Business interruption insurance claims are on the rise, and analysts need to be on the lookout for misrepresentations. Michael Haugen, CPA, CFF, CFE (JS Held) conducted a session on this at the recent AICPA FVS Conference, and it’s an area where valuation experts would do well to bolster their knowledge and skills in financial forensics. During his session, Haugen gave some tips on how to “sniff out” misrepresentations in these claims. In the recent Business Valuation Update (BVU) article, “14 Ways to Detect Misrepresentations in Business Interruption Claims,” Haugen classifies specific techniques to detect misrepresentations in business interruption claims into three categories.
1. Detecting Incorrect Assertions
Do some online research. What you can dig up over the internet can help uncover an incorrect assertion. In one engagement, Haugen was working with a hotel that catered to the construction industry, i.e., many of its guests were construction workers who were on local jobs. The hotel experienced some property damage and had to close off some rooms. Of course, revenue dropped and then stabilized at a point less than the preloss level, which is what you would expect. Then, all of a sudden, revenue dropped again. Was this subsequent drop due to the same damage (“covered peril”) and would thus be included in the loss measurement? Members of hotel management asserted that repairs to the roof caused them to close off more rooms, which triggered the further drop in revenue. The trouble was that the new drop in revenue did not coincide with the timing of the roof repairs. A little online research revealed that a large nearby construction project had ended at a time that coincided with the drop in continuing revenue.
Look for corroborating evidence. It’s important to confirm the narrative about the loss with other sources, such as data from accounting records or other documents. In one case, Haugen was measuring the loss at a manufacturer that had two different plants. A fire shut down one of the plants, and the work was shifted to the other plant. The business income loss claim included increased labor expenses due to outsourcing to third-party labor, which was more expensive than in-house labor. To corroborate this, budgets were examined that revealed that outsourcing was planned in the normal course of business. This did not match the narrative told to the analysts about the extra expense due to the damage.
2. Detecting Omissions
Ask open-ended questions. When you are finished asking limited-scope and leading questions when measuring losses, ask this: Is there anything else you want to tell me? Now that the interviewee knows what you are trying to accomplish, it gives him or her the opportunity to tell you anything else he or she thinks is important. “You may be surprised what you find out,” says Haugen.
Do a clawback analysis. This is an analysis that involves taking a look at what happened after a business reopens after damages have been repaired. Haugen says it is rare to get a chance to do this unless you are looking at what’s called an extended period evaluation. But it can function as a litmus test with regard to the reasonableness of your expectations. In one case involving a restaurant, he was able to analyze the operations after the business reopened and revised expectations downward to reflect a change in structure that had not been accounted for in the original analysis.
Look at payroll. If a small business has a few key employees that it relies on for its success, consider looking at payroll records that might lead you to believe that there’s been a substantial change in staffing. This might affect your understanding of what a business could have accomplished had a covered peril not occurred.
3. Detecting Incorrect Records
Do a book-to-tax reconciliation. The primary tool to detect incorrect records is to do a book-to-tax reconciliation, that is, examine the differences between the accounting records and what is reported on the tax returns. The business owner will typically assert that the tax returns are correct, so something is missing in the accounting books, such as year-end adjustments not being recorded. If you can’t reconcile the two, it doesn’t necessarily mean fraud is going on, but this may limit the extent that you rely on certain internal books.
Consider industry data. To test the reasonableness of financial data, check industry benchmarks. For example, if the business owner claims a 30% cost of goods sold, is that in line with industry averages? If not, the owner needs to explain.
Examine trends and a vertical analysis. This is helpful when a business has multiple locations, and you are measuring a loss at one of the locations. Trend and vertical (common size) analysis can help you spot abnormalities such as a big spike in revenue at one location that can influence your expectation of continuing revenue. The business owner needs to explain these abnormalities to see whether they are legitimate or an error in accounting records.
The techniques listed above may take a lot of time and effort, which, of course, can mean extra costs. How do you determine how far to go? Haugen advises that you work with the insurance carrier and business owner when sorting out potential misrepresentations and whether or not to take the next step and try to flush out the correct answer. Identify the issues and the potential impact on the claim and provide an estimate of what it might cost to address them. Be sure to disclose any set of parameters or instructions you are given that would limit what you would recommend doing if you were to fully investigate the issues.
This is just a summary of what was discussed during the session, but a complete recording of the AICPA event is available. For a complete list of tips and techniques to use when detecting misrepresentations in business interruption claims, download the full article from Business Valuation Update, a monthly newsletter that includes new thinking from leading professionals from around the globe, detailed reports of the latest news in the profession, analysis of new business valuation approaches, brief analyses of important court cases, tips from the field, data summaries, and more.