Chapter 12

Financial Statement Fraud and the Investment Decision

Harry Cendrowski

James P. Martin


Private equity (PE) investment decisions are made under the premise that the target entity has the ability to meet predetermined financial goals. Certainly, there are unforeseen circumstances and unidentified risks that overcome the organization's ability to maintain its business plans and adhere to the expectations, but generally, given a fair chance to evaluate the organization's business situation, the PE firm should be able to evaluate the target company's earnings potential. At the same time, fraud is a very real threat to every organization's ability to meet its financial objectives, and it can remove the chance of fair evaluation of the business situation. Given the increasing incident rate of fraud across all segments of business, it is no longer feasible to consider fraud an “unidentified risk.” PE firm managers and financial institutions must consider the risk of fraud when evaluating financial statements and organizational operations for the purposes of making an investment decision.

Fraud is broken down into two main categories. Additionally, there is an overarching risk of financial distortion due to money laundering activities, either by the principals of an organization or as a service provided to third parties. Money laundering can make an organization appear to have increased sales and revenues, without any services actually being performed.

Money Laundering ...

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