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  • Writer's pictureJerry Ipsen, CFE, MBA

Detecting Financial Fraud in Real Estate

An article by the Association of Certified Fraud Examiners (ACFE) which appeared in their Fraud Magazine reminds us that targeted financial diligence can reveal several red flags. Potential real estate investments call for more than cursory reviews of financial statements. They require targeted inquiries — remotely or in person. Here are some areas in the financial statements that may reveal fraudulent activity.


BALANCE SHEET


The first step in the forensic assessment of the aftermath of a fraud is always to “follow the cash” and confirm with independent third parties whenever possible. However, reviewing the balance sheet in advance with financial advisors could reveal wrongdoing. While the bottom line of a balance sheet, or the net income over a certain period, may show that a company is solvent, reviewing the debt owed to third parties or the total principal amount of debt outstanding could confirm that the figures aren’t as strong as they first appear. Make similar independent confirmations on the asset side of the balance sheet by testing each aspect of the company’s assets such as cash on hand or the value of properties.


INCOME STATEMENT


It’s important to look at the relationship among revenue, net income and expenses. (Revenue is the income generated before expenses, while net income is revenue less the expenses of doing business.) Typically, as revenue increases, so should variable expenses. The same holds true in commercial real estate. As revenue increases, so should expenses, such as sales commissions, professional fees and the cost of maintaining properties. If these expenses aren’t correlating to an increase in the portfolio of properties or loans, misreported revenue likely exists.


A detailed review of revenue at the investment level also would likely expose related party transactions. If a significant percentage of revenue is derived from related parties or there’s a concentration in one or two related investments, it’s worth confirming their independence and financial integrity to ensure there’s a legitimate business and, therefore, revenue sources in place.


CASH FLOW


An examination of a company’s cash flow and personal expenses of the principals of the company is also an important part of the due diligence process. This could reveal that money is being siphoned into the account of a possible perpetrator. Any disparities in the industry norms and the financial records of the potential investment entity should warrant a reasonable explanation or raise further questions.


Jerry Ipsen, CFE, MBA of Ipsen Due Diligence subscribes to the concepts outlined in the ACFE article.  Keep in mind, perpetrated frauds are different in each case and may require a modification in methods and procedures.




 

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