How to Spot Fake Financial Records

"The numbers looked great. Turns out, they were completely fabricated."

Financial fraud in business sales is more common than you think. Sellers don't usually create fake documents from scratch—they manipulate real ones just enough to make the business look better than it is.

Here's how to spot the red flags and verify the numbers are real.

## Why Sellers Fake Financial Records

**The motivation is simple: more money.**

A business selling for 3x EBITDA:
- Real EBITDA: $100,000 → Sale price: $300,000
- Inflated EBITDA: $150,000 → Sale price: $450,000

That's a $150,000 incentive to "enhance" the numbers.

## Most Common Types of Financial Fraud

### 1. Revenue Inflation
**How they do it:**
- Recording revenue before it's earned
- Creating fake customer invoices
- Shipping product without orders (channel stuffing)
- Related party transactions at inflated prices

**How to catch it:**
- Compare sales to tax returns (can't lie to IRS)
- Verify bank deposits match reported revenue
- Call major customers to confirm orders
- Check inventory turns (if selling product)
- Review credit card processing statements

### 2. Expense Reduction
**How they do it:**
- Not recording expenses
- Capitalizing expenses that should be expensed
- Personal expenses run through business (claiming they're "add-backs")
- Hiding payroll in subcontractors
- Deferring maintenance and repairs

**How to catch it:**
- Compare expense categories year-over-year
- Check for unusually low expenses vs. industry norms
- Verify all "add-backs" are truly personal
- Review vendor invoices and payments
- Inspect equipment condition

### 3. EBITDA Manipulation
**How they do it:**
- Adding back legitimate business expenses
- Overstating owner compensation
- Hiding true compensation levels
- Not including all owner benefits
- Excluding "one-time" expenses that actually recur

**How to catch it:**
- Recalculate EBITDA yourself from tax returns
- Verify all add-backs are truly discretionary
- Check if "one-time" expenses happen annually
- Calculate true owner compensation (salary + benefits + perks)
- Compare to industry compensation benchmarks

### 4. Asset Overvaluation
**How they do it:**
- Inflating inventory values
- Overstating AR collectibility
- Not writing off obsolete inventory
- Including worthless assets
- Inflating equipment values

**How to catch it:**
- Physical inventory count
- Age analysis of AR and inventory
- Compare asset values to tax return depreciation
- Get independent equipment appraisals
- Review collectibility of old AR

## Red Flags That Scream "Investigation Needed"

### Document Red Flags

**QuickBooks Issues:**
- Recently created QuickBooks file
- Few historical transactions
- Round numbers (real accounting has decimals)
- Clean, perfect entries (real books have corrections)
- File created after business was listed for sale

**Financial Statement Issues:**
- Not prepared by CPA
- Numbers don't foot (don't add up correctly)
- Inconsistencies between different statements
- Different numbers on different versions
- Handwritten alterations

**Tax Return Issues:**
- Won't provide tax returns
- Returns not signed
- Returns don't match bank statements
- Returns show losses but claiming business is profitable
- Major differences between P&L and tax return

### Reconciliation Red Flags

**When numbers don't match:**
- QuickBooks ≠ Tax returns
- Tax returns ≠ Bank statements
- Bank deposits ≠ Reported revenue
- Checks written ≠ Reported expenses
- P&L ≠ Balance sheet changes

**If seller says:** "My accountant made mistakes" or "I keep two sets of books" — WALK AWAY.

### Behavioral Red Flags

**Seller is evasive about:**
- Providing source documents
- Introducing you to accountant
- Letting you talk to customers
- Bank account access
- Credit card statements

**Seller says:**
- "I run a lot of cash through the business" (tax fraud)
- "The books don't show the real profit" (fraud)
- "Trust me, it makes more than it shows" (fraud)
- "My accountant screwed up the returns" (excuse for manipulation)

## Forensic Accounting Techniques

### 1. Revenue Verification

**Bank Deposit Test:**
- Get 12 months of bank statements
- Total all deposits
- Remove owner contributions and loans
- Compare to reported revenue
- Investigate major discrepancies

**Customer Verification:**
- Call top 10 customers
- Confirm: recent purchases, payment terms, ongoing relationship
- Ask about any disputes or quality issues
- Verify they plan to continue

**Credit Card Processing:**
- Review merchant statements
- Total deposits
- Compare to reported revenue
- Look for refund patterns

### 2. Expense Verification

**Vendor Verification:**
- Call major vendors
- Confirm: typical order sizes, payment history, outstanding balances
- Ask about owner's payment reliability
- Verify business is current on payments

**Payroll Verification:**
- Get payroll reports
- Verify with payroll company if outsourced
- Check payroll tax filings
- Compare to reported salaries
- Look for unreported employees

**Lease Verification:**
- Get lease agreement
- Verify rent amount
- Check for personal guarantees
- Confirm lease term remaining
- Look for pending increases

### 3. Asset Verification

**Inventory Count:**
- Physical count of all inventory
- Compare to reported amounts
- Check for obsolete items
- Review inventory aging
- Verify valuation method

**AR Verification:**
- Age analysis of all receivables
- Call customers with large balances
- Review collection history
- Verify balances are legitimate
- Check for related party AR

**Fixed Asset Review:**
- Physical inspection of equipment
- Compare to depreciation schedule
- Get independent appraisals
- Check for missing items
- Verify ownership (titled, leased, financed)

## Advanced Detection Methods

### Benford's Law Analysis
Real financial data follows mathematical patterns. Fraudulent data often doesn't.

**First digit frequency in legitimate data:**
- 1: ~30%
- 2: ~18%
- 3: ~12%
- ...
- 9: ~5%

**How to use it:**
- Extract all transaction amounts from QuickBooks
- Analyze first digit frequency
- Significant deviation suggests manipulation
- Not definitive proof, but a red flag

### Ratio Analysis

**Compare these ratios to:**
- Prior years
- Industry benchmarks
- Seller's claims

**Key Ratios:**
- Gross margin (should be stable year-to-year)
- Operating expense % (shouldn't change dramatically)
- Inventory turnover (matches industry norm?)
- AR days outstanding (reasonable collection period?)
- Revenue per employee (compared to industry)

**Red flags:**
- Sudden improvements in margins
- Expenses as % of revenue dropping significantly
- Ratios significantly better than industry average
- Ratios inconsistent with business description

### Pattern Analysis

**Look for:**
- Seasonality that makes sense for the business
- Customer concentration that's explained
- Expense patterns that match business cycles
- Growth that's explained by business changes

**Red flags:**
- No seasonality when there should be
- Random revenue spikes
- Flat expenses when revenue growing
- Dramatic changes with no explanation

## How to Protect Yourself

### Due Diligence Steps

**1. Multiple Document Sources**
✅ Tax returns (3 years minimum)
✅ Bank statements (12+ months)
✅ Credit card statements (12+ months)
✅ QuickBooks file (full history)
✅ Accounts payable
✅ Accounts receivable
✅ Payroll records
✅ Merchant processing statements

**2. Independent Verification**
✅ Call major customers
✅ Call major vendors
✅ Verify with landlord
✅ Check with payroll company
✅ Confirm with bank
✅ Talk to accountant directly

**3. Professional Help**
✅ Hire forensic accountant for:
- Businesses over $500K
- Complex financial structures
- Suspected fraud
- High-risk situations

**4. Reconciliation Requirements**
✅ All sources must reconcile
✅ Explainable differences only
✅ No "trust me" gaps
✅ Documentation for everything

### Purchase Agreement Protections

**Include these:**
- Detailed representations about financial accuracy
- Right to walk away if statements are materially false
- Seller escrow (hold back portion of purchase price)
- Earn-out based on actual future performance
- Indemnification for undisclosed liabilities
- Specific fraud remedies

**Typical holdback: 10-20% of purchase price for 12-24 months**

## When to Walk Away

### Definite Walk-Away Signals:

❌ **Won't provide tax returns** → They're hiding something
❌ **Numbers don't reconcile** → Financial records are unreliable
❌ **Catches seller in lies** → Everything is now suspect
❌ **Recently created QuickBooks** → Likely fabricated
❌ **Won't let you verify with customers** → Red flag
❌ **Admits to running cash** → Tax fraud
❌ **Different numbers on different documents** → Manipulation
❌ **Bank deposits don't match revenue** → Serious problem

### Proceed with Caution Signals:

⚠️ **Minor discrepancies with explanations** → Verify thoroughly
⚠️ **Sloppy bookkeeping** → Hire accountant to clean up
⚠️ **Some missing documentation** → Recreate from other sources
⚠️ **Legitimate add-backs** → Verify and adjust price accordingly

## Real Case Examples

### Case 1: The Inflated Revenue
**What happened:** Seller showed $500K revenue. Bank deposits only $350K.
**Explanation:** "Lots of cash sales not deposited."
**Reality:** That's tax fraud. If he's lying to IRS, he's lying to you.
**Outcome:** Buyer walked away.

### Case 2: The Channel Stuffing
**What happened:** Q4 revenue was 40% of annual sales.
**Investigation:** Called customers. Most orders were "trial orders" with right to return.
**Reality:** Seller shipped inventory to inflate Q4, knowing it would return in Q1.
**Outcome:** Buyer renegotiated price down significantly.

### Case 3: The Missing Expenses
**What happened:** Seller showed 60% gross margin (industry average: 35%).
**Investigation:** Verified all COGS were included. Found $50K in "consulting fees."
**Reality:** "Consulting fees" were actually COGS that seller miscategorized.
**Outcome:** True gross margin was 38%. Deal repriced.

## Your Verification Checklist

**Before closing, verify:**

✅ **Revenue:**
- Bank deposits match revenue ± 5%
- Customer confirmations received
- No unusual Q4 spike
- Merchant statements reconcile
- All cash claimed is reasonable

✅ **Expenses:**
- Major vendors confirmed
- Payroll verified
- Rent confirmed with landlord
- Utilities seem reasonable
- No obviously missing expenses

✅ **Assets:**
- Physical inventory counted
- AR aging shows collectible balances
- Equipment exists and functions
- Titles/ownership verified
- Values are reasonable

✅ **Liabilities:**
- All debts disclosed
- No hidden liabilities
- AP matches vendor confirmations
- Payroll taxes current
- No threatened lawsuits

## The Bottom Line

**Financial fraud happens. Protect yourself:**

✅ Get multiple document sources
✅ Verify everything independently
✅ Don't accept explanations without proof
✅ Hire professionals when needed
✅ Walk away if it doesn't feel right

**Remember:**
- If numbers seem too good to be true, they probably are
- Verify, verify, verify
- Every number should have a source document
- Bank statements don't lie
- Trust your instincts

**The cost of verification is tiny compared to the cost of buying a business built on fake numbers.**

Want help? Our Financial Analysis Template includes reconciliation checklists and ratio analysis tools to help you verify the numbers are real.