Business Valuation and Forensic Accounting

AuthorHouse

Contents

Dedication......................................................................vIntroduction....................................................................ixChapter ONE Fundamentals Of Valuing A Business.................................1Standards.......................................................................1Credentials.....................................................................6Defining the task...............................................................7Research........................................................................11Approaches and methods..........................................................13Discounts and Premiums..........................................................16A Valuation is not an audit.....................................................17Chapter TWO Valuation Cases In The Hawaii Courts...............................21Personal Goodwill Is Not A Marital Asset........................................22Chapter THREE Fundamentals Of Forensic Accounting..............................27Standards.......................................................................28Credentials.....................................................................28Accounting for the non-accountant...............................................30Income Statement................................................................38Statement of Changes in Owner's Equity..........................................39Balance Sheet...................................................................40Frequently seen red flags in financial disputes.................................41Defining the task...............................................................43Techniques......................................................................44Finding hidden assets...........................................................47Appendix Hawaii Case Law in re Valuation Antolik v Harvey,.....................51Appendix Types of Misappropriation Schemes.....................................65Appendix Business Valuation References.........................................83Appendix Forensic Accounting References........................................85Appendix Valuation Terminology.................................................87Appendix Basic Accounting Terminology..........................................105About The Authors...............................................................121

Chapter One

This chapter very briefly describes business valuation, which is also called business appraisal. More in depth discussions of the topic are available in a variety of sources, including Valuing a Business by Shannon Pratt et al and Understanding Business Valuation by Gary Trugman. There are also business valuation texts directed at specific readers, such as The Lawyer's Business Valuation Handbook, which is published by the American Bar Association for attorneys. Our goal here is to open the door, providing you with an introductory look.

Standards

Prior to the 1920's, business valuation was more an art than a science. Buyers and sellers used their experience, wits, knowledge and best judgment to estimate the value of a business interest. It's likely that no one trading stocks back then would have agreed with that statement. Modern day appraisers, however, have a wide array of tools available that were not available in the past. Among those tools are standards that provide a structure for conducting a business valuation study.

The U.S. Prohibition Act, believe it or not, was the catalyst for the first formal set of standards for developing an opinion of value for a business. The economic losses resulting from the sudden demise of the liquor industry in 1919 were tax deductible. Intent, it appears, on fostering reliable valuations, the Internal Revenue Service began publishing guidance on valuing the lost businesses. The first such guidance was Appeals and Revenue Memorandum No. 34, which is usually referred to as ARM 34. This publication in 1920 was only the beginning of many IRS rulings, IRS orders and Court opinions about valuing businesses. Revenue Rulings 59-60 and 68-690, for instance, address the research required in a business valuation and are often cited in business valuation reports in words more or less like the following:

1. Analyze the characteristics and history of the subject enterprise and the subject interest, including: past transactions; the size of the subject interest relative to the total ownership interest, other rights and obligations, and any agreements restricting transferability or otherwise affecting value and marketability.

2. Analyze the financial condition and operating results, including: historical operating results; earnings capacity; distributions paid historically and distribution-paying capacity; balance sheets, historical and as of the Valuation Date; assets, liabilities, and book value; the liquidation value of the subject interest's assets; and the outlook as of the Valuation Date.

3. Consider the economic outlook in general and the condition and outlook of the relevant industry in particular.

4. Review the history and management of the subject interest, the nature of the business, factors affecting the business, whether or not the enterprise has goodwill or other intangible value, and its prospects for the future.

5. Review published market data and other available public information relating to the Company and its industry, including: relevant historical trends; current performance indicators; and the outlook as of the Valuation Date for the economy and capital markets.

6. Review other relevant factors.

Over the years, as business appraisers began to form professional societies and associations, they adopted their own standards for developing and reporting on an opinion of value. Each of the several societies, institutes and associations that serve business appraisers requires its members to follow their respective professional standards and ethics codes, which include requirements that the appraiser be objective and independent of their client. For example, the American Institute of Certified Public Accountants' Statement on Standards for Valuation Services includes the following about independence and objectivity:

The AICPA Code of Professional Conduct requires objectivity in the performance of all professional services, including valuation engagements. Objectivity is a state of mind. The principle of objectivity imposes the obligation to be impartial, intellectually honest, disinterested, and free from conflicts of interest. If necessary, where a potential conflict of interest may exist, a valuation appraiser should make the disclosures and obtain consent as required under Interpretation No. 102-2, "Conflicts of Interest," under Rule 102, Integrity and Objectivity (AICPA, Professional Standards, vol. 2, ET sec. 102.03).

If valuation services are performed for a client for which the valuation appraiser or valuation appraiser's firm also performs an attest engagement (defined by Rule 101 of the AICPA Code of Professional Conduct), the valuation appraiser should meet the requirements of Interpretation No. 101-3, "Performance of Nonattest Services," under Rule 101, Independence (AICPA, Professional Standards, vol. 2, ET sec. 101.05), so as not to impair the member's independence with respect to the client.

Some business appraisers are also required to follow the Uniform Standards of Professional Appraisal practice. The Uniform Standards of Professional Appraisal Practice ("USPAP") were developed in reaction to the 1980's Savings & Loan crisis, and the related unhappiness with some real estate appraisals. Several major appraisal societies, most of them involved in real estate appraisal, formed The Appraisal Foundation to promote professionalism in valuation. In early 1989, The Appraisal Foundation adopted USPAP, which includes standards for developing and reporting on the appraisal of business interests as well as real estate and personal property. USPAP also includes standards for reviewing another appraiser's work.

The Appraisal Foundation does not have enforcement powers. These are left to the professional societies that require their members to follow USPAP. Among those professional groups is the American Society of Appraisers, a multi-disciplinary society that includes business appraisers.

Credentials

There are several credentials available to qualified business appraisers. We will introduce the major designations in the order they first appeared on the scene.

The American Society of Appraisers, founded in 1936, is a multi-disciplinary society that awards the Accredited Senior Appraiser and the Accredited Member designations to appraisers of closely-held and publicly-traded business interests. Among other things, a candidate for the ASA or the AM designations must pass qualifying examinations, submit an example of their appraisal work to an anonymous review board for approval, and have a minimum amount of experience: two years for the AM and five years for the ASA.

The Institute of Chartered Financial Appraisers first awarded the Chartered Financial Appraiser designation in 1963 to qualifying appraisers in the finance and investment professions. Candidates for the CFA designation must, among other things, pass three qualifying examinations and have four years of appropriate work experience.

The Institute of Business Appraisers was founded in 1978 as a for-profit entity to serve appraisers of closely-held businesses. The IBA awards several designations, including Certified Business Appraiser, to qualifying candidates. Among other things, a candidate for the CBA designation must pass qualifying examinations and submit two examples of their appraisal work to an anonymous review board for approval.

The National Association of Certified Valuation Analysts was formed in the early 1990's as a for-profit entity to serve appraisers of closely-held businesses. NACVA awards several Designations, including Certified Valuation Analyst, to qualifying candidates. Among other things, a candidate for the CVA designation must have been a licensed Certified Public Accountant for at least two years, pass a qualifying examination and submit an example of their appraisal work to an anonymous review board for approval.

Shortly after 2000, the American Institute of Certified Public Accountants created the Accredited in Business Valuation designation to enhance the quality of business valuation services provided by CPAs. Candidates for the ABV must have a valid CPA license, belong to the AICPA, pass the qualifying examination, attest to obtaining 75 hours of appropriate education and attest to completing either 150 hours of education or six business valuation assignments.

Defining the task

All business valuations are alike, but no valuation is exactly like another. Each business, of course, has its own personality. Even among businesses that are outwardly similar, variations in their operations can be dramatic. This greatly affects how an appraiser conducts a valuation study. In addition, the purpose of the valuation will determine which definition of value is appropriate as well as which valuation approaches are best in the circumstances.

When a potential client contacts an appraiser, the appraiser will need to learn a number of things before they can determine how best to help. A specific description of the business interest to be valued and a general description of the business itself are obviously required. For example: a 100 share block of the 10,000 outstanding common shares of Heavy Lifting Construction, Inc.

It's also critical to know the purpose of the appraisal. Different purposes require different definitions of value, which we will explain later.

The appraiser will want to know what portion of the ownership must be valued. Is it 100%? Is it 1%? Is it something in between? An owner of a small interest in a business usually cannot control its operations or, for instance, decide to sell its assets. This can cause a small ownership interest to be worth far less than its pro-rata share of the total value of that business. Valuing a small ownership interest usually also involves additional work.

Choosing the correct valuation date is also important because business appraisers are precluded from considering information that was not known or knowable on the valuation date.

Standards of value—The most widely employed standard of value in matters involving the courts or the tax authorities is Fair Market Value. In very simple terms, Fair Market Value can be defined as the price a willing buyer would pay and a willing seller would accept for a property where both parties are informed about the property and neither is being coerced. (See the Valuation Terminology in the appendices for a detailed definition.)

A valuation study for the purposes of a divorce will most likely be conducted using a version of fair market value, the definition of value called for by the courts. The Hawaii Intermediate Court of Appeals' decision that has adapted the basic Fair Market Value definition for divorce purposes, which may only be relevant in Hawaii, is summarized in the valuation case law chapter of this book.

A business valuation in connection with a purchase or a sale of a business interest would also likely be conducted using the Fair Market Value definition unless an agreement among the stockholders requires a variation of that definition.

Fair Market Value is also the standard of value for matters that involve alleged stockholder oppression in Hawaii. To our knowledge, Hawaii has not adopted another standard of value for this purpose either through statutes or case law.

In other states, Fair Market Value has been amended in one way or another, usually by the courts, for use in matters where there is a claim of stockholder oppression. The amended definition is usually referred to as Fair Value. It is defined by state law and generally is meant not to penalize a non-controlling shareholder for taking action. In many cases, this is accomplished by valuing minority shares as if they were controlling shares.

Many business owners find that a valuation study using the Fair Market Value definition results in a lower value than they had expected. Several things can explain this. The Fair Market Value definition contemplates a market comprised of many potential buyers of the business. Since closely-held businesses are not listed on stock markets, an appraiser using the Fair market Value definition almost always adjusts the preliminary indication of value to reflect the difficulty involved in actually selling the closely-held business. This adjustment is called either the Discount for Lack of Marketability or the Discount for Illiquidity.

Using the Fair Market Value definition can also result in a lower than expected value because a business owner who manages their business usually knows it better than a prospective buyer, which puts them in the best position to optimize its profitability. Valuation appraisers use the term Investment Value to describe the value perceived by a specific investor.

Premise of values—There are several premises of value, each of which ordinarily is informed by the prospects of the business being valued. A business that is expected to continue its operations into the foreseeable future would be valued under the going concern premise of value. A business that is not expected to continue its operations would be valued under the orderly liquidation premise of value or, if circumstances were dire, under the immediate liquidation premise of value.

Research

Many factors potentially impact the assessment of the value of a business. The appraiser will need to conduct research into the:

• Nature and history of the enterprise

• Condition and outlook for the economy and the specific industry

• Ability of the enterprise to continue as a going concern

• Book value of the stock and financial condition of the enterprise

• Ability of the enterprise to make distributions to owners

• Whether or not the enterprise has goodwill or other intangible value

• Sales of the stock and the size of the block of stock to be valued

• Market price of stocks of enterprises engaged in same or similar lines of business

• Dependence on customers and/or suppliers

• Effects of competition

• Contingencies

The appraisal appraiser gathers data from a variety of sources, including economic and industry reports prepared by governmental and private-industry appraisers; industry sources; the enterprise's records; and interviews with the business's ownership, management, and consultants.

In addition to interviews with relevant parties and a site visit, an appraiser will consider, as appropriate, such things as:

• articles of incorporation;

• partnership or shareholder agreements;

• buy / sell agreements;

• corporate by laws;

• corporate or partnership minutes;

• key person insurance agreements;

• any prior valuation reports;

• historical income statements and balance sheets;

• income and general excise tax returns and related records;

• accounting and financial records;

• salary and benefits data for shareholders and key persons;

• retirement plan documents;

• business projections or forecasts;

• contracts with major suppliers;

• leases;

• employment contracts;

• collective bargaining agreements;

• advertising collateral and web site data;

• debt instruments; and

• fixed asset listings and property records.

Approaches and methods

The fundamental premise on which all investment decisions are based is that value to a potential investor is equal to the present worth of future benefits. This basic concept can be applied to the valuation of an entire company, as well as to the respective securities that comprise the capital structure of a business. In each instance, it is a matter of identifying the future returns that the business can be reasonably expected to generate and determining their present value in the context of the uncertainty associated with realizing these returns.

The three general approaches to valuing a business are the Income Approach; the Market (Guideline Company)Approach; and the Asset-Based Approach. Each approach is accomplished via the application of a variety of methods, each of which can be more or less appropriate depending on the circumstances.

Other methods, which are either a mix of the three general approaches or informal `rules of thumb,' are sometimes widely used in a particular industry. They can be considered, but generally should only be used as a reasonableness test of the valuation appraiser's conclusion.

Income approaches involve estimating the present worth of a business, business ownership interest, a security, or an intangible asset by discounting the future expected benefits by a rate of return that is comparable to investments in the market with similar characteristics and risks. Methods of applying the Income Approach include:

• capitalized net cash flows or earnings;

• discounted cash flows or earnings;

• and capitalization of gross cash flows.

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Excerpted from Business Valuation and Forensic Accountingby John Candon Kimo Todd Duane Seabolt Copyright © 2012 by John Candon, Kimo Todd, Duane Seabolt. Excerpted by permission of AuthorHouse. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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