The Crossroads of Business Valuation and Forensic Accounting

Business valuation methods are commonly used by practitioners to assess damages in litigation, prepare for mergers and acquisitions, and properly execute estate planning.However, business valuation is not just a “back of the envelope” exercise because the financial data on the books and records may not tell the entire story.As a result, a deeper analysis is often necessary to find the explanations behind the numbers.

It is within this context that the roads of business valuation and forensic accounting intersect.

Forensic accounting has been commonly defined as the application of investigative and analytical skills for the purpose of resolving financial issues in a manner that meets standards required by courts of law.While definitions of forensic accounting commonly refer to fraud-related activity, forensic accounting is often applied in a number of business valuation cases, some that are being litigated and some that are not.This is because it is not just the calculation of numbers, but the details behind the numbers that count.Therefore, forensic accounting allows for the process to identify, explain, contradict and verify the financial data presented when valuing a business.

Valuation 101

Business valuation is the process of determining the economic value of a business. There are generally three acceptable valuation approaches: Asset, Income and Market.

Under the asset approach, a company’s value is equal to the fair market value of its assets less the fair market value of its liabilities, essentially looking at what it would cost to recreate the business.This approach often serves as a valuation floor since for many companies the present value of future cash flows generated by the assets exceeds the liquidation value of those assets.

The income approach is based on the premise that the value of a business is equal to the present value of the company’s future stream of cash flows.There are generally two methods used under this approach: the capitalization of earnings method, which is utilized when earnings are stable and projected to change at a relatively fixed rate, and the discounted cash flow method, which is utilized when earnings are not stable and are projected to change at variable annual rates.

The market approach estimates value based on recent sales of similar businesses or ownership interests which are then adjusted for difference in size, quantity or quality. In selecting these companies and transactions, consideration is given to financial condition, operating performance, business description and other factors. Pricing multiples are then calculated using financial metrics such as earnings, cash flows and revenues. These multiples are then applied to the financial metrics of the subject business to estimate the value.

Regardless of the approach(es) used, the financial records of the business are significant. But what happens when those numbers are incorrect or misleading?Or more importantly, how can you verify whether the numbers are reliable?

Normalization Adjustments

Normalization adjustments may be applied to the financial statement of a company being valued.These adjustments eliminate the effects of nonrecurring events (e.g. one-time gain on sales of assets, severance payments, legal settlements) or discretionary expenses to determine a normal level of business activities. It is these discretionary expenses that may be more difficult to determine and may involve more complicated techniques to unearth.

Common adjustments from discretionary expenses include:

• Excess owner’s compensation
• Wages for family members who do not actually work for the company
• Personal expenses such as travel and vacations recorded on the company’s books

While these adjustments may appear obvious, they are often not easy to find.This is where forensic accounting techniques come into play. Using specialized skills that may include auditing, finance, accounting, research and investigative and interviewing techniques, information can be identified that provides clarity to the numbers in the books.

For example, in one case our standard financial analysis, due diligence and research while valuing the business in a shareholder litigation matter led to questions regarding the company’s accounts payable and cash levels because the company’s ratios were not typical for the industry.Through a combination of targeted questioning and investigation, we discovered that approximately 50% of all payables to one supplier were actually going to pay off the shareholder’s gambling debts (clearly a non-business expense).

In another case while valuing the marital assets in a divorce proceeding, which included a cash-based, family-owned restaurant, we discovered unreported business income. The scope of our initial valuation work was limited to a review of the historical books and records that had been maintained by our client’s spouse, the proprietor of the restaurant.Suspicious that sales were lower than anticipated given the size and location of the business, we asked to compare the historical sales with those from a future period. We then covertly placed the restaurant under surveillance during the examination period to establish the revenue threshold by counting the number of customers entering and leaving the restaurant.Comparing the results of our surveillance to the restaurant’s books revealed that the restaurant failed to account for all of the transactions. In fact, the business actually had three cash registers: one for cash, one for credit, one for Take Out, which was a euphemism for cash into the pocket. The end result was an increased valuation of the business.

Normalization adjustments can have a significant impact on the value of a business.For example, consider that Company A and Company B (similar companies) are both sold, but Company A’s expenses are overstated by $400,000 of discretionary expenses. Under the market approach, assuming an average price-to-earnings multiple of 8.0, Company A’s valuation would be $3.2 million less than Company B’s if no normalization adjustments were made.Similarly, under the income approach, assuming a capitalization rate of 20% and a tax rate of 40%, Company A’s valuation would be $1.2 million less than Company B’s if no normalization adjustments are made.

These examples illustrate why blindly relying on financial records when the reliability of those records is in question may result in significant valuation errors. It is in these instances, where the application of business valuation and forensic accounting techniques can lead to accurate and meaningful results.