Michael B. Lehner, CPA/ABV, CFE, ASA
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Factoring fraud into the business valuation equation

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Fraud is a risk for virtually every business. But some companies are better at deterring and preventing fraud than others. On average, businesses lose 5% of their annual revenues to fraud, according to the biennial Report to the Nations on Occupational Fraud and Abuse issued in 2014 by the Association of Certified Fraud Examiners (ACFE). The median loss was $145,000 — but 22% of victim organizations in the study incurred losses of $1 million or more.

Clearly, fraud can devastate a closely held business. Although testing for and investigating fraud isn’t normally part of the valuation process, valuators do take fraud risks into account when appraising a private business interest.

Who’s most at risk for fraud?

The ACFE defines occupational fraud as “the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s resources or assets.” Examples include corruption, asset misappropriation and financial misstatement.

Some businesses are more vulnerable to fraud than others. When assessing fraud risks valuators consider issues such as:

Size. High-profile fraud cases — such as Enron or WorldCom — make front-page news. But the ACFE reports that companies with fewer than 100 employees are “disproportionately victimized by fraud and notably under-protected by anti-fraud controls.” Because private businesses also typically possess fewer fiscal and human resources than their public counterparts, they often struggle to rebound from fraud losses.

Industry. Some industries tend to be more fraud-prone than others. The top five most represented sectors in the 2014 ACFE study include:

  1. Banking and financial services,
  2. Government and public administration,
  3. Manufacturing,
  4. Health care, and
  5. Education

Industry research is a critical part of the appraisal process. Valuators need to understand which schemes the subject company may be prone to based on the industries in which it participates. For example, manufacturers are at high risk for billing scams and corruption, such as purchasing schemes, bid rigging and kickbacks, according to the ACFE.

Internal (or antifraud) controls. These are the policies and procedures companies use to protect assets, improve operating efficiency and ensure reliable financial statements. A strong system of internal controls, including fraud training programs and whistleblower hotlines, is a company’s first line of defense against fraud.

The 2014 ACFE study reports that the most effective controls at reducing fraud losses are:

  • Proactive data monitoring and analysis,
  • Employee support programs,
  • Management review, and
  • Formal codes of conduct.

Victim organizations that had these internal controls in place experienced losses that were at least 50% smaller than companies that didn’t.

How do fraud risks affect value?

High fraud risk equates with lower values. For example, when applying the income approach, valuators might increase their company-specific risk premiums, a component of the cost of equity, to account for significant fraud risks.

Similarly, under the market approach, fraud risk may come into play when choosing criteria for picking guideline companies — or when adjusting median (or average) pricing multiples for differences between the subject company and the comparables.

A subject company with significant fraud risk — or that has fallen victim to fraud in the past — might be less marketable to potential buyers or less desirable to potential minority interest owners. Accordingly, valuators might factor fraud risk into their valuation discounts.

Only part of the story

The ACFE study exposes only the tip of the iceberg. Fraud is a far more pervasive problem that often goes undetected or unreported. It also carries indirect costs, such as lost productivity, reputational damage and lost revenues — not to mention the costs of investigating fraud and pursuing fraud claims. Experienced valuators understand these potential costs and factor fraud risks into the valuation equation.

Michael Lehner

This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations.