Investigating your investment

Strategic partnerships can be the lifeblood of a project, injecting funds into a joint venture or a business to enable growth – and ultimately, profits. Both active operators and passive investors bring strength to projects, with the first involved in day-to-day operations, including financial reporting and accounting, and the later providing capital assets and financial backing.

But what happens when a passive investor questions how the active investors are allocating funds while managing a project or business? Perhaps dividends or distributions have decreased, or revenues have fallen but not expenses. When should you be concerned and what recourse do you have?

Red flags

Projects and businesses generally issue financial statements to their investors on a regular basis, often annually or bi-annually. Difficult to understand or overly summarized financial statements often are the first indicators of financial misconduct, as the issuer seeks to cover irregular actions. For example, an operator could be diverting revenue, paying themselves additional unwarranted compensation, have created shell vendor companies to invoice, or is expensing personal items.

Within the financial statements, a drop in net income accompanied by unexplained increases in costs, or lower revenues reported against unchanged expenses could raise concerns. Or new vendors on the list of accounts payable differ from those at the start of the partnership, and you want to check their validity.

In one case MNP forensic accountants investigated a manufacturing company, which had a passive shareholder. The active operator was found to have been expensing personal expenses through the manufacturing company’s operating expenses while reducing the profits of the company to the detriment of the passive shareholder. These personal expenses included non-business related car, travel and meals and entertainment expenses.

If you have concerns, request more detailed information from the person who controls the financial information. If they are not forthcoming to queries about the use of company funds, assets and employees, or keeps delaying a response, action should be taken as soon as possible to stem further possible fraud.

The role of a forensic accountant

As an investor, it is reasonable to want to verify that a business or project you have invested in is treating you fairly, if there are concerns about unexpected or unexplained costs. Work with your legal and accounting team to investigate if the active operator is acting fairly and using the funds appropriately.

While you can directly hire a forensic accountant to investigate, there are benefits to working with a lawyer who hires the forensic investigator. Under that scenario, information the forensic accountant discovers may be covered by law under solicitor-client privilege. This may help protect the communication between client and lawyer, and some of the preliminary work analysis of the forensic accountant.

Once the forensic accountant is brought on board, they review the financial information, analyse it, see if it is complete and if anything is missing. They also determine if the source documentation that’s being presented with the financial statements makes sense when put into context with the project or business operations.

They will report on the findings and can serve as an expert witness in court to present them.

What you can do

Prior to entering a partnership, business, or project as a passive investor, ensure there is a clause in your agreement that grants you more access to financial records and information than the limited reporting you receive on a periodic basis, like an annual financial statement. This will enable you to go in and check everything they’re telling you seems above board.

It is important to get involved as soon as there is a concern. By investigating early, you can work with your lawyer and forensic accountant to attempt to obtain a Mareva Injunction and potentially freeze accounts to help stem alleged fraud or further loss of funds.

Sometimes, the forensic accountant does not find anything untoward, and can clarify seeming discrepancies with the data they uncover and provide an investor with peace of mind. However, if irregularities are found, a report prepared by an experienced forensic investigator provides legal counsel with more support.