How to Spot Fraud Your latest issue of . . .

Eric D. Colca, CPA, CVA
Kelly G. Besaw, CPA, CVA
Chiampou Travis Besaw & Kershner LLP
45 Bryant Woods North
Amherst, New York 14228
How to Spot Fraud
Your latest issue of . . .
If you have any questions,
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broadly declined. Therefore, analysts who have been using lower equity risk
premiums because of perceived changes in the market over the past decade
will have to revert to higher, historical premiums.
Current debt to equity ratios are probably not sustainable in the long-term
for many companies and therefore analysts need to consider estimating the
discount rate with an expectation of changing capital structures.
Because income subject to income taxes is and will continue to be less than
zero for many companies, analysts cannot automatically use an after-tax
cost of debt capital (i.e., multiply the interest rate by one minus the income
tax rate) in calculating an appropriate weighted average discount rate.
Analysts need to pay special attention to the specific company risk factor
that will be included in the built-up discount rate being developed, as each
subject company will respond differently to current economic conditions.
Analysts must always test the resulting discount rate estimates for
reasonableness and not simply apply data or formulas by rote.
Estimating a discount rate is always the most difficult part of a valuation
assignment, and today’s economic environment has only made this exercise
more challenging.
please contact our office.
Eric D. Colca, CPA, CVA
Kelly G. Besaw, CPA, CVA
Chiampou Travis Besaw & Kershner
45 Bryant Woods North
Amherst, New York 14228
Phone: (716) 630-2400
Fax: (716) 630-2401
E-mail: [email protected]
[email protected]
Services Offered:
• Business Valuations
• Lititation Support
• Expert Witness Testimony
• Forensic Accounting
• Settlement Negotiations
Industry Specializations:
• Shareholder Actions
• Estate and Gift Taxes
• Mergers and Acquisitions
• Buy/Sell Agreements
• Intangible Assets (SFAS 141 & 142)
I N T HI S I S S U E :
How to Spot Fraud
Case Law and Business Valuation
Discount Rates in Times of
The shock of realization when a
victim recognizes that a trusted
employee —and even a friend—has
stolen from them ranges from sad
to tragic. It is a very personal
feeling of betrayal and violation.
It strikes fear in some, grief in
others, and anger in most. It is
almost always accompanied
by a sense that “I should
have known this was
going on.” The evidence
of theft sheds a very
bright light on the
rear-view mirror.
Patterns and
circumstances take
on a clarity that
experience either
hid or obscured.
Sometimes the
clarity was there,
but for a variety
of reasons,
it was ignored.
Years of fraud investigations have
presented some simple, some would
say obvious, warnings that, if heeded,
would prevent or quickly expose fraud.
Know your employee. In one case the
victim business owner recounted that he
knew the prior employer of the employeebookkeeper really well. He was aware
that the bookkeeper had left the prior
employer on less-than-positive terms, but
figured it was none of his business and
hired the bookkeeper anyway because
of knowledge of the industry. After the
embezzlement was discovered, a phone
call to the prior employer/friend revealed
that the bookkeeper was stealing from
the current victim to pay off a judgment
obtained by the prior employer to recover
embezzled funds.
Embezzlers tend to be repeat offenders.
This is an obvious follow-up to the prior
point. A simple background check is not
expensive, easy to do, and in this case
would have prevented a really bad hiring
decision. It would have confirmed the illat-ease feeling of the employer at the time
of hiring.
Open your own mail. Let the bookkeeper
do the bookkeeping. You cannot
abdicate other important (and seemingly
unimportant) functions because the
clerk is always around and does the job
well. Vendor communications, bank
statements, and bills from vendors
and suppliers are important sources of
information. One person having access to
all of that makes fraud that much easier.
Separate functions and duties. Many
small business owners are so busy that
they tend to overlook common sense
when assigning work. In many cases, the
employee was given the responsibility for
answering the phones, opening all the
mail, writing checks, making deposits,
preparing invoices, reconciling the bank
statements, and preparing the financial
reporting provided to the business
owner and the outside tax preparer.
Strategically reassigning even one of those
functions would have greatly reduced the
opportunity and longevity of the fraud.
Don’t accept bad answers to good
questions. When the forensic accountant
arrived on-scene in one case, the business
owner requested a report showing
payments to all vendors. The request was
preceded with a long list of qualifications
by the fraud victim recognizing that it was
“difficult” to put such a report together,
would “take a long time,” and would
not be precisely correct. The accountant
produced a complete and accurate vendor
payment report in about 90 seconds. The
business owner was shocked—and the
point was made. His bookkeeper, for a
long time, had prevented him from seeing
the very report that exposed the whole
scheme. He had been given every reason
in the book why the report couldn’t be
produced. He learned too late that it was
available at the push of a button.
Force vacations. In almost every case,
another set of eyes on the accounting
records would have exposed everything.
Follow your instinct. If the lifestyle of
the employee exceeds what you know
about the legitimate compensation, there
is good reason to look harder. If you have
a bad feeling when hiring an employee
(see above), don’t! If the bookkeeper can’t
produce simple reports from “the books”
they are keeping, there is a problem. If you feel like you are working for the
bookkeeper rather than them working for
you, something is wrong. If it feels like
the business is doing better than ever, but
there isn’t any cash, there is good reason to
find a reasonable explanation.
All of the above rules are separate points
of recognition by the business owner when
they realize they are a victim of that trusted
employee—“I knew something wasn’t right. I should have known this was happening.”
That kind of recognition is never good after-the-fact.
The process begins with a grasp of the problem
(issue), determination of relevant law (rule),
application of the rule to the facts (analysis),
and discussion of the outcome (conclusion).
This method applied to the relevant cases allows
for the ability to compare and contrast decided
cases with current cases on similar issues.
Some cases are used by judges to intentionally
challenge established case law. This strategy
typically involves the appeal process where
the higher courts may re-examine established
precedents and perhaps change it based on a
new outlook of the issue.
Case Law and
Business Valuation
Case law is developed when
judges, either state or federal
higher courts, provide a written
ruling explaining the basis for
their decision in a particular
case. The ruling contains their
decision and the reasoning
supporting their decision.
Precedents from prior cases
and statutes having a bearing
on their decision are cited in
the written ruling. Collectively,
individual cases are compiled
in case reporters and stored in
law libraries and legal databases
for future review and citation in
other cases. Ready access to these case reporters allow for
the law to remain relatively
consistent from ruling-to-ruling
on similar cases.
Case law can be easily researched through
existing online resources. The process
begins with the identification of the issue.
For instance, the proper treatment of a
Business valuators must stay abreast of federal
tax court rulings as well as the relevant
state jurisdiction rulings. In these rulings,
established precedent can be found and
reaffirmed. Equally, any current or potential
future changes to established precedent might
be found in the discussion details of the rulings.
While Tax Court rulings may reflect the
inclination of certain courts to accept, for
instance, allowance for tax affecting built-in
capital gains, these rulings may or may not
play a role in the business appraiser’s analysis
and value conclusion. The business appraiser
must consider the relevant facts in the subject
valuation and make a reasoned, informed
decision regarding the tax affecting of built-in capital gains in developing a
conclusion of value.
With respect to case law, business appraisers
should be aware of the issues that may impact
a valuation. Often times, the business appraiser
consults the client’s legal counsel for their
position on specific case law issues. Again, the
business appraiser must use reasoned, informed
judgment in developing a conclusion of value,
considering the case-specific facts relevant to
the valuation.
Court cases typically are not cited in valuation
reports. The valuator addresses the issues,
with due regard for the rule of law, making a
thorough analysis of the specific facts of the
subject, leading to his conclusion. He builds
his conclusion on the foundation of financial
theory, professional standards and generally
accepted practices.
Discount Rates in Times of Uncertainty
When the stock of a business is valued using the income approach,
whether by the single–period capitalized cash flow method or the multiperiod discounted cash flow method, the valuation analyst focuses on three
fundamental factors to determine value. Those factors are the amounts of
expected annual cash flows, the rate at which those cash flows are expected
to grow over time, and the risk of actually achieving those cash flows as
reflected in the discount rate. These value drivers apply whether a cost of
equity discount rate or a weighted average discount rate is being developed.
For small businesses, the discount rate
is usually established by use of what is
known as the “build-up method,” whereby
the analyst begins with a risk-free rate,
commonly the 20-year Treasury bond
rate, and then builds on that by adding an
equity risk premium, an industry premium,
a size premium and a specific company
risk premium. From this built-up discount
rate, the analyst will subtract the long-term
expected growth rate in cash flow to arrive
at a capitalization rate.
Since the early fall of 2008, all three
value drivers have been influenced by
the economic meltdown, but the most
severely affected has been the discount rate,
causing valuation analysts to reassess their
traditional methods of deriving estimates
and data for the build-up method. For
example, some of the issues and problems
that analysts have to deal with are as
U.S. Treasury bond yields are likely at
a temporarily low point, resulting in low
estimates of the discount rate just when
the economic climate contains more,
not less, uncertainty and risk. Therefore,
analysts should ignore the low “spot”
yield on 20-year Treasury bonds at
December 31, 2008 and instead opt for either a longer-term historical
average yield or use a “forward” rate on such bonds.
The expected equity risk premium, the
rate of return on a diverse portfolio
of common stocks in excess of the
rate of return on Treasury bonds, has
increased as stock market values have Continued on back cover