Valuation and forensics often go hand-in-hand, and the latest report from the Association of Certified Fraud Examiners (ACFE) illustrates this. Companies lose approximately 5% of revenues to internal theft and financial misstatement each year, and it can have a big effect on valuation.
Valuation impact: Fraud affects revenue and cash flow and can also have an effect on the company’s reputation and goodwill. When looking at pricing multiples keyed to revenue, the impact of fraud can cause a valuation to drop materially. Using the 5% figure from the study, if a pricing multiple of 1.5 times revenue is used, this means a value impairment of 7.5% (5% times 1.5).
The notion that small companies are riskier than larger companies generally holds true regarding fraud. The 2016 ACFE study revealed that check tampering, skimming, payroll, and cash larceny schemes were twice as common in small organizations as in larger ones. However, corruption was more prevalent in larger organizations. Industry also affects the fraud risk assessment, according to the report, with banking and financial services, government and public administration, and manufacturing as the sectors most likely to experience fraud.
What to do: Do a fraud risk and assessment and customize it depending on the size and industry of the subject company. This includes an evaluation of the firm’s internal controls, such as looking at formal policies and procedures and any mechanisms in place, including reporting hotlines or anti-fraud training. Also, when interviewing management, ask about any past incidents of fraud and try to get a sense of whether the corporate culture has any effect on the possibility of fraud. For example, are managers under severe pressure to meet budget or sales goals? If your probe indicates a hotbed of fraud, you may have to bring in a financial forensics expert. For the future, beef up your own abilities by adding an understanding of forensic tools to your valuation arsenal.
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