Despite several high-profile COVID-19-related bankruptcies, financial markets are continuing their “bull” runs in 2021. However, some say the large number of transactions in 2021, coupled with a trend of overly optimistic company valuations, foreshadows the possibility for a large financial market reset later this year and beyond. This, in turn, could spark another increase in corporate bankruptcies.
Young companies can draw private equity and placement suitors quickly, particularly in hot spaces like technology and cryptocurrency. As the lifecycle to pursue an initial public offering or a direct listing on an exchange is shortened, management teams should ensure that all operational and financial risks have been properly assessed and the necessary operational and reporting processes and internal controls are in
place to ensure a company’s success and regulatory compliance once it goes public.
This responsibility rests on management’s approach to managing and executing the IPO program, setting the public company up for success and ensuring the necessary infrastructure (e.g., technical accounting, financial reporting and treasury support, etc.) is in place to manage business and financial statement reporting risks. These actions are not only good management practices but also can mitigate bankruptcy risk.
If bankruptcies happen, it is crucial that audit committees, management and legal counsel consider the possibility of fraudulent conveyances or transfers. As
competing priorities arise, such as bankruptcy proceedings while operating a business, it is important that a company’s management team evaluate if it has the right financial advisors, such as forensic accountants, in place to guide the business through the complexities of a bankruptcy. Forensic accountants can provide an unbiased look into a company’s historical books and records leading up to the bankruptcy and play an independent role with respect to reviewing and validating a company’s books and records to ensure that no fraud or malfeasance has occurred.
The Role of Forensic Accountants in Bankruptcies
It is prudent for audit committees, management and legal counsel to consider the risks and be prepared to deal with a bankruptcy filing. An important aspect of this is understanding the facts and circumstances resulting in the bankruptcy and considering and looking for indications of possible fraud or other suspicious activities.
Forensic accountants, many of whom are licensed certified public accountants or certified fraud examiners, are uniquely trained to review a bankrupt entity’s financial records and business transactions with an eye toward identifying anomalies. They can provide key insights that might guide or alter key decisions made by the board of directors, audit committees and other stakeholders (e.g., restructuring officers, ad-hoc investor committees, secured and unsecured creditor committees, and legal counsel). Serving as a trusted advisor to company management and the restructuring team, forensic accountants can add another layer of scrutiny during bankruptcy proceedings. They can contextualize a company’s corporate governance and internal controls, business records, bank statements, financial systems and subledgers. They also can identify irregularities (e.g., unusual or unexpected accounting journal entries made to improve a company’s asset base as presented in financial statements) that might otherwise seem insouciant or go unnoticed by management.
In a bankruptcy, forensic accountants may begin with an initial assessment of a company’s internal control environment, books and records before doing a deep dive into support for financial statements to establish a baseline on the historical state of a company’s financial accounting and reporting.
Any findings uncovered by the forensic accountant’s initial assessment can assist management and a company’s restructuring advisors in identifying the areas that will be best served by a forensic accountant’s investigative skill sets and scope, especially when essential staffing resources may be limited.
It is important that a forensic accountant does not duplicate efforts by other stakeholders participating in the bankruptcy process since a single analysis also may be used for different purposes. For example, detailed analysis performed by a forensic accountant regarding the timing and nature of preference payments or fraudulent conveyances can be summarized and shared to facilitate understanding for all stakeholders. If given legal privilege, pursuit of investigative leads and preparation of analyses might be shared with secured and unsecured creditors, among other stakeholders, to help them understand the financial position and performance of a company before and leading up to bankruptcy.
How Forensic Accountants Can Help
When a company is going through bankruptcy, there may be indicators that suspicious activities occurred before or during the bankruptcy process. Forensic accountants can identify these issues, including, among others:
- Significant selloffs: Significant shareholder activity by key stakeholders before the bankruptcy may be indicative of misappropriated assets. This could include capitalization buy backs, tendering of shares, exercising of options and large selloffs by employees or executive officers in relation to the timing of the bankruptcy.
- Management’s representations: How management represents financials can be an indicator of questionable activities. These can include overly optimistic financial forecasts that did not materialize, incomplete investor disclosures, inaccurate data provided to financial and lending institutions and guarantors, and more. At the most basic level, forensic accountants can determine if the financial statements “make sense” given what is known or knowable about the operating history of the company.
- Directors and officers (D&O) insurance: Forensic accountants can look out for any increases in D&O insurance policies (insurance riders) leading up to the bankruptcy.
- Excessive spending: Forensic accountants should be aware of executives or key stakeholders spending excessively on company-issued corporate or personal credit cards, which may be reimbursed by the company. They can dig deeper to find out who participated and if there was a legitimate business purpose. In the case of public companies, they can examine how such expenditures were historically monitored for proxy, tax reporting and perquisite (i.e., perks) purposes.
- Intercompany and/or related party transactions: Forensic accountants can investigate whether there were any unusual or undisclosed intercompany or related party transactions or transfers prior to the bankruptcy. They will look especially for large cash or business transactions occurring within 24 months of the bankruptcy. To do this, a deep dive into a company’s bank statements and analysis of disbursement data will be needed. Forensic accountants should be on the watch for complex legal structures that may exist to hide assets, especially when there is no apparent underlying business model that requires such complexity.
- Tax returns: Forensic accountants can check to see if there are any inconsistencies between a company’s financial statements and the amounts presented on the company’s corresponding tax forms. Are they properly explained through book-to-tax adjustments or accrual versus cash method? Does anything appear to warrant further investigation?
- Asset impairments: Forensic accountants will look to see if there are any significant asset impairments, or if there should have been, before entering bankruptcy. If they are working with a public company, the forensic accountant would identify the company’s process for periodic review and assessment of financial/intangible assets for fair value and impairment purposes. In addition, a forensic accountant can help validate whether assets were fairly stated on the balance sheet, such as assets being held and reported at their appropriate fair values or at historical cost.
- Significant changes in compensation: Forensic accountants also can examine if senior leadership received a substantial increase in compensation or bonuses within the last 24 months that was not tied to business performance. Red flags also may include new or changed compensation arrangements.
During the second half of 2021 and beyond, continued COVID-19 pressures, such as variant mutations or logistical issues related to vaccine distribution, could further complicate market and company financial performances and elevate bankruptcy pressures. When disputes arise related to bankruptcy, stakeholders need as much transparency as possible into how the company was operated and managed prior to a Chapter 11 filing. To ensure there is no fraud related to a company’s bankruptcy filing and to provide the context around the events leading up to the bankruptcy, forensic accountants can play a key role in telling the story, validating the books and records of a company, and ensuring that assets were not misappropriated or hidden leading up to the bankruptcy. Insight gleaned from a forensic accountant can help a bankrupt company continue its ongoing operations, learn from past experience and successfully exit Chapter 11 proceedings.
The views expressed herein are those of the author(s) and not necessarily the views of FTI Consulting, its management, its subsidiaries, its affiliates or its other professionals.
George A. Saitta Jr. is involved in the leadership of the SEC and accounting advisory services practice of FTI Consulting in Washington, DC. Scott Perez is a director in the SEC and accounting advisory practice for FTI Consulting. Jay Spinella is a senior managing director in the SEC and accounting advisory practice for FTI Consulting.