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Financial Engineering

Greg A. Raffaele CPA CVA FCPA

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). If the business owner wants to decrease the value of his business, he would decrease his profits (and equity) by:

• Recording asset purchases as expenses (or sales returns, a contra-sales account)
• Recording cash sales as liabilities (and writing-off inventory as worthless)
• Not recording cash sales
• Simultaneously reversing accrued sales when cash is received against accounts receivables and recording the cash receipts as liabilities
• Recording cash lent to the business owner as expenses (or sales returns)
• Recording sales as other income (suggesting that it has a non-operating quality and therefore has no future economic value)
• Spreading personal expenses across several expense accounts (Although using one expense account is too obvious, it is often done.)
• Using company credit cards, credit lines and credit facilities for personal expenses
• Writing-off or writing-down collectible accounts receivables, salable inventory and productive fixed assets as impaired or worthless assets
• Overestimating reserves (or allowances) for impaired or worthless accounts receivables, inventory and fixed assets
• Overestimating depreciation and amortization expenses
• Creating phantom employees, suppliers and vendors
• 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:

• Not closing the books on a monthly basis (most QuickBooks users close annually)
• Recording adjustments in closed periods (closed months or years)
• Accounts receivable, inventory and fixed assets write-offs and write-downs
• Unusual or numerous general journal or general ledger entries
• Even dollar amounts (like $2,000 or $6,500).
• High-dollar miscellaneous accounts
• High-dollar travel, meals and entertainment
• 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.

We proudly serve Orange County and Greater Los Angeles. We are dedicated to serving the business valuation and forensic accounting needs of business owners, especially small business owners. We are also dedicated to serving the business valuation and forensic accounting needs of attorneys, CPAs and their clients. We are a solid alternative to high-priced business valuation and forensic accounting firms. We are a solid value. Contact us for a free consultation.