Getting businesses back to reality – it's all in the detailby
The language of forensics is very often the language of fraud and investigation in insolvency. So, what can accountants and CFOs learn from the worlds of turnaround and insolvency?
Detecting fraud and assessing and enforcing effective controls against it are increasingly important issues for any business. But the trouble with getting businesses to take the possibility of them becoming victims of fraud seriously, is that most companies don’t have the accounts monitoring and reporting systems in place to detect fraud.
Indeed, most directors are optimistic and do not want to believe, or want to uncover, what is truly happening within their businesses.
“In turnarounds, we adopt a forensic approach to gain a granular insight into a business – the reality is always in the detail,” said Tony Groom, investment partner at turnaround specialists, K2 Business Partners.
“The starting point for us in any turnaround activity is that we need to get to a clear understanding of what the real current position is by first taking apart the current balance sheet. One of the things that often comes out of this process is that the reality of the financial position is much worse than that presented in the accounts.”
As an example Mark Blayney, the investment partner at K2, was recently asked by an investor to look into a business.
“On the surface it looked as though the business was doing reasonably well (turning over a couple of million per year, and making a quarter million pounds profit), but it had a few one-off hits that were causing the business to struggle,” he said.
“The investor suspected something was wrong. On investigation I found that instead of a quarter million pounds profit that the company was claiming in its accounts, there was in fact, a million-pound loss – and the whole situation had been covered up in the accounts by fudging the stock. Once the stock issue was taken out of the equation a clearer picture started to emerge on the real state of the business.”
Get right inside the business
As Groom added, turnaround professionals look at businesses in terms of the balance sheet, and the balance sheet bridge – analysing what the balance sheet says, and what is the reality to give a true statement of affairs. “We need to take a forensic view, because we want to get to the bottom of it as a turnaround professional looking to save a business,” he said.
Turnaround professionals need to look at balance sheets through a different lens and assess which assets the business will need going forward. Groom calls this a ‘trial balance bridge’ –it highlights whether there are any assets which can be realised and what the liabilities in the future will be.
In addition, he highlighted the importance of considering the ‘P&L bridge’. “On a forensic level we need to know what the sales really are. Accountants are taught to report in terms of taxes and therefore statutory accounts have a single line item for sales and a single line item for cost of sales. Whereas at a forensic level, we want to know what a company is selling and to whom it is selling it to,” said Groom.
It is important to understand the business in terms of sales by customer, sales by product, sales by category, costs by customer, and by product. The same level of scrutiny applies to all other costs.
“If you think of this as a P&L Bridge, what we see is the current income and expenditure of a business via all these trial balance line items, not just a single line for sales. This gives a granular level view and allows us to get right inside the business. This granular forensic side is essential in making the right decisions about what to save and what to cut. Even identifying items to invest in such as training and marketing,” said Groom.
“When we do this, we find out all sorts of things that have been leaching cash out of the business. For instance, if you look at the line in the accounts that says, ‘Computer Finance’, when drilling into this figure at a granular level you may find, as I did, that one company had been paying finance agreements which were ten years old, and the computers had been scrapped seven years beforehand.
“Because the finance agreement provided for a one month notice of termination and no one had cancelled it, the direct debit was still going through each month. This meant that years later, thousands of pounds were leaving the company’s bank account every month,” says Groom.
This is because the accountant, CFO and the directors of the business were simply looking at the single line item – they hadn’t been looking at the details.
“All business owners say they understand their business far better than an outsider ever can. Yet, the example I’ve just cited was someone who had been running his business for over 30 years – the last seven years of which, he had been paying finance on computers that he no longer had!”
Poor accounting records
There will always be good bits and bad bits in any business. Many businesses have relatively poor accounts monitoring and reporting systems. Business owners tend to view the cost of producing good quality accounts as a waste of money.
“Poor accounting records are a recurring problem,” says Greg Palfrey, head of restructuring and recovery services at Smith & Williamson.
“When companies’ bookkeeping systems are poorly managed, we have to go in and piece together that information both in turnaround situations and formal insolvencies. Often, we are up against deadlines driven by statute to compile that information. But if you can't find it, then the information needs to be matched from elsewhere. We call this, an incomplete records exercise whereby we are basically trying to piece together what has happened to a business bit-by-bit.”
“In many ways, it almost becomes like an old scenario of the past, whereby the auditor might be presented with a box of receipts to pull together the accounts for the last year using the cash book information from bank statements against any receipts and invoices that can be found. At this point in time, we could be dealing with hundreds, thousands or even tens of thousands of transactions and documents depending on the size of the organisation – analysing that information can be time consuming. Fortunately, technology has provided an answer,” said Palfrey.
The role of document management systems
The usage of document management systems, artificial intelligence (AI) and business intelligence (BI) systems are gathering pace when it comes to analysing information in the world of insolvency.
“Today, document management (DM) systems are capable of scanning vast amounts of documents at speed, by and using BI tools documents such as invoices and receipts can be reconciled to bank entries,” explains Stewart Wright, managing director, YourDMS and Truth BI.
“We are seeing a vast take up of document management systems in the world of accountancy and insolvency. The ability of being able to apply BI and AI tools to DM allows for vast amounts of data to be searched, and an unlimited number of insights to be generated. In addition, information can be pulled together in one space making it easily available to a number of different people – particularly useful for insolvency practitioners for instance, trying to trace assets.”
In insolvency, one of the challenging things to trace is cryptocurrencies. As Julie Palmer, regional managing partner, Begbies Traynor Plc explained, “The whole area of cryptocurrency is going to become an increasingly important side of our investigations. When we undertake an investigation, our original starting point is to look at the bank accounts to see the original transaction and then trace where the money has gone – whether it has been paid out as a preference or hidden in an overseas trust.”
“Sometimes a cryptocurrency has been used to pay a transaction. Payment by cryptocurrency is becoming more accepted, but it is very difficult to find the source of the transaction, or to track the flow of funds”, says Palmer. “As such, we see cryptocurrency being increasingly used by people who want to hide assets and conceal funds.”
When it comes to forensics – the value of professional support is clear. Not only do accountants and CFOs need to be the critical friends of the business, but they also need to understand what it is that they are being told.
But more importantly, they need to be prepared to be question and challenge business owners – getting them to seek the right advice at the right time. After all, the earlier problems can be highlighted, the easier and quicker those problems can be resolved.