The Search for Financial Fraud Often Overlooks a Surprise: Fraud Committed by Owner-Managers Against Their Own Businesses

NEW YORK, NY--(Marketwire - Mar 21, 2012) - 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 & Shron LLP (MP&S). "Auditors and attorneys should be alert to the possibility of fraud committed by owner-managers."

"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," Mr. Barron says. "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."

According to Mr. Barron, the current auditing standard for fraud 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. But this guidance can lead auditors to overlook the risk of fraud committed by owner-managers themselves, and should be changed."

Mr. Barron sheds light on the dimensions of owner-manager fraud:

• Why owner-managers commit fraud: "There are several ways an owner-manager can benefit from fraudulent financial reporting," Mr. Barron says. "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."
  
  
• How owner-managers conceal fraud: "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." Misappropriation of funds is typically concealed 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.
  
  
• "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."
  
  
• Why professional guidance on owner-manager fraud is ineffective and should be changed. "The language in the auditing standard, SAS 99, points to the risk of fraud when non-owner management is dominated by a single person or small group. The assumption seems to be that an owner would not defraud his own business -- but would detect frauds 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."
  
  

"Being an owner-manager does not exempt you from human behavior," Mr. Barron says. "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."

For more information, or to schedule an interview or bylined article, contact Katarina Wenk-Bodenmiller of Sommerfield Communications at (212) 255-8386 or katarina@sommerfield.com.

About John E. Barron, CPA
John E. Barron, CPA, is a Director in the Litigation and Corporate Financial Advisory Services Group at Marks Paneth & Shron LLP. His career in the accounting industry spans more than 30 years, during which time he has served as an audit partner in a "Big Four" accounting firm as well as the chief financial officer of a privately held real estate investment and development firm. Since joining Marks Paneth & Shron in 2003, Mr. Barron has specialized in the application of accounting principles and auditing standards in cases involving the financial services sector. He has addressed a wide variety of issues including derivative accounting, valuation of non-publicly traded investment securities, revenue recognition, accounting for purchase acquisitions and the adequacy of valuation allowances and reserves. In addition to cases involving the mortgage banking, hedge fund, and financial services industries, Mr. Barron has served as a testifying expert or consultant in cases involving the technology, manufacturing and real estate industries. Mr. Barron has served as an Adjunct Professor of Accounting and Auditing at Baruch College since 2008.

About Marks Paneth & Shron LLP
Marks Paneth & Shron LLP is an accounting firm with nearly 475 people, of whom approximately 60 are partners and principals. The firm provides businesses with a full range of auditing, accounting, tax, consulting, bankruptcy and restructuring services as well as litigation and corporate financial advisory services to domestic and international clients. The firm also specializes in providing tax advisory and consulting for high-net-worth individuals and their families, as well as a wide range of services for international, real estate, media, entertainment, nonprofit, professional and financial services, and energy clients. The firm has a strong track record supporting emerging growth companies, entrepreneurs, business owners and investors as they navigate the business life cycle.

The firm's subsidiary, Tailored Technologies, LLC, provides information technology consulting services. In addition, its membership in Morison International, a leading international association for independent business advisers, financial consulting and accounting firms, facilitates service delivery to clients throughout the United States and around the world. Marks Paneth & Shron LLP, whose origins date back to 1907, is the 30th largest firm in the nation and the 13th largest in the New York area. In addition, readers of the New York Law Journal rank MP&S as one of the area's top forensic accounting firms.

Its headquarters are in Manhattan. Additional offices are in Westchester, Long Island and the Cayman Islands. For more information, please visit www.markspaneth.com.