We must admit that fraud has been very very good to us. If it were not for fraud we would have no work preventing fraud: People just don’t spend money preventing things that don’t happen. Nor would we make any money investigating the frauds and recovering assets from the fraudsters.
But can a fraud be a good thing? Well, yes it can, if you are the buyer of a fraud-ridden company. These good frauds create opportunities to buy companies that are undervalued because of the fraud. The fraud can be used as a negotiating tool to drive down the price of the company to be acquired. The good fraud can also be one of those items that the acquirer notices but the seller does not. The buyer keeps the fraud under wraps until the purchase is completed, and then works to cure the fraud, increasing the profits of the company acquired by curing the fraud.
Sellers usually use one of the following ways to fraudulently cook the books.
• Revenue Recognition schemes, where revenue is recognized prematurely, or where there is fictional revenue
• Cost and Expense Schemes, where costs are delayed, or liabilities are not recorded
• Over Stated Assets, where the value of assets are too high, or the assets don’t exist
• Understated Liabilities where the liabilities are buried or not disclosed
• Related Party Transactions, not done with a bona fide third party,
that may have quantity and quality issues
• Misappropriation of Assets, missing assets, or failure to record the loss of assets
• Management’s Discussion of Financial Statements, where many liabilities are omitted or glossed over
So what is a good fraud from the buyer’s perspective? A good fraud (for the buyer) is any fraud that can be detected and deterred. Once detected it can be dealt with to reduce cost and increase earnings. As noted above, these frauds can be in a number of areas such as cost of materials where the seller is paying a kickback. Or loss of inventory thought theft or misappropriation. Or the payables department sending checks out to fake suppliers or ghost employees. Or checks paid for fake returns. And, of course, when buying a small closely held business, the former owner can no longer skim revenue.
A dollar lost to fraud goes right to the bottom line. Fraud elimination is an immediate profit enhancer. Gross margin increases, profit increases, and, if you are a public company and trade at a PE ratio of 15, even a small increase in profitability by eliminating fraud in an acquisition can have a very dramatic effect on your stock price.
The flip side of this is that if the sellers have been sloppy, and have not rooted out fraud – even fraud by the owner – they end up selling their company for a value much below what the company, not riddled with fraud, would otherwise sell.
Our experience is that most companies not aware of fraud suffer a loss equivalent to about 5% of revenue, with some as high as 19% of revenue.