How real estate investors can uncover financial statement fraud
With millions of dollars at stake, an overextended real estate developer has a lot to lose if lack of funds causes a project to collapse. To attract investment capital, some developers have been known to resort to financial statement fraud. If you’re considering financing a project, you need to know how to spot such deception.
Ample opportunity to cheat
There are many ways to falsify a financial picture. For projects in the planning phase, a company seeking financing may provide overstated appraisals of the completed property. Or it may fail to mention its inability to secure utility access or approval from local authorities to rezone the property’s intended location.
For projects already under construction, the developer may inflate the percentage of development completed or amount of materials already purchased. Or a developer could neglect to report funds received from previous lenders or investors.
Sweat the small stuff
To avoid shady deals, review project proposals carefully. For example:
Look at supporting documents. In their rush to “improve” financials by manipulating income statements, balance sheets, and cash flow statements, some companies may overlook supporting documents such as project-related budgets and forecasts. Compare these to the company’s primary financial statements and, if you find discrepancies, ask for a detailed explanation.
Scrutinize line items. Certain financial statement line items tend to correspond to each other. For example, labor expense and the accounts payable balance should increase at a rate similar to the percentage of construction completed to date. If line items appear out of sync, ask to see the books of original entry such as the accounts payable aging reports or salary expense reports.
Employ analytical techniques. Common size analysis can help you verify the integrity of specific line items. The process converts each item to a percentage of a base number. For example, to analyze wages and benefits expense, you would divide wages and benefits expense by revenue. Once you’ve converted every line item on the income statement to a percentage of revenue, you can compare the percentages within a reporting period and against prior and subsequent reporting periods.
Given the inherent complexity of commercial and residential construction projects, there are plenty of ways for unscrupulous developers to con lenders and investors. Contact us. We can help you determine whether a project’s financial statements appear sound.