Category: General Business News

According to a 2022 Allied Market Research report, the size of the global forensic accounting market is forecast to increase in value to $11.68 billion in 2031, up from its 2021 estimated value of $5.13 billion. Allied Market Research puts this compound annual growth rate at nearly 9 percent (8.8 percent). This same report found that the Covid-19 pandemic saw an uptick in the need for forensic accounting skilled professionals and approaches.

Forensic accounting is a specialization within the general accounting profession. Professionals in this specialized subset focus on allegations of financial fraud brought by individuals and businesses in the civil courts and government agencies in the criminal courts. Disputes can range from family members contesting assets and valuations of such assets in an estate, business, or divorce proceedings. When it comes to proving criminal allegations, government agencies look to forensic accountants to investigate financial records for evidence of fraud in the quest to prove crimes such as securities fraud or identity theft.   

Forensic Accounting Methodology

According to the Journal of Accountancy and the Association of Certified Fraud Examiners (ACFE), CPAs and specifically forensic accountants can use Benford’s Law to begin the process of identifying potential fraud. Examples of data sets that forensic accountants can build and analyze come from income statements, expense reports, ledgers, balance sheets, invoice and inventory data, accounts payable, and accounts receivable. When analyzing the leading or first digit in a data set, forensic investigators can take the data set and look at how the leading digits are distributed against the percentages that Benford’s Law sets out.

According to the ACFE, in contrast to the common belief that digits occur in equal probability, Benford’s Law states that numbers starting with 1 as the first digit occurs with the highest frequency. Then each subsequent number 2 through 9 occurs with lower probability. According to Carnegie Mellon University, per Benford’s Law, 30.1 percent of a data set will be led by a 1. The digit 2 will be the first in a data set 17.6 percent of the time. For numbers 3 to 9, the likelihood of each respective number leading the data set should become less frequent.

The ACFE gives the example of a counting exercise to illustrate Benford’s Law. When counting to 25, only one of the 25 numbers would lead with a 3; seven numbers would lead with a 2; and there would be 11 leading numbers beginning with 1. Numbers generated by a computer would give equal weighted probability to 1 to 9 being the first or leading digit. If equally weighted numbers were in fact generated, the results would deviate from Benford’s Law. However, simply because Benford’s Law is not observed in the dataset analyzed, it doesn’t automatically mean fraud occurred. But it is a tool that helps forensic accountants investigate further and determine through additional means if fraud did, in fact, occur.

Similarly, the ACFE points out that if someone wants to commit a financial crime, they would generate invoices worth a lot. It would be a lot more effective for someone to pass off invoices of $800 or $900, versus smaller $100 or $200 amounts. While this would make better use of a criminal’s time, according to Benford’s Law, if a forensic accountant were to test a data set against a few hundred invoices, they might see an abnormal percentage of them with high leading numbers, prompting further investigation.

The Journal of Accountancy reminds readers that it’s important to keep in mind a few caveats. The more numbers available in the data set, the better. It can work with as few as 50 to 100 numbers, but more is always preferred. Another consideration, per the ACFE, is where the data comprising the data set originates. Using a sports analogy, if players are between 5 feet and 8 feet tall, it would make testing the data set against Benford’s Law impossible because there’s zero chance of numbers 1 through 4 and 8 or 9 showing up in a probability test. In these scenarios, Benford’s Law wouldn’t apply.

While the method for detecting financial fraud is not black and white, the need for more forensic accountants will not slow down any time soon.

Sources

https://www.acfeinsights.com/acfe-insights/2023/3/28/benfords-law-how-to-use-it-to-spot-fraudnbsp?rq=Benford

https://www.acfeinsights.com/acfe-insights/2023/3/21/benfords-law-applicationsnbsp?rq=Benford

https://www.acfeinsights.com/acfe-insights/what-is-benfords-law?rq=Benford

https://insights.sei.cmu.edu/blog/benfords-law-potential-applications-insider-threat-detection/

https://www.journalofaccountancy.com/issues/2017/apr/excel-and-benfords-law-to-detect-fraud.html

https://www.alliedmarketresearch.com/forensic-accounting-market-A17182

When it comes to businesses looking to mitigate risk, one concept that’s important to explore is reproduction costs. The first step is to distinguish between reproduction and replacement costs. Replacement cost refers to how much it would cost a company to replace an asset that will duplicate the performance of the beginning asset; however, it does not necessarily have to meet the same materials, specifications, etc. Reproduction cost refers to how much it would cost a company to reproduce the asset so that it’s constructed of the same materials, specifications, etc., based on current market prices.  

When looking to assess real estate accurately, the cost approach examines how much a builder would need to spend on the land and building outlays to replicate the original building and its functionality. This looks at what the current market conditions would assess the land for and the construction/development costs on said land. From there, it removes depreciation to obtain its property value.

It’s expressed as follows:

Property Value = Replacement / Reproduction Cost – Depreciation + Land Value

The first step is to determine the structure’s reproduction and replacement costs. The Replacement Method looks at expenses that would be incurred to build a structure featuring the same usefulness as the building under review, constructed with present-day raw materials, blueprints, specifications, etc. The Reproduction Method looks at how much it would cost to build an exact replica of the original structure, employing analogous inputs and building standards. It also requires adhering to historically accurate conventions and blueprints. Naturally, when comparing a historic property to a recent building, there would be a greater divergence between replacement and reproduction costs.

Depreciation of improvements for the next step must be estimated. This is defined as the difference between the value of renovations and the current contributing value of them, which is measured in three ways:

• How much has the building physically deteriorated?
• How much has the building has fallen out of favor with real estate purchasers over time?
• How much value has the building lost due to factors beyond itself? Examples include deteriorating local economic conditions, recent and lasting environmental contamination, etc.

After calculating the three conditions in the aforementioned questions, the resulting figure is the accrued depreciation. This step entails looking at current property values to ascertain a competitive worth for the land. This can be referred to as the Estimated Assessed Value of Land to give the value a name.

From there, the accrued depreciation must be taken off the value of either the replacement cost or reproduction cost. It’s expressed as follows:

Replacement Cost or Reproduction Cost (either can be selected depending on the desired outcome) – Accrued Depreciation

The resulting figure is referred to as the Depreciated Cost of the Structure.

Once the Accrued Depreciation is accounted for, the land’s estimated assessed value must be added to the Depreciated Cost of the Structure figure. It is calculated as follows:

Completed Estimate of Real Estate = Depreciated Cost of the Structure + Estimated Assessed Value of Land

Contemplating the Cost Approach’s Drawbacks

One concern is that if there’s a problem finding the right lot, the parcel’s valuation might not reflect its true worth. Zoning or land-use restrictions can reduce the attractiveness of a parcel of land, thereby lowering its value. When it comes to calculating depreciation for older properties, age could skew the value estimate. For example, with construction materials for certain items may not be available anymore, making the calculation subject to interpretation.

Understanding how different cost assessments work allows business owners to make decisions that benefit their customers and their bottom line.

When it comes to valuing a business, there are many ways to examine a company’s profitability. Looking at a business’ liquidation value and its breakup value are two of many approaches to see how a company is functioning and how it might run under different management and economic environments.

Liquidation Value

This type of valuation can be defined as the difference between what tangible assets would sell for at auction minus outstanding liabilities. Typically, intangible assets are not considered in this type of valuation. However, if the intangibles along with the physical assets, are considered for sale and not sold at auction, it would be considered a business’ “going-concern value.” Examples of intangibles include goodwill, brand recognition, patents, etc.

There are many considerations when exploring liquidation value. Generally speaking, the liquidation value is more than the salvage value but less than the book value. When a company is going out of business and assets are auctioned off, proceeds will normally be valued below the asset’s historical cost. Historical cost refers to how assets are reported on the balance sheet. However, if the market assesses assets lower in value compared to business use, it could be lower than book value.

Here is an example of how liquidation value can be calculated. Say a business has liabilities of $1.1 million. Based on the balance sheet, the book (or historical) value of assets is $2 million; and assets have a salvage value of $100,000. If the value of selling the business’ assets via auction is projected to be $0.80 per dollar, it could be expressed as follows:

$1.6 million (assets sold at auction at $0.80 per dollar) – $1.1 million (liabilities) = $500,000 (Liquidation Value)

Breakup Value

Also known as “the sum-of-parts value,” the breakup value determines the worth of a corporation’s individual segments if they were operating independently. Investors might pressure the company to spin off one or more segments into a separate publicly traded company to maximize its value.  

For each operating unit, the first step involves determining the segment’s cash flow, revenue, and earnings. Such valuations can be benchmarked to publicly traded industry peers to determine comparative value of the business segment in question.

Financial ratios, including price-to-earnings (P/E) or price-to-free cash flow, are examples of starting points that analysts use to compare segmented business lines to industry peers to determine if it’s trading at below fair value, fair value or above fair value.

For example, if the P/E ratio of the company being analyzed is lower than its peers, it could mean the company is cheaper or trading below fair value on an earnings basis. Though a more thorough financial analysis and assessment of macroeconomics is recommended, such as interest rates, inflation, etc., analysts could make an educated projection on how future earnings may or may not hold up in the future, compared to the business segment’s snapshot valuation.

Another way to evaluate is via discounted cash flows (DCF). This shows the segment’s future free cash flow projections through a discount rate, generally the weighted average cost of capital (WACC). The formula arrives at the present value of the business segment’s future cash flows. The following DCF example can tell the expected profitability and how to treat it going forward as part of the business:

Assume the company’s WACC is 10 percent; the amount invested is $5 million; it will last three years, and the annual estimated cash flows are as follows:

Cash Flow                Discounted Cash Flow

Year 1: $2 million       $1,818,181.82

Year 2: $4 million       $3,305,785.12

Year 3: $6 million       $4,507,888.81

Compared to the amount invested of $5 million for the business’ selected business segment, the discounted cash flows for the project are $9,631.855.75. This could give an indication of how the business line might do if it’s spun off or how its performance will impact other lines of the business financially.

While valuation is subjective, especially in periods of volatile inflation and interest rate conditions, the more points of valuation analysis that occur, the better the chances that valuations will turn out to be correct.

The Setting Every Community Up for Retirement Enhancement 2.0 Act of 2022, otherwise known as SECURE 2.0, is a piece of legislation that focuses on how employers and their employees are able to save for retirement and how it impacts their bottom lines.

Businesses with as many as 50 employees can receive a tax credit when they offer a defined contribution plan to employees. The start-up tax credit permits up to 100 percent of start-up costs ($5,000 annually) to offset administrative expenses to implement a start-up plan. However, for businesses with 51 to 100 employees, the first SECURE Act’s tax credit equal to 50 percent of administrative costs, capped at $5,000, remains in effect.

SECURE 2.0 also allows for an employer tax credit of up to $1,000 per employee, effective Jan. 1, 2023, when the business contributes to defined contribution plans as long as the employee makes no more than $100,000 annually. It’s phased down over a five-year period. For employers with 51 to 100 employees, the credit phases down based on the number of active employees.

Another tax credit is for eligible employers that employ military spouses. Beginning in 2023, employers with up to 100 employees making at least $5,000 annually are able to obtain a general tax credit, up to $500 for three years as long as they meet the following conditions in conjunction with the company’s defined contribution plan:

• Qualified employees enroll within two months of onboarding.
• Once qualified, an employee is entitled to plan benefits he wouldn’t otherwise be eligible for until after 24 months of employment, such as the employer deposit of an amount equal to what the employee contributes to his plan.
• Contributions from the business are assigned in full to the employee.       

The $500 tax credit is comprised of $300 contributed by the employer to the employee and $200 based upon eligible military spouse participation.

Employers may utilize the tax credit during the year the military spouse is onboarded and the following two tax years. Employees also need to attest to their status to qualify.

If an employee is married to someone who is actively serving in the armed services, that person is considered a military spouse. However, if such an individual is considered a Highly Compensate Employee (HCE), he or she must be excluded from this definition based on compensation level.

Based on IRS regulations, there are two different tests that determine if an employee is an HCE and determines eligibility for contribution plan participation by employees and potential tax implications for employers. The first test is an ownership test; the other is a compensation test to determine if an employee is an HCE.

Looking at the compensation test, the IRS’ HCE Threshold for 2022 and 2023 is $135,000 and $150,000 in compensation, respectively. The ownership test looks at whether an employee owns 5 percent of the business during the determination year or within the present plan year. If the same employee has the same 5 percent ownership stake within the lookback year, which is the past 12 months immediately preceding the determination year, they are deemed to meet the ownership test.

While each company has different attributes and must navigate the tax code based on their own circumstances, understanding how the SECURE 2.0 law works is one way to make the most of tax obligations.

Sources

https://www.finance.senate.gov/imo/media/doc/Secure%202.0_Section%20by%20Section%20Summary%2012-19-22%20FINAL.pdf

When it comes to defining an impaired asset, its fair market value is worth less than the original cost of the asset – or, more formally, its carrying value. As a company re-evaluates its assets’ value, and when it determines there’s a discrepancy between the book or original value and the current market value, impaired assets that are lower in value are written down on the balance sheet. The business’ income statement shows a loss for the negative difference in value. Impaired assets can be Property, Plant, and Equipment (PP&E), goodwill, or fixed assets.

Making a Judgment on Asset Impairment  

One more consideration to get an accurate calculation, according to generally accepted accounting principles (GAAP), is to ensure that accumulated depreciation is subtracted from the asset’s historical or original cost before assessing the difference between the fair market and carrying values. Equally as important is the GAAP recommendation for businesses to perform impairment tests annually.

Assets could be damaged physically, consumer demand may change, or legal factors could reduce its fair market value. These reasons may cause lowered projected future cash flows – lower than an asset’s current carrying value. It, therefore, requires an impairment assessment.  

Illustrating With a Real-World Example

Take a business that bought a piece of equipment 24 months ago worth $500,000 and depreciates it $25,000 annually. Using these two figures, we can determine the equipment’s carrying value is as follows for the present year:

[($500,000 – ($25,000 x 2 years)] = $450,000

If the same type of asset (same age, usage, etc.) can be purchased on the open market but is able to be purchased for $400,000 (market value), the asset the business owns would be considered an impaired asset.

The difference between the current market value and the carrying value is: $450,000 – $400,000 = $50,000. The $50,000 would be written down.

It’s important to note that once an asset is impaired, depreciation going forward must be recalculated based upon the new valuation figure.

Criteria to Establish Impairment

According to GAAP, businesses must begin with a recoverability test. If the initial cost of an asset (minus any depreciation or amortization) is more than the non-discount rate adjusted cash flows it’s projected to produce, the asset is considered impaired.

Assuming the asset is deemed impaired, the second part determines how much impairment exists, which is the gap between the original and market value of the asset in question. If the fair value is unspecified, the total of the discount rate adjusted future cash flows is acceptable.

Assuming the total of non-discount rate adjusted future cash flows is $90,000 – the projected undiscounted cash flows through the next 36 months, which is lower than the estimated carry amount (or book value) of $115,000. The recoverability test is passed, so the asset should be impaired. Based on the second step, the impairment loss will be $25,000 ($115,000 – $90,000). If, however, the fair market value is unknown, the projected cash flows of $30,000 per year for the next 36 months should be discounted to present value. This example can assume a 5 percent discount rate:

Year 1 – $30,000 / (1+0.05) = $30,000 / 1.05 = ($28,571.43)

Year 2 – $30,000 / (1+0.05)^2 = $30,000 / (1.1025) = ($27,210.88)

Year 3 – $30,000 / (1+0.05)^3 = $30,000 / (1.1576) = ($25,915.69)

To calculate the impairment loss with an unknown fair market value: $115,000 – ($28,571.43 + $27,210.88 + $25,915.69) = $115,000 – $81,698.00 = $33,302.00

Whether it’s a time of economic uncertainty or the economy is firing on full cylinders, assets can change value. Businesses that effectively navigate changing conditions are able to increase their chances of surviving or thriving amid the challenges they might face.