Employee theft in company valuations

Update from our forensic accounting team

Theft in any form is a hot topic, but it is particularly distasteful when undertaken by a trusted
employee.

There has been a growing trend for strong action on employee theft – whether in response to the theft of millions, or even a sandwich (yes, allegedly an employee of Citi was suspended over the theft of sandwiches from the cafeteria).

In the current economic climate, even the most loyal employee may be driven to actions they may never otherwise have considered out of necessity or simply because the opportunity arises due to management being distracted.

Whatever the size, uncovering employee fraud is, without doubt, a bitter pill to swallow. The impact can be long lasting, both on the health of a company and on the attitudes of the directors. Whilst employee fraud does not only exist in small businesses, a lack of internal controls is more common in smaller operations.

We have previously looked at methods of prevention and detection.

Albeit not a necessity in the case of a stolen sandwich, a fraud investigation is typically a costly and time consuming exercise. The decision to quantify amounts taken and identify how a fraud was concealed must therefore be undertaken on a case by case basis, and where there are no assets to pursue, involving forensic accountants may be a case of throwing good money after bad.

Misappropriation of funds can be disguised in a company’s accounting records in many different ways – from fake purchase invoices, salaries paid to phony employees to purchase of non-existent assets.

Identifying the method of concealment is crucial to understanding the impact on a company’s accounts

It is important to note that the method chosen to conceal fraudulent activities will likely have a bearing on a company’s tax liability. Stolen funds may not be a tax deductible expense (depending on the perpetrator) and VAT returns may well have been misstated if false purchases have been recorded.

From a company valuation perspective, therefore, understanding not only the quantum but also the method of concealment has an important bearing on not just the company’s financial results but also on its value. This was the case in a recent matrimonial valuation which we undertook as single joint expert.

Impact on valuation – if quantified

If the nature of fraud is known, and the quantum determined, the false accounting transactions can be reversed in order to establish the performance of the underlying trading activities and the realisable assets of the company.

If, for example, stolen funds were hidden as purchases of fake assets, the balance sheet will be overstated. An asset based valuation will therefore be artificially increased by the amount taken (being the value of fake assets) and must be reduced accordingly.

Employee theft in company valuations
Fraud could affect both the balance sheet and profits of a company

If stolen funds were hidden using fake supplier invoices, the company’s profits will be understated. In order to calculate the company’s true profits and therefore its maintainable position, the amounts stolen in each period will need to be added back. If the period affected by the fraud is used as a basis for determining maintainable profits, this adjustment will increase the company’s enterprise value in an earnings based valuation.

Of course if there is any prospect of recovering stolen funds from the perpetrator or an insurer this should be taken into account to increase the valuation of the company, albeit fraudsters rarely have a stash of ready cash or other assets from which to repay their debts.

Impact on valuation – if unquantified

As you’ll have guessed, if the nature and quantum of fraud can’t be determined, the appropriate adjustments cannot be made. This was the situation we faced in a recent divorce case where we were asked to value a number of companies owned by the husband and the wife. Over the course of the last few years, four of the five companies been subject to fraud committed by a member of the accounts team.

The companies had taken the individual to Court and a settlement had been reached in mediation. In many ways this was still unsatisfactory as both the husband and the wife suspected that the true loss was several times larger than the settlement amount and the cause of poor trading performance in the last financial year.

The full extent of the fraud had never been quantified and the method was unknown. For the purposes of our valuation, therefore, it was unclear which balances in the companies’ accounts had been misstated – and by how much.

Following fraud, consideration on sale of a company would no doubt be contingent on future trade

In reality, in the event of a sale of the companies, a prospective purchaser (assuming one could have been found) would have undertaken extensive due diligence in order to best estimate the extent of the fraud and would no doubt have required the majority of the consideration payable to be contingent on future performance.

In this case the companies had minimal asset backing and had made a loss in the current year. In the absence of quantitative information to enable us to strip out the impact of the fraud we were unable to provide a robust asset based valuation (usually the minimum value). This was unsatisfactory for everyone involved, but the silver lining was that we had some up to date post-fraud trading information from which we could estimate the current
earnings based value of the companies.

This article was originally published in Forensis Autumn 2020.

For more information

For more information, please contact us on:

01483 416232