Where to find fraud in closely held companies.

• Author: Lundelius, Charles R.

Privately held firms and public companies may have different incentives to perpetrate fraud, although the methods used are similar. Here's some guidance on why fraud may occur in a private company, where to look for it, and how to help prevent it. The following article is adapted from Financial Reporting Fraud: A Practical Guide to Detection and Internal Control by Charles R. Lundelius, Jr., CPA/ABV (New York: AICPA, 2003).

Closely held private companies and public companies are equally likely to experience fraud; only the motives and timing are slightly different. The management of closely held companies might not have to worry about securities analysts' expectations, but outside shareholders, bankers, and venture capitalists may demand better earnings performance. These demands can lead management to employ any of the earnings manipulation schemes used by public companies. Of course, if management bonuses are a function of increased earnings, there is a motive for earnings manipulation regardless of whether the company is publicly traded. The timing of these pressures may differ from that of public companies, though. If the outside investors are passive, the moment of performance assessment for management will most likely be the end of the fiscal year. Management of public companies, on the other hand, may feel pressure to hit targets quarterly, if they have to publish their financial statements. Regardless of whether the pressures come annually or quarterly, the motives for fraud exist.

The flip side of earnings manipulation that improperly creates additional income for financial reporting purposes is earnings manipulation that improperly lowers income for tax reporting purposes--tax fraud. To achieve this result, the manipulator may operate with two sets of books that do not reconcile; one for investors and bankers and one for the tax authorities. Most companies, of course, maintain separate tax-basis books that allow them to determine tax gains and losses from asset dispositions, for instance. The difference between the fraudster's tax books and legitimate tax books is that the fraudster's books may not reconcile to the financial reporting books through legal reconciling entries. For example, through revenues parked off-shore in a tax haven or the use of related entities, costs can be shifted from low-tax rate to high-tax rate affiliates.

Placating outside shareholders

The shareholders of private companies who are not part of...