A Surprise In The Search For Financial Fraud: Owner-Manager Fraud

March 29, 2012

A Surprise In The Search For Financial Fraud: Owner-Manager Fraud

Auditors and attorneys are diligent about ferreting out financial fraud but often miss a surprising kind: fraud committed by owner-managers against their own businesses.

"It seems unthinkable that an owner would raid his or her own business, but owners can have strong motives for doing just that," says John E. Barron, Director in the Litigation and Corporate Financial Advisory Services Group at New York accounting firm Marks Paneth LLP . "Auditors and attorneys should be alert to the possibility of fraud committed by owner-managers," according to Barron. Barron has more to say about owner-manager financial fraud:

Financial Fraud Law Blog: Is owner-manager fraud a large problem?

Mr. Barron: Normally you'd expect that fraudulent financial reporting or misappropriation of assets would be committed by members of management who don't have a significant ownership stake. Auditors and attorneys rightfully place most of their attention on those non-owner managers, who are responsible for most frauds. But in privately held companies, owner-managers can be the perpetrators of fraud and it is a mistake to overlook them, especially when the owner-manager has direct involvement in (or influence over) the financial reporting process.

Financial Fraud Law Blog: Why do owner-managers commit fraud?

Mr. Barron: There are several ways an owner-manager can benefit from fraudulent financial reporting. They falsify financial reports to secure financing – third party financing normally depends on the entity's reported financial results, and poor performance could lead to restrictions on credit. Also, private equity investment or joint venture agreements might be contingent on favorable financial results. Owner-managers might need to maintain compliance with debt covenants or regulatory requirements. Or they might be trying to secure contracts that require that the business is financially sound or profitable.

Finally, they might take a step beyond fraudulent financial reporting and actually misappropriate funds. In a case like that, they're not necessarily stealing from themselves – they could be stealing funds provided by lenders or from other owners who aren't directly involved in the management of the business and therefore aren't in a position to monitor it.

Financial Fraud Law Blog: How do owner-managers conceal their financial fraud?

Mr. Barron: Owner-managers cover their tracks in exactly the same way as other members of management. They intentionally misapply Generally Accepted Accounting Principles. They put pressure on staff to complete transactions such as those with side agreements that lead to misstated results – they'll say things like, "We need to make the numbers and I don't care how you do it." They make their own financial estimates or pressure others to overestimate the value of assets or underestimate liabilities.

Financial Fraud Law Blog: How is misappropriation of funds typically concealed?

Mr. Barron: In overstated assets or expenses or understated liabilities or revenues. The owner-manager may be in a position to authorize and record fraudulent transactions. The owner-manager may have unchecked access to cash receipts or the ability to authorize fraudulent expenditures and the source of the funds may be from other owners or lenders.

Financial Fraud Law Blog: Are there special considerations that lead to owner-manager financial fraud?

Mr. Barron: The owner-manager has power and authority that isn't available to non-owner managers. He or she can intimidate subordinates into "cooking the books" or going along with questionable accounting, perhaps by the implied threat of job loss. Coming from the owner, that's a very serious threat. What makes the situation more challenging is that in private, closely-held companies, there often aren't compensating controls, such as segregation of financial reporting or record-keeping duties that are typically employed in larger, public companies. And in closely held private businesses, federal whistleblower protection statutes normally don't apply.

Financial Fraud Law Blog: Doesn't the current auditing standard for fraud help to prevent owner-manager fraud?

Mr. Barron: The standard should be revised. The standard, expressed in SAS 99, Consideration of Fraud in a Financial Statement Audit, calls attention to the risk of ineffective monitoring when management is dominated by a single person or small group in a non-owner-managed business. That presumes that an owner-manager is likely to identify fraud committed by others. However, as we've seen, there are both incentives and opportunities for the owner-manager to commit fraud and this requires an appropriate audit response. The current standard seems to give owner-managers a pass; it allows auditors to ignore the risk of fraud committed by an owner-manager. That language should be changed and the "owner-manager exception" should be removed.

Financial Fraud Law Blog: What's the bottom line?

Mr. Barron: Being an owner-manager does not exempt you from human behavior. Attorneys and auditors need to remember that owner-managers have the same opportunity to commit fraud as any other senior manager, and often have as much or more incentive and the ability to do so. Businesses led by owner-managers need as much or more auditor vigilance as any other company.

Financial Fraud Law Blog: Thank you, Mr. Barron.

To view the article in Financial Fraud Law blog click here.