What is a Forensic Reconstruction, Why Would You Need One, and How Can You Avoid One?
If you own a business and your financial records don’t add up, you may need a financial records reconstruction. What exactly is a records reconstruction?
Think of all of your business transactions as pieces of a very large puzzle. To have a clear picture of your business you have to connect the pieces correctly. Transactions must be logically characterized and accurately recorded, errors must be discovered and corrected, accounts must be reconciled, balances balanced, and transfers matched. If your transactions are not properly accounted, you simply will not know how your business is performing, whether your tax filings are correct, or whether your strategic financial assumptions can be relied upon.
As with many puzzles, you may discover pieces are missing--unrecorded transactions that could significantly affect the accuracy and usefulness of your financial reports. You may discover that your bookkeeper hammered a transaction into an account where it doesn’t belong, much as your younger brother did with your Star Trek Christmas gift puzzle years ago. And while mom may have fixed that mess, don’t think for a second that the IRS will be so helpful when it flags your tax returns because your deductions resemble the exponential mathematics of tribbles.
The puzzle can be enormous. Do the math: A monthly financial statement can contain, say, 50 transactions. One archive box holds approximately 2300 pages. This means that an archive box filled with financial statements could contain 115,000 transactions. In our experience, even a modest business can fill 10 archive boxes in only a few years. That’s over one million transactions. Even if your business transactions are only a fraction of this number, you can quickly see how difficult it would be to solve a puzzle with thousands of jumbled or missing pieces.
A reconstruction, then, is a process by which your accounting data is checked to ensure that it accurately and completely reflects your business transactional activity.
Many business owners have been led to believe that QuickBooks and other business accounting software will rectify the myriad accounting mistakes that contribute to a need for a reconstruction. Not true. In the hands of a competent user, these programs certainly make accounting tasks and report generation considerably easier and more flexible. The relevant keyword, in case you missed it, is ‘competent’. Intuit, the maker of QuickBooks, touts the program as easy, automatic and simple. For a knowledgeable and experienced QuickBooks user, the program can indeed simplify otherwise complex and tedious accounting functions, and make the accounting process more efficient. Unfortunately, QuickBooks can't make up for a user who doesn't understand essential bookkeeping and accounting concepts.
And then there is the GIGO principle: Garbage in, garbage out. If your accounting staff mischaracterizes an expense, omits key transactions, wrongly postpones recognizing revenue, or among the thousands of other potential mistakes simply doesn’t set the program’s preferences correctly, it’s a steaming plate of GIGO for you. Considering the deceptively steep learning curve for these programs combined with many business owners’ lamentable hands-off approach to bookkeeping and accounting tasks, there is really no mystery why so many businesses end up facing a forensic reconstruction.
The typical reconstruction scenario goes something like this: the business owner, whether through benign neglect, active mismanagement, or by innocently relying on an incompetent or dishonest bookkeeper, allows his books to slip into a state of confusion. This continues until an event forces the owner to produce a set of reliable financial records. Tax deadlines, loan applications, disaster recovery, and acquisitions and mergers are common examples of an event necessitating the production of accurate financials. Under pressure, the business owner takes his records to his tax CPA who he expects will sort everything out.
This is where things get interesting. Most CPAs and tax preparers do not reconstruct books! Reconstructions are time consuming and laborious. Reconstructions can be extraordinarily complex. During one of our previous reconstruction engagements we combed through records stored in a fire damaged storage unit. When fraud is suspected, reconstructions often trigger obstructionist and openly hostile responses from accounting staff. Conducting an on-site reconstruction in an adversarial work environment creates special challenges that most CPAs understandably avoid.
What can you as a business owner do? Obviously, the best course of action is to make sure that your books never fall into such disrepair that a reconstruction would be necessary. Sometimes that’s easier said than done, especially if records have been destroyed or if fraud is suspected. Still, you can help yourself tremendously by hiring and actively supervising competent accounting staff, learning bookkeeping concepts, and reviewing frequent and meaningful financial reports. Many business owners will hire an independent bookkeeping or CPA firm to inspect their financial records annually. Depending on what is being examined and the level of scrutiny, this has the effect of double-checking the accuracy of the business’ records while also deterring fraud.
If a reconstruction is necessary, you can reduce its cost by making a habit of retaining primary source documents—the actual receipts, invoices, expense statements, for example. One of our clients memorialized business expenses on the backs of cocktail napkins. Hey, it works. Backing up electronic data files should be a no-brainer. With QuickBooks, your accounting staff should regularly create a backup file and save it to a drive secure from potential damage and theft. Investigating lost documents and omitted transactions or corrupted data files takes time, which increases the cost of the reconstruction. And speaking of cost, let’s be honest, reconstructions can be expensive depending on the circumstances. We've yet to meet a business owner who takes as much pleasure writing a check for a reconstruction as he might for a business trip to Europe.
This raises an interesting point about priorities and false savings. With accounting staff, price doesn’t necessarily correspond to competency and honesty. Most business owners are surprised to learn that anyone can market himself as a bookkeeper. Other than a basic business license, independent bookkeepers are not required to possess any academic or professional credentials, or undergo mandated criminal background checks. Since bookkeepers range from $15 to over $100 per hour, a business owner would do well to thoroughly examine a prospective bookkeeper’s experience and pay for a criminal background and credit check. It makes no sense to scrimp on a background check if the bookkeeper ultimately triggers a $20,000 reconstruction.