The Legal Intelligencer Blog

Making Sense of Life Insurance Carrier Ratings

By David B. Bruckman and David Pilaitis
Special to the Legal

Business owners looking for life insurance coverage face myriad factors to consider. We often review the financial strength of life insurance companies where our clients own policies or are contemplating applying for insurance. Ratings also may be relevant if a client has an existing contract that is sold to or otherwise acquired by a new carrier.

Most folks know the names of some of the major ratings agencies, such as Moody’s or Fitch. We, however, generally focus on a carrier’s Comdex score.

The Comdex is a composite index based on the ratings received by an insurance company from the individual ratings agencies. It is expressed as the average percentile ranking for all of the ratings received by an insurance carrier. The Comdex score is not, in and of itself, a rating, but is rather an independent scale to compare companies, with a score of 100 being the best.

We focus on the Comdex because individual ratings can be complicated. Rating agencies do not use a universal scale, because each tries to differentiate itself. That makes it hard for a consumer to compare apples to apples. For example, an A-plus rating from one service will mean something quite different than an A-plus from another service.

See, for example, a report for a representative carrier, which sets forth the following ratings and Comdex scores:

• A.M. Best Company (Best's Rating, 15 ratings) A-plus
• Standard & Poor's (Financial Strength, 20 ratings) AA-minus
• Moody's (Financial Strength, 21 ratings) A1
• Fitch Ratings (Financial Strength, 21 ratings) A-plus
• Comdex Ranking (Percentile in Rated Companies) 91

We generally recommend carriers with a Comdex of 90 or higher. That said, there may be valid reasons to use a carrier with a lower Comdex rating. Such reasons include getting an underwriting concession, or the need or desire for a specific product not offered by a carrier with stronger ratings.

If you own a policy that is sold to or acquired by a new carrier, you should research the new carrier’s strength. Usually, it will not make sense to seek out new insurance, especially if it is permanent coverage, even if the Comdex of the new carrier is lower than normally desired.

David B. Bruckman is managing director of Citrin Cooperman Wealth Management, a registered investment advisory group that provides personal financial planning, investment management and insurance design and brokerage. He can be reached at [email protected].

 

 

David Pilaitis is a director and chief compliance officer with the firm. A certified financial planner, he provides comprehensive financial planning and investment advisory services to the firm’s clients, including high-net-worth individuals, corporate executives, trusts and small pension plans. He can be reached at [email protected].

Sticky Fingers: Minimizing Expense Report Fraud

By B.J. Hoffman
Special to the Legal

As outlined in a recent study by the Association of Certified Fraud Examiners, businesses typically lose 5 percent of annual revenues to fraud, waste and abuse. Fraud comes in many shapes and sizes, ranging from fictitious vendor schemes to “ghost” employees and inventory that perpetually falls off the back of company trucks.

Perhaps the most common schemes, though, are the smallish, “drip…drip...drip” losses from inflated employee expense reimbursements. Though the individual dollar amounts of these abuses tend to be low, often the losses are widespread within a company and occur over extended time periods. Accordingly, company losses grow to material levels.

Expense reimbursement schemes can be grouped into several categories:

• Personal expenses mischaracterized as business-related: Examples include personal lunches that are mischaracterized as business-related, or auto reimbursements for personal trips.
• Fictitious expenses: Reimbursement for expenditures that are never made by the employee. For instance, an employee who has access to a stack of blank toll receipts, or who writes a personal check for a business expense, later voids the check, and submits a photocopy of the original check to the employer for reimbursement.
• Overstated expenses: Legitimate business expenses incurred by an employee are overstated by altering supporting documentation. Also possible is inflation of expenses, where an employee is able to submit receipts for one level of travel, but where actual travel is at a less expensive rate (the classic example is reimbursement for business class airfare, while actually flying coach).
• Multiple reimbursements for the same expense: The employee is reimbursed more than once for a single business expense. An employee who is reimbursed for airfare based on a booked itinerary report, and then requests reimbursement based upon a credit card charge statement. Employee expense reports receive less scrutiny from employers, as amounts are often low. Also, employers want to trust employees, and don’t ordinarily want to disrupt workplace culture by imposing police-state-like rules. However, this trust is what allows for losses to accumulate.

Employers and auditors should be on the lookout for several indicators of potential expense reimbursement schemes, including:

• Expense reports that lack supporting documentation or which ordinarily are not subject to any review.
• Employee reimbursements that exceed annually budgeted amounts.
• Supporting expense documentation that is composed of photocopies, rather than original invoices.
• Submission for reimbursement of dated/old expenses.
• Reimbursement requests for “cash” expenses.
• Multiple expenses in the same or similar dollar denominations, or for rounded dollar amounts, or for total amounts that fall just shy of a predetermined threshold for further employer review.

Of course, it is preferable to devote resources to discouraging employees from attempting to falsify expense reports, rather than trying to ferret out individual fictitious expenses. Accordingly, policies should be developed and communicated to employees that outline acceptable expense reimbursement procedures, such as:

• Requiring detailed descriptions on expense reports, including the expense’s time, date, individuals involved and purpose.
• Mandating that original supporting invoices (not copies) be attached to the report.
• Outlining limitations on elapsed time under which an expense will be reimbursed (i.e. monthly).
• Listing specific types of reimbursements that are (or are not) reimbursable, and at what rates.

All expense reports should be first reviewed by the employee’s direct supervisor, as he or she has a deep understanding of the employee’s daily activities and would be the most knowledgeable party in determining whether an expense is reasonable.

Development and adoption of clear policies and procedures regarding employee expense reports will serve to limit losses to fraud, waste and abuse, and such savings can be highly material over time.

B.J. Hoffman is a certified public accountant and certified fraud examiner for Citrin Cooperman, an accounting, tax and business consulting firm. A partner in the Philadelphia office, he provides clients with a mix of audit, tax and litigation support services. He often works with closely held entities in a variety of industries, including professional service firms and real estate enterprises. He can be reached at [email protected] or 215-545-4800.

Business Valuations for Gifting

By Terry Silver
Special to the Legal

The Internal Revenue Code allows an individual making a gift (referred to as a donor) to utilize a lifetime gift tax exclusion. Owners of businesses often wish to pass assets via gifting to children and grandchildren. This is partially or totally accomplished by the use of an individual’s lifetime allowable gift exemption, currently set at $5.25 million (indexed for inflation annually). For indirect or direct skips to grandchildren, a donor also may want to allocate the current available lifetime exemption for generation-skipping tax, also currently $5.25 million (indexed for inflation). For a more detailed description of gift taxation, consult your tax adviser.

A business owner may take advantage of the lifetime gift tax exemption by gifting an interest in his or her closely held business enterprise to a family member. Typically, if a minority, nonmarketable interest of a business is gifted, valuation discounts can be computed, which will increase the amount being gifted from generation to generation. This often can be accomplished while still avoiding the payment of gift tax by staying below the exemption levels of $5.25 million.

A significant advantage of pre-death gifting is the anticipation of the asset’s growth in value from the gift date to the donor’s death date, thus transferring the asset’s appreciation to the donee (younger generations).

Following is a case study:

A privately owned company is equally owned by two individuals via traditional voting stock. The company recapitalizes its equity via the creation of nonvoting stock, which in our case study composes 80 percent of the total equity. An original, 62-year-old shareholder gifts 60 percent of his nonvoting stock to his 35-year-old daughter; the amount represents 24 percent of the outstanding equity of the company. The company had an estimated value of $8 million, pursuant to the business valuation as of the date of the gift. Since the gift represented a minority interest, a discount for lack of control of 25 percent might be utilized. Assume further that the valuation analyst determined this ownership block was not readily marketable, so an additional 20 percent discount for lack of marketability might be utilized. It is even further possible that the analyst might consider an additional 3 percent discount for lack of voting.

In this case study, the resulting estimated value of the 24 percent noncontrolling, nonmarketable, nonvoting interest was $1.1 million. This compares to the intrinsic or nondiscounted estimated value of $1.9 million. Thus, in our case study, the donor transferred $1.9 million of value via a gift of $1.1 million, which represents just a portion of the donor’s lifetime exemption of $5.25 million. Of course, valuation discounts are not always as shown in this case study, and are determined by the valuation analyst based on the specific facts and circumstances of the particular company being valued.

In summary, business owners can utilize discounting to economically transfer company interests to their children and grandchildren during their lifetime. In addition, the donor can transfer the asset’s appreciation to subsequent generations, while still maintaining control over the asset during their lifetime.

A partner in Citrin Cooperman’s Philadelphia office, Terry Silver’s specialties include business valuation services and forensic accounting, testifying as an expert witness in Pennsylvania and New Jersey courts. He is accredited in business valuation through the NACVA and in forensic accounting through the AICPA.

Combating Employee Theft

By Colleen S. Vallen
Special to the Legal

As a forensic accountant, I often am hired when a client is concerned about inappropriate employee behavior and needs these concerns analyzed and addressed. In recent years, I have worked on a number of cases involving employee theft. As a result of this work, I have identified common themes present in a number of these cases.

A critical common element is reliance and trust between the employee and business owner. The employee typically develops a relationship with the owner where the employee is valued and relied upon. The employee often attempts to informally define his or her role as the person to relieve an overburdened owner of his or her workload; the employee takes control of daily business functions, freeing the owner to focus on more important business functions. This allows the employee to gain additional knowledge and access to the business’ processes and systems while limiting oversight of the individual’s activity. This is particularly an issue for smaller businesses, as the ability to segregate duties and implement controls often is challenging. As an employee becomes trusted and takes on more roles, the ability of the employee to perpetrate and conceal theft increases.

Another common theme is that the employee is knowledgeable about the business. The employee uses this knowledge to build confidence and credibility with the employer. This knowledge, however, also provides the employee with key information on the company’s policies and procedures and its internal control structure, as well as an understanding of what oversight, if any, exists. The employee often knows more about how the business functions than the owner. The employee uses this information to identify weaknesses in the systems and then exploits them to perpetrate and conceal theft.

Another theme centers on complexity. The employee frequently creates complexity in financial transactions to make it difficult for others to understand. Complexity provides two benefits. First, it enhances the employee’s value to the business, as he or she is seen as able to manage important, challenging issues. Complexity also provides the employee the ability to respond to questions that may be raised about inappropriate activity. The employee can weave an explanation that may sound plausible but not be clearly understood by the employer. This often extends the length of time the theft occurs, as early warning signs that may have uncovered the scheme are explained away.

For example, in one case, an employee was using corporate funds to pay personal credit card balances. The employee had built a relationship with the owner of the business and had advanced in the company. Throughout the employee’s tenure, the employee’s responsibilities increased and by the time the theft was identified, the employee had taken on most of the financial responsibilities of the business. The employee understood the company’s processes surrounding payables and used this knowledge to take funds from the company. The employee prepared company checks to pay personal credit cards. Instead of getting these checks signed with the legitimate payables, the employee would hold these checks aside and use a check stamp. The company’s normal procedure was to have the owner review and sign the checks, but a check stamp existed for emergency occasions. The employee was able to gain access to this check stamp and use it to sign the unauthorized checks. Further, the employee was handling the transactional recording in the general ledger systems and performing the back reconciliations, so the employee was able to conceal the fraud from the owner of the business.

While there is no magic answer to prevent employee theft, a business owner should consider reviewing all policies and procedures and internal control systems. Identifying areas of weakness can help a business monitor its financial information more effectively. Also, a business owner should consider routinely adding something new to oversight processes. As discussed above, employees who commit theft understand the business systems. Adding a new level of oversight or reviewing data not typically reviewed makes it more difficult for an employee to target weaknesses in the systems. Finally, although this seems fairly straightforward, a business owner should independently review the bank statement, including canceled checks, as these checks often contain information that would identify suspicious transactions.

Colleen S. Vallen is a partner in Citrin Cooperman Philadelphia’s valuation and forensic services group. An expert in the field of forensic and investigative accounting, she focuses her attention on forensic and fraud investigations, the preparation of financial damage analysis and litigation support. She is also highly experienced in the analysis, investigation and review of financial documents, as well as case planning and management, financial and economic analysis, expert report preparation, oral presentation of findings and assistance with discovery, interrogatories and depositions. She can be reached at [email protected] or 215-545-4800.

 

The Backsolve Method to Value Common and Preferred Stock

By Craig Jacobson and David Kaye
Special to the Legal

The valuation of early-stage companies can pose unique challenges because of a lack of historic earnings or operating cash flow. However, when there has been a contemporaneous arm’s-length transaction such as a recent financing round, one can estimate the value of the company using a valuation method known as the backsolve method. This market-based valuation method has gained prominence in the valuation community. This is evident with the release of the American Institute of Certified Public Accountants’ 2013 guide, Valuation of Privately-Held Company Equity Securities Issued as Compensation, in which this method is discussed extensively.

The backsolve method considers the capital structure and the liquidation claims of the various securities issued by the subject company. The valuation analyst will often work closely with legal counsel to accurately interpret the rights of the various securities. Usually, with early-stage companies, the securities being valued (e.g., common stock) have junior rights compared to the securities sold in the most recent financing round (such as a senior series of preferred stock).

The senior claim of the preferred stock creates an “option-like” payoff structure for the common stock (i.e., the future enterprise value needs to exceed the preferred claim in order for the common to realize any value at all). As such, the backsolve method utilizes option pricing models such as the Black-Scholes model.

The backsolve method first estimates the enterprise value of the subject company based on the price of a recent arm’s-length transaction. The enterprise value is then allocated among the different ownership classes. In performing the backsolve method, the valuation analyst will apply a series of concurrent option pricing models to consider several “break points.” For example, initially, only the most senior securities will participate. The first break point is at the future liquidation value where the preference of the most senior securities is satisfied and the incremental value determined applying option pricing models is attributed solely to the holders of these securities. This “waterfall” procedure is repeated until the incremental value attributable to the securities sold in the most recent round equals the price paid by the investor.

The model considers the probability of a range of future values that may be realized at a liquidity event, and therefore reflects the possibility that a security class that might not have value upon an immediate liquidity event still might have value based on the possibility of an increase in value.

As with any valuation method, the backsolve method requires the use of several assumptions, the most subjective of which are (1) the term to an expected liquidity event and (2) assumed volatility. The expected time to a liquidity event should reflect the expectations as of the valuation date of investors in the company.

The backsolve method can be very helpful in estimating value in the presence of an arm’s-length transaction in company ownership. Sometimes the hardest question is: How does one determine whether a transaction is truly arm’s-length?

Craig A. Jacobson is a principal in Citrin Cooperman’s valuation and forensic services group. He helps clients resolve issues regarding the buying or selling of a company, intellectual property valuations and damages/lost profits analysis, among other issues. He can be reached at 212-697-1000 or [email protected].

 

David M. Kaye works in Citrin Cooperman’s valuation and forensic services group. He provides specialist valuation and consulting services for transaction, litigation support, financial reporting and tax compliance purposes. He can be reached at 212-697-1000 or [email protected].

Ratio Analysis – How to Find the Fraud Needle in the Company Haystack

By B.J. Hoffman
Special to the Legal

It is not uncommon to hear executives air concerns about possible exposure to internal fraud. In such cases, company owners are typically unable to put their finger on exactly what might be wrong other than having an uneasy feeling about a particular employee, or group of employees, a controller, a CFO, or another individual with access to company assets. Though there may be red flags of untoward behavior by employees – unexplained spending, working odd hours, sloppy record-keeping – company owners are generally at a loss as to how to explore potential fraud further.

The most effective first step in determining whether further investigation is warranted is ratio analysis applied to historical company financial results. Ratio analysis serves to highlight financial anomalies and trends, identifying areas of financial risk for additional testing. In its simplest form, ratio analysis is merely the evaluation of company historical results over several years.

I typically want to have five years of company data (internal financial statements or tax returns) available when performing ratio analysis, laid out by year in an electronic spreadsheet. Horizontal and vertical ratio analysis is the usual starting point in any investigation.

Horizontal Ratio Analysis

Horizontal analysis is the evaluation of a particular line item’s trend over a multi-year period. For instance, if the company reported that advertising expenses have increased by 100 percent from 2008 to 2013, is that reasonable or have fictitious expenses been coded in the advertising category?

Vertical Ratio Analysis

Vertical ratio analysis compares one line item with another in a given year. For instance: advertising expenses versus sales revenue. If the company advertising expenses approximate 2 percent of annual sales from 2008 through 2011, but jump to 8 percent of sales in 2012 and 2013, perhaps the underlying details of 2012 and 2013 advertising expenses should be explored. Maybe the jump in expenses is the result of a new 2012 advertising campaign or, alternatively, perhaps the advertising expense increase coincides with the hiring of the company’s new controller.

Exploring Ratio Analysis Further

Ratio analysis can be much more detailed than horizontal and vertical evaluations. Certain ratio analysis tests are designed to examine the speed of a company’s collection of its accounts receivable over time, its gross margin on inventory sales, or the rates of customer refunds issued by a particular retail cashier.

If accounts receivable collections are slowing over time, is someone in the accounts receivable department stealing customer payments? If gross margins on product sales are declining, is a warehouse employee misappropriating inventory? If one cashier’s rate of refunds issued is greater than all others, is that cashier fabricating refunds and pocketing cash?

Ratio analysis is a flexible tool and can be tailored to the individual department under scrutiny. It can assist in overseeing operations from 30,000 feet, or it can be designed to drill down at an excruciatingly detailed level, such as in analyzing stadium beverage sales by vendor location, for a given ticketed attendance, under set weather conditions, etc.

The beauty of ratio analysis as an investigative tool is that it cuts to the chase, identifying likely areas for more intensive testing. When fraud is a concern but management has little else to go on, open the ratio analysis toolbox to find the needle in the haystack.

B.J. Hoffman is a certified public accountant and certified fraud examiner for Citrin Cooperman, an accounting, tax and business consulting firm. He is a partner in the Philadelphia office. Hoffman provides clients with a mix of audit, tax and litigation support services. He often works with closely held entities in a variety of industries, including professional service firms and real estate enterprises. He can be reached at [email protected] or 215-545-4800.

 

Small Stock Risk Premium for Business Valuations

By Terry Silver
Special to the Legal

In my last blog, I discussed assessment of risk in the context of business valuation. I stated, “In valuing a privately owned company, where public markets do not assess the risk, the assessment is determined by the valuation analyst. This assessment is one of the most significant and subjective aspects of business valuation.”

Risk is quantified by the development of the cost of equity. Key elements of the cost of equity include:

• Market risk premium
• Small stock risk premium
• Company specific risk premium

Once these specific risk premiums are quantified, they are added to a risk-free rate of return to arrive at the cost of equity. This process is called the “build-up approach.” In this post, I expand on the technical aspects of the development of the small stock risk premium.

Small Stock Risk Premium

To measure the small stock risk premium element of cost of equity, we use data from the portfolio created by the Center for Research in Security Prices, University of Chicago Graduate School of Business. This portfolio is widely used by business valuators and represents data accumulated from 1926 through 2011. The portfolio is separated into 10 deciles, with decile 1 representative of the largest companies and decile 10 the smallest companies. The deciles are assigned based upon the market capitalizations of the companies. It compares the average return on investment and risk increase in deciles 8 to 10 (smallest companies) to the deciles 1 to 3 (largest companies). The companies contained in the portfolio are all public companies, listed on public stock exchanges. Decile 1 and 2 companies generally are characterized as large cap, deciles 3 to 5 as mid-cap, deciles 6 to 8 as small cap and deciles 9 and 10 as micro-cap. Decile 10 (smallest companies) is further split into four groupings designated as 10 w, x, y and z, with “w” companies the largest and “z” companies the smallest. Deciles 1 to 5 are assigned size premia in the range of (0.38) to 1.74 percent. At decile 9, the size premia is 2.8 percent, jumping to 6.10 percent for decile 10. The w, x, y and z subgroups of decile 10 are assigned size premia in the range of 4.34 percent to 11.77 percent. As can be seen, the smaller the company, the greater the size premia. There is a relationship between the size of a company and its return on investment, and this relationship is amplified for smaller companies.

The portfolio of companies utilizes a formula to mathematically convert a range of data points into a size premia, which becomes a component of cost of equity. The data points include the beta, the arithmetic mean return, the actual return in excess of the riskless rate and, finally, the Capital Asset Pricing Model return in excess of the riskless rate.

Once the small stock risk premium is determined, it is included as a component of the build-up approach to arrive at the cost of equity.

Terry Silver is a certified public accountant, certified valuation analyst and certified in financial forensics for Citrin Cooperman, an accounting, tax and business consulting firm in Philadelphia, where he is a partner with more than 33 years of experience as an accountant and auditor. He focuses his practice on business valuation and financial forensic services, expert testimony and matrimonial actions. He can be reached at [email protected] or 215-545-4800.

 

Red Flags in the Analysis of Balance Sheets – Inventory

By Colleen S. Vallen
Special to the Legal

In recent blogs, I have been discussing red flags in financial data. Red flags are circumstances unusual in nature or deviations from customary activity. In this blog, I want to focus on one specific balance sheet item: the current asset inventory. For manufacturing and merchandising firms, inventory can be a significant balance sheet item.

Defining Inventory

In order to discuss the red flags related to inventory, it is important to understand what inventory is and how it relates to the financial statements of a business. Inventory represents goods produced or purchased for the purpose of resale. In a manufacturing situation, inventory can include raw materials, work-in-process and finished goods. Inventory in simplest terms is product a business owns but has not sold. Inventory is carried on the balance sheet at cost and is considered a current asset because it is expected to be sold in the relatively near future.

Components of Inventory

The two key components of inventory are quantity and price. While these seem to be simple concepts, the nature of inventory can cause quantity and price to be confusing. The inventory process involves purchases and sales over time. In addition, for many businesses, transfer of inventory between locations is also a regular occurrence. Depending on the accounting procedures a business utilizes, determining the goods on hand at any point in time may involve a number of procedures. For example, some companies do not track inventory movement on a transaction-by-transaction basis, but perform physical counts of inventory periodically to obtain that information.

In addition, the cost of inventory has its own complexities. Costs fluctuate over time. Further, tracking of costs, as with quantity, may not be done on a transaction-by-transaction basis, but may involve the use of accounting procedures.

Finally, inventory is connected to the balance sheet as well as the income statement. Merchandise prior to being sold is reported as inventory; however, when merchandise is sold, the cost of the items sold is reported on the income statement as “cost of goods sold.”

As a result, analyzing red flags related to inventory involves two general areas: theft of inventory and financial statement fraud involving the inventory account.

Theft of Inventory

Theft of inventory is more often than not done by an employee or group of employees and involves actual physical loss of inventory. Inventory is taken for personal use or for resale. For most businesses, the loss of inventory by employee theft is the largest component of inventory shrinkage. Inventory shrinkage includes physical loss of inventory related to a variety of events, including theft, bookkeeping errors and damage.

Examples of red flags related to inventory theft include unexplained inventory variances, missing documentation, particularly related to the receiving and shipping processes, unexplained credits and write-offs to inventory.

Those who want to defraud a company via theft of inventory often use more than one scheme when manipulating inventory. For example, they create fictitious purchase orders, alter inventory physical counts and use journal entries to artificially inflate the inventory account.

Overstatement of Inventory

Overstatement of inventory is a common financial statement fraud. To illustrate this concept, consider the income statement equation. The income statement provides information on a business’ profitability. The formula: Revenues minus expenses equals net profit or net loss. In a simple world, if expenses are lower, profitability is improved. Inventory is connected to the expense (i.e., cost of goods sold). When inventory is sold, the corresponding cost is taken as an expense on the income statement. Therefore, when ending inventory is overstated, the costs for the period are understated and result in reporting higher profit. Conversely, at times, companies may understate inventory, as there are motivations to show lower profit in a particular period.

Red flags to consider include inventory values that do not change or minimally change from period to period and gross profit percentages that remain consistent period to period.

To better understand inventory, consider comparing the inventory and cost of goods sold accounts from period to period to help identify areas of potential concern and areas that need to be considered in more detail. In addition, using ratio analysis can also help identify trends and patterns as well as variances that should be questioned and discussed.

Colleen S. Vallen is a partner in Citrin Cooperman Philadelphia’s valuation and forensic services group. An expert in the field of forensic and investigative accounting, she focuses her attention on forensic and fraud investigations, the preparation of financial damage analysis and litigation support. She is also highly experienced in the analysis, investigation and review of financial documents, as well as case planning and management, financial and economic analysis, expert report preparation, oral presentation of findings and assistance with discovery, interrogatories and depositions. She can be reached at [email protected] or 215-545-4800.

 

Understanding Your Business’ Financial Statements Is the First Step Toward Preventing Fraud

By David A. Anderson
Special to the Legal

Many of my recent forensic and litigation engagements have arisen when business owners (including legal and other professional firms) suddenly learned that trusted individuals within their businesses had perpetrated a fraud upon the business. Most of these business owners had received regular monthly or quarterly financial statements for the business but had failed to read and understand them. Had they done so, they could have caught the fraud earlier or prevented it altogether.

Why does this happen? My experience reveals that most of these business owners had minimal knowledge and understanding of their business’ financial statements, and instead relied upon another owner/partner or trusted employee to handle all of the business’ financial matters. In each case, a careful analysis of the financial statements would have identified that something was wrong. Furthermore, when the economy was booming (as in the early to mid-2000s) and/or the company was growing, the fraud could be more easily hidden. However, when revenues and cash collection slowed down, it became more difficult to hide the fraud.

Let’s look at two examples.

Financial Fraud: Destroyed Cash Sales Invoices and Pocketed Cash

In one instance, the trusted employee in a business that generated a significant amount of cash sales destroyed cash sales invoices (so they were never entered into the accounting system) and pocketed the cash. In addition, at the end of each quarter (when he produced financial statements for the owners), the trusted employee made a large journal entry to increase the cash account balance so it appeared as if the business had more cash than it did. If the business owners had understood the quarterly financial statements, they would have noticed that: (1) the gross margin on sales had begun to decline significantly even though neither selling prices nor purchase prices had changed (because sales costs were entered into the accounting system, but the corresponding sales were not); and (2) the accounts payable balance kept growing significantly (because there was insufficient cash to pay the bills). Also, if any of the business owners had reviewed the monthly bank statements, they would have noticed that the cash balance shown on the bank statements was significantly lower than that shown in the financial statements.

Financial Fraud: Cash Distributions Without Informing Partners

In another instance, one business partner took significant cash distributions from the business without informing his other business partners. Because this business partner controlled the financial matters of the firm, he was able to mask these cash distributions by recording the distributions as increased operating expenses of the firm. If the other business partners had read and understood the financial statements, they would have noted that certain expense balances were much higher than expected, and they would have raised the issue with the financial management partner. (For example, more than $25,000 in office supply purchases in one month for this 10-person company or more than $20,000 in travel expenses in a month when no one in the company had traveled out of town.)

Business owners who regularly read and understand their business’ financial statements can identify warning signs in those statements and stop or prevent fraud from occurring.

David A. Anderson is a director in the valuation and forensic services group of Citrin Cooperman, an accounting, tax and business-consulting firm in Philadelphia. He has more than 30 years’ combined experience in public accounting and consulting as well as service at the CFO and COO levels in private and public companies. He specializes in fraud detection and prevention, business valuations, insolvency and reorganization and litigation support, including commercial and matrimonial litigation. He can be reached at [email protected] or 215-545-4800.

 

Common Mistakes in Valuing a Business

By Terry Silver
Special to the Legal

In the past, I have written about business valuation matters such as types of engagements and reports, assessment of risk, the management interview and where business valuation meets forensic accounting. However, when discussing this topic, I would be remiss not to share the common mistakes that are often made during this process.

Expert Selection: Once there is a decision to value a business, the valuation analyst selection process begins. How do you know if your expert is in fact an expert? The first mistake is the selection of an unqualified valuation analyst. The first acid test is credentials, including:

• Accredited in Business Valuation, ABV, issued by the AICPA
• Certified Valuation Analyst, CVA, issued by the NACVA
• Accredited Senior Appraiser, ASA, issued by the ASA
• Chartered Financial Analyst, CFA, issued by the CFA Institute

Once a properly credentialed valuation analyst is identified, the analysis of his or her judgment, which comes from experience and prior involvement in the litigation process, will narrow the field of selection.

Standard of Value: Every valuation must represent the standard of value utilized. Typically, the standard of value is either fair-market value, fair value or investment value. A common valuation mistake is mismatching the purpose of the valuation to the standard of value used. Various reasons to value a company include mergers and acquisitions, family gifting, divorce, shareholder oppression, shareholder dissent, damages, bankruptcy, shareholder agreements and financial statement purposes. Having the knowledge to properly match the reason for the valuation to the appropriate standard of value is key to establishing a credible conclusion of value.

Risk: Generally, the valuation discount rate is equivalent to risk. We comprehend risk more easily in public markets. For example, in municipal markets, would we consider a bond issued by Harrisburg, Pa., equal to the risk of a New York City bond? The valuation analyst is truly an assessor of risk. The level of risk dictates the rate of return. Mistakes in the calculation of the discount rate are common, but admittedly, sometimes subjective. Misstating the discount rate can make a significant change in the value conclusion.

Discount Rate vs. Capitalization Rate: Confusing the discount rate with the capitalization rate is a common error. While the discount rate is developed via the identification and quantification of various risk components, the capitalization rate adjusts the discount rate for a growth factor. In order to convert a discount rate into a capitalization rate, we must subtract growth because the discount rate is designed to be applied to future income streams. The discount rate is used in the discounted cash flow method, which assumes growth, while the capitalization rate is used in the single-period capitalization of income method, since no growth is assumed.

Normalization Adjustments: Another valuation error is accepting financial statements/tax returns without questioning the need for normalization adjustments. For example, in privately owned companies, certain expenses may not be representative of market value, including owner compensation, owner perquisites, rents paid to related parties, etc. Normalization adjustments may also be necessary to adjust tax-motivated accounting methods, non-recurring income or expenses, unusual litigation costs or settlements.

These five common valuation mistakes are by no means all-inclusive. In my future blog posting, I will elaborate on other commn valuation mistakes.

Terry Silver is a certified public accountant, certified valuation analyst and certified in financial forensics for Citrin Cooperman, an accounting, tax and business consulting firm in Philadelphia, where he is a partner with more than 33 years of experience as an accountant and auditor. He focuses his practice on business valuation and financial forensic services, expert testimony and matrimonial actions. He can be reached at [email protected] or 215-545-4800.