Eric D. Colca, CPA, CVA Kelly G. Besaw, CPA, CVA Chiampou Travis Besaw & Kershner LLP 45 Bryant Woods North Amherst, New York 14228 4th QUARTER 2012, VOLUME IV How to Spot Fraud Your latest issue of . . . If you have any questions, Continued from page 3 • 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 LLP 45 Bryant Woods North Amherst, New York 14228 Phone: (716) 630-2400 Fax: (716) 630-2401 E-mail: [email protected] [email protected] www.chiampou.com 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 Uncertainty 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 contemporaneous 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. Continued • • • • 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 Continued 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 follows: • 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