Financial engineering is the design of creative solutions to problems in finance. From a business valuation perspective, financial engineering is used to increase or decrease the value of a business depending on the motives of the business owner. Unlike publicly traded companies that are motivated by increasing shareholder value by artificially increasing profit and equity, business owners in a divorce are motivated by decreasing business value by decreasing profits and equity.
The value of a business is driven by three things: profits, risk and growth. The minimum value (suggesting zero implied goodwill) of a going concern business is its net book value (assets less liabilities) or its equity. Financial engineering focuses on profits and (to a lesser extent) equity of the business. Financial engineering is common to both accrual and cash basis of accounting. In the accrual basis accounting, revenue and expenses are respectively recognized when earned and incurred. In the cash basis accounting, revenue and expenses are respectively recognized when received and paid. If the business owner wants to decrease the value of his business, he would decrease his profits and equity by:
- Recording personal expenses of the business owner as business expenses, which are paid for by the business’ cash or credit . Often the personal expenses are in obvious accounts such as meals and entertainment and automobile. Sometimes; however, business owners spread their personal expenses across several not-so-obvious expense accounts. Nevertheless, the effect would be a decrease in profits (P-) and a decrease in equity (E-).
- Recording assets purchases as expenses (P-;E-)
- Not recording cash sales (P-;E-)
- Reversing, deleting or voiding an open invoice when the cash is received and not recording the cash (P-;E-)
- Same as above, but recording the cash as equity contributions (P-;E+)
- Delaying invoices to customers (P-;E-)
- Accelerating expenses to vendors and suppliers (P-;E-)
- Recording monies lent to the business owner as business expenses (P-;E-)
- Creating phantom employees, suppliers and vendors (P-;E-)
- Recording cash sales as “phantom” or related party liabilities (P-;E=)
- Recording cash sales as equity contributions (P-;E+)
- Overestimating or accelerating depreciation and amortization expenses (P-;E-)
- Overestimating reserves (or allowances) for impaired or worthless accounts receivables, inventory and fixed assets (P-;E-)
- Writing-off or writing-down collectible accounts receivables, salable inventory and productive fixed assets as impaired or worthless assets (P-;E-)
- Recording sales as other income, which suggests that it has a non-operating quality and therefore has no future economic value (P+;E+)
- Recording the same vendor invoice twice in one year, paying for it once in the same year and then reversing the second invoice in the next year (after the divorce)
If intent is proven, then the financial engineering is fraud. Unfortunately, studies have shown that only about 20% of fraud is discovered through transaction testing. So here are some accounting signs that may suggest financial engineering:
- Lack of separation of function. for example, the business owner is also the bookkeeper.
- Poor or unorganized books and records. While more commonly an indicator of negligence, it may also be an indicator of financial engineering.
- Not closing the books on a monthly basis (most QuickBooks users close annually)
- Recording adjustments in closed periods (closed months or years)
- Unusual accounts receivable, inventory and fixed assets write-offs and write-downs
- Unusual or numerous general journal or general ledger entries (instead of using the accounts receivable and payable ledgers, which have a better “paper trail”)
- Even dollar amounts (like $2,000 or $6,500)
- High-dollar miscellaneous accounts
- High-dollar travel, meals and entertainment
- High-dollar personal expenses
- Decreasing sales or increasing expenses while cash and liabilities are increasing
- Internal financial statements that do not reconcile (within reason) to tax returns
Time and money is spent uncovering potential financial engineering in litigated divorces. Although the parties operate in the context of openness and honesty in mediated and collaborative divorces, just be open to the possibility of some financial engineering.
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.