuation professional, but forensic accountants specifically look for them.

2. Purchase of troubled assets – In a tough economy, the last guy standing with cash in his pocket is in a position to make some great deals on business assets or whole businesses. But troubled companies — ones that are barely keeping the lights on, that have idled property and machinery, or that have padlocks on the door — got that way for a reason. Forensic accountants can check to see whether mistakes or malfeasance devalued those assets.

3. Investigation of company theft – Some of the worst financial crimes happen right under the nose of the boss. Ghost payrollers — fake employees getting real checks — are common in companies and governments alike. Crooked employees can create such scams very easily, based on resources close to them. They can funnel cashable paychecks through currency exchanges that are in on the scam, for example. Forensic accountants are trained to spot irregularities in accounts that can reveal such mischief.

4. Divorce investigations – Never underestimate the loss potential of love gone wrong. And forensic accountants may play a big part in that process. In family law, a lot of the friction occurs over the lack of information sharing and suspicions that shared numbers are far below — or sometimes far above — where they should be.

5. Global terrorism – Increasingly, companies have to meet legal standards to make sure that employees in the United States and abroad are not involved in illegal activities that could affect local, state, or national security. Terrorists gather their funding through many disparate sources, delivering small amounts that largely go undetected.

The USA Patriot Act, signed after the terrorist attacks of September 11, 2001, requires financial institutions to establish and maintain anti-money-laundering programs. In addition, all U.S. companies are required to comply with the Foreign Corrupt Practices Act, which establishes acceptable business practices. Many states have laws governing private investigation practices that apply to CPAs.

 

From The Business Valuation’s Perspective

Most of the time, a valuation professional does “amateur” forensic accounting work on her own, but her work doesn’t replace the formal procedures and tests done by a trained and certified forensic accountant. Valuation professionals get close to the forensic process when they begin to normalize the financials of the business. Most of the time, they’re just adding back the owner’s perks or making adjustments for fair market rent, fair market wages, and various other financial activities inside the company. If a valuation professional sees something that doesn’t look quite right, she simply notes it in the valuation report.

Here’s an example that should raise the eyebrows of a valuation professional but could be found more easily by a forensic accountant doing some closer snooping: A medical-device company takes an order, delivers the equipment to the patient’s home, and charges the customer (or his insurance company) for the items. So far, things seem perfectly normal. But suppose that the customer no longer needs that oxygen tank or hospital bed in his home, and he returns it to the company.

The transaction was originally structured to declare the patient the owner of that equipment. Here’s the problem: When the material is returned, the company illegally takes the equipment back into its inventory without recording it and then uses the returned equipment to fulfill new orders as they come in. This process works to understate the company’s actual inventory and its overall cost of goods, making the company appear to be more profitable than it actually is. Higher profit means higher valuation—which may be based on fraud.

Because this operation is likely being done off the books (with no formal records being kept), a valuation professional may not catch the fraud. But if she were to smell something funny — such as margins wildly higher than those of competitors in the industry — she’d either try to investigate it herself or recommend an audit. The forensic exercise would take place as part of the audit.

In essence, the forensic accountant would perform an investigation to uncover the truth behind the numbers; then the valuation professional would use the results of the forensic exercise to renormalize the numbers. The two professionals would combine their efforts to establish and reinsert the true normal inventory costs, thus realigning gross margins to what they should’ve been.

Many appraisers working on small-company deals don’t catch this sort of operation unless they’re very talented and experienced. They simply don’t have records to tip them off and have to rely on other signals, such as erratic margins or other swings in financial performance that can’t be explained through traditional business evidence. But if a forensic accountant is brought in during due diligence, this situation is exactly what he should be looking for.

 

From The Forensic Accountant’s Perspective

The relationship between a valuation professional and a forensic accountant should be close. A valuation professional is something like an emergency medical technician, whereas a forensic accountant is like a pathologist. Both parties need to be talking. The same relationship rules go for attorneys and other professionals brought into the process.

Like valuation professionals who are CPAs, however, forensic accountants have only one allegiance: to their certificate, meaning the set of professional standards to which they’re required to adhere. They have to honor those standards ahead of our client’s preferences because they are often called on to testify to those findings under oath.