Effective Business Valuations & Forensic Accounting In Marital Disolution Matters

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In California marital dissolution cases involving business assets, efficient resolution hinges on comprehensive business valuations and forensic accounting. Key steps include detailed business valuations covering operations, financial, economic, and industry analyses, as well as forensic accounting to verify records and identify non-business or non-recurring expenses.
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Many family law matters become contentious and emotional. However, California is a community property state and each marital dissolution case has an end in sight, i.e., the division of assets.1 In contrast, other types of civil litigation are fraught with unknowns including rulings on liability and whether the court will find economic damage analyses, such as plaintiff's lost profits and defendant's disgorged profits, acceptable measures. The narrower focus in marital dissolution litigation can provide an opportunity for efficient and effective solutions. A major key to efficient resolutions in divorce proceedings involving business assets is: (1) a business valuation supported by incisive research and analysis, and (2) forensic accounting of all relevant records and systems to assist in calculating the proper revenues and profits for the valuation.

Business Valuations

To perform a business valuation, the appraiser will conduct due diligence that typically covers the following:

  1. Company operations: Review of products/services, customers, suppliers, workforce, intellectual property, and litigation/regulatory matters. The goal here is to determine how the business' processes, infrastructure, and management relate to and result in its financial performance.
  2. Financial analyses: Review of past several years company financial statements and review of any available projections, budgets, or forecasts. The determination of fair market officers' compensation. Identifying non-business perquisite expenses and/or non-recurring one-time expenses. Fair market compensation adjustments as well as non-business and non-recurring expense adjustments are usually the two major calculations to arrive at the company's profit to use in a business valuation. Additional discussion on the non-business/non-recurring expenses appears in the Forensic Accounting section below.
  3. Economic analyses: The analysis will focus on prevalent conditions in GDP, unemployment, financial market conditions, and inflation. The goal is to determine how economic conditions, both historical and forecast, impact the company's value.
  4. Industry analyses: The analysis will center on competition trends, consumer preferences, historical and projected total industry revenues, and potential disruptive technologies. The objective is to determine how industry conditions, both historical and forecast, impact the company's value.
  5. Valuation research and analyses: The appraiser will select relevant methods, determine representative revenues and profits, calculate discount and capitalization rates, and select guideline comparable business sales for valuation multiples. The valuation opinion(s) should logically follow the appraiser's analyses and conclusions associated with 1. through 4. above.

A business valuation encompassing 1. through 5. above meets all the diligence requirements in any matter including marital dissolutions, broader civil litigation, mergers and acquisitions, and estate/probate matters.2 In many California counties, it is the case that family law judicial officers frown upon the use of projected income statements and guideline comparable business sales valuation methods. However, there are circumstances warranting their consideration, including but not limited to the following:

  1. The company's industry is in an active merger and acquisitions (M&A) market and the business being valued has the infrastructure, organization, and financial performance typical of potential buy-out targets. Buyers of businesses in this industry utilize comparable business sales valuation methods and projections.
  2. The company has a history of performing annual projections and overall, for the past several years, its actual financial performance has come in close proximity to the projections.
  3. Industry, economic and/or technology conditions have changed to a degree that make reliance on historical income statements irrelevant to the valuation. The company's projections incorporate the altered conditions.

The author has been involved as an expert in matters wherein the family law judge has accepted the use of projections and comparable business sales. However, it is always prudent to play it safe and also use traditionally accepted methods, such as the historical income statement capitalization rate method. Furthermore, the appraiser's report and testimony should be clear that if the trier of fact does not accept projections or comparable business sales then the alternative expert opinion is the amount governed by the traditionally accepted method.

While many California counties only require bare bones business valuation reports, e.g., schedules without footnotes, it is very advantageous to consider more extensive narratives for any critical issues impacting the valuation conclusion. Also, as discussed in detail in the Forensic Accounting section below, presenting an executive summary that concisely and convincingly presents findings and opinions may be highly influential to the opposing spouse and the trier of fact, thereby providing an opportunity for a faster resolution of the case.

Forensic Accounting

At the outset of the family law matter, the forensic accountant should obtain company bank statements, financial statements (income statement, balance sheet, and statement of cash flows), and underlying accounting records (general ledgers, trial balances, and accounting software). Generally, these documents will cover the period of the most recent three to five historical past years.

There are several tests to make on the above documents. The overall initial analyses will be to determine if the various documents support or bring into question the accuracy of the financial statements. An example of a red flag would be if bank statement deposits or withdrawals differ substantially from income statement revenues and expenses and such difference is not the result of anything else that could cause this to be the case, e.g., a major loan paydown. Another would be constant reclassifications of assets, liabilities, revenues, and/or expenses in the general ledgers.

Testing the support for accounting records is fundamental to this process. The forensic accountant should, on a statistical examination basis, review underlying customer and vendor invoices, relevant contracts, and bank reconciliations. He should interview the bookkeeper, controller, chief financial officer, and the business' outside accounting or audit firm, typically, but not always, Certified Public Accountants (CPAs). The more red flags identified, the more testing will increase. 

Additionally, the forensic accountant's work is critical in determining non-business perquisite expenses and/or one-time non-recurring expenses. Such items are crucial to the business valuation's accuracy. From a business appraisal perspective, non-business and non-recurring expenses artificially deflate a company's profits. Non-business expenses are personal owner costs such as automobiles not used for business purposes, excessive meals and entertainment charges not for reasonable business development purposes, and having non-working relatives on the payroll. A buyer of a business can operate without such expenses and would adjust out such costs to calculate higher profits on which to value the company in making an offer price.

The same would be done with one-time non-recurring expenses. These can include temporarily outsourcing, at above market compensation rates, the retiring chief financial officer; a litigation-clean business settling a customer dispute; and environmental remediation costs permanently settling the issue at hand. Again, from a valuation perspective, the business' profits cannot be unfairly penalized for such expenses. Once more, the business' buyer would adjust out such costs to calculate higher profits on which to value the company in making an offer price.

All too often, the forensic professional's report and court presentations will fall into the trap of using the language of “accountese.” Such presentations force readers to plow through numerous documents, with myriad cross references across hundreds or thousands of pages. Of course, the forensic accountants should be supported by all these documents, but there must also be an executive summary that concisely and convincingly presents the findings.

The executive summary format cannot be a one-size-fits-all format. Rather, it should be flexibly tailored to meet the findings of each particular marital dissolution case. For instance, if the financial statements and accounting records are in excellent shape, the summary can succinctly state the records examined, the state of their accuracy and the conclusions. Much less is better in this case. On the other hand, if all the accounting is in major disarray, then the summary might incorporate flow charts, graphics, and related succinct outline narratives.

The executive summary also serves a dual process of making the forensic accountant think about the reasonableness of the opinions to outside parties such as opposing counsel, mediators, arbitrators, and judicial officers. This is very helpful in preparing for deposition, mediation, arbitration, and trial testimony.

Process

Often the duration of family law cases can span several months to a few years. It is best to keep the communication process frequent and consistent among the business appraiser/forensic accountant, client, and client's legal counsel. Recurrent status meetings should be held for the appraiser/forensic to report the status of information requested versus received and offer preliminary, or at end final, opinions. These meetings also provide meaningful dialogues for the appraiser/forensic and attorney to address issues and problems that arise through the course of the matter.

As stated at the beginning of this article, California marital dissolution cases have an end in sight, i.e., the division of assets. In matters involving ownership of a business, qualified and experienced business appraisers and forensic accountants can help pave the way to a steadier course to resolution.

Footnotes

1. In addition, divorce cases may also involve calculating spousal and child support. However, this article focuses solely on community assets.

2. The Uniform Standards of Appraisal Practice (USPAP) promulgates the due diligence presented in this article. USPAP was created by the Appraisal Foundation which oversees and governs the accreditation and ethics for business, real property, and personal property appraisers. The US Congress adopted USPAP as the national standard for appraisals.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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