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Sitting At The Intersection Of Business Valuation & Forensic Accounting

Posted in Business Valuation, on Feb 2018, By: Mark S. Gottlieb

The business valuation and forensic accounting disciplines often intersect when valuing a business for divorce or shareholder dispute. Controlling shareholders may try to hide assets or downplay cash flow to minimize buyouts of their spouses or minority shareholders. As valuation experts we know how to approach these situations to unearth and adjust for the common and uncommon financial misstatements.

 

Look Beyond The Financials

Financial statements and tax returns are often the first source of information to analyze when valuing a business. But it’s also important to look for public sources of information, as well as to conduct site visits and management interviews. These steps can be especially important in adversarial situations to ensure that controlling shareholders (1) aren’t hiding assets, (2) underreporting income, or (3) overstating liabilities and expenses.

Nowadays, a simple internet and/or social media search can help reveal financial misstatement. In a more traditional sense, a review of the detailed accounting general ledgers can provide valuable information.  In a recent shareholder dispute between two brothers we uncovered a fictitious foreign entity.  In this instance, payments to this entity were used by one brother to divert profits and funds from the other.  But for our analysis and inquiry to explain a sudden decrease in gross profit margins, this diversion many never had been discovered.

Aside from the traditional financial review, there are three things you, the litigation attorney, should consider:

  1. Get your financial expert involved early on.
  2. Pay attention to warning signs.
  3. Don’t be hesitant to expand the scope of the assignment, if necessary.

Here’s a closer look at these issues.

Involve Experts Early On

  • Patience and diligence are key elements to unearthing hidden assets and income. So, it’s critical to involve a financial expert during the discovery phase of the case. Even if a matter starts out amicably, the situation can quickly change as the details of the case unfold and the parties see how much money is at stake.
  • Early on, the expert can provide a comprehensive documents request. In addition, it’s often helpful for minority shareholders and spouses that don’t control the business to obtain a court order, allowing their experts to tour the facilities and interview management. If an expert is hired late in the case, he or she may be denied physical access to these resources.

Understand The Warning Signs

Controlling shareholders aren’t always dishonest. But experienced valuation experts know the warning signs that something’s awry. During site visit and management interviews, experts consider a variety of factors. This includes asking certain key questions:

  • Do company personnel seem uncooperative or reluctant to answer questions?
  • Does the interviewee seem agitated or nervous – for example, sweating profusely or avoiding eye contact?
  • Do members of the management team provide conflicting answers?
  • Does an answer to a question contradict the interviewee’s previous responses or what’s reported on the financial statements?
  • Was the valuation expert denied access to certain parts of the facilities?
  • In addition to these qualitative factors, valuation experts evaluate quantitative signals of impropriety. Benchmarking performance over time and against competitors can also help identify hidden items.
  • Experts also look for new line items that appear on the financial statements after the lawsuit is filed. Examples include loans, contingent liabilities, management fees, rent or lease expense paid to related parties, phantom employees on the payroll, and excessive professional fees, which may include the controlling shareholder’s personal legal fees.

Expand The Assignment

  • Valuation experts employ professional skepticism, but they’re not responsible for unearthing fraud unless a client specifically hires them to conduct a forensic investigation.
  • In cases where the controlling shareholder has a financial incentive to hide assets or downplay cash flow, consider expanding the scope of the engagement from the get-go to include additional forensic procedures.

What Else Should You Consider?

A company’s balance sheet tells only part of the story about a company’s financial condition. There may be other assets and liabilities that aren’t reported, such as pending litigation or regulatory inquiries, warranties, bad debts and built-in capital gains tax obligations.

These items may not necessarily be hidden because management is intentionally misrepresenting the truth. In some instances, they’re not required to be reported under U.S. Generally Accepted Accounting Principles (GAAP) – or a private company’s financial statements may not conform to GAAP.

Although unreported, these items can impact future cash flows and, therefore, the value of a business interest. If investors would consider a hidden item, it should generally be factored into a valuation expert’s analysis.

Financial statement footnotes and management interviews can help reveal these hidden items. Additionally, valuation experts who specialize in a niche tend to be familiar with what other industry participants report on their balance sheets, helping them to identify possible omissions.

For more information about hidden assets or unreported income please browse through our earlier blog posts on related topics.

For a specific concern, contact Mark S. Gottlieb by phone (see numbers above) or by email msgcpa@msgcpa.com