Small Business Valuations: Using Forensic Accounting to ensure Data and Results Reliability

According to the U.S. Small Business Administration’s (“SBA”) 2018 Small Business Profile there are 30.2 million small businesses in the U.S., accounting for 99.9% of U.S. Businesses and employing 58.9 million individuals (47.5% of U.S. Employees). While the definition of what is a small business can be argued, what cannot be disagreed is that the U.S. business valuation community deals with “small business” valuations much more widely than public companies. Valuing the small business is how most valuators earn their living. These small businesses pose as much issues to valuation professionals as they do for tax, accounting and legal professionals by providing these entities with advice. The issues are wide-ranging, and the purpose of this article is not to patronize small business owners; rather, the purpose of this article is to discuss the challenges we in the valuation community face when valuing small businesses and how forensic accounting techniques can help. 

How many of you have started a valuation engagement and the only financial statements you receive are the previous years tax returns? How many of those tax returns have discarded Schedule L (Balance Sheet) information? The point I am trying to make is that valuators are already starting at a disadvantaged place. Many of the valuation engagements we perform require us to put on our forensic accounting and tax advisor hats on to unravel the poor books and records to ensure that the “baseline” financial data is accurate. Many small businesses only reporting requirements are for federal tax purposes; thus, there is a heavy emphasis by their preparers to minimize tax liabilities and not to ensure that tax returns (which are NOT financial statements) are complete and accurate. What we are left with is a picture through one view point and this may not be representative of the financial condition of the subject company. 

Two common methods used today to determine and allocate value to enterprise and personal goodwill are the “Bottoms-Up Approach” and the “With-or-Without Method”. To correctly apply these methods an analysis needs to use techniques founded in forensic accounting. The remainder of this article discusses those techniques and their application to the valuation process

In my opinion, before we look at any financials or speak to management we need to understand the industry and the market the subject company works in.  An understanding of the typical types of revenues, expenses, assets and liabilities will allow the forensic accounting expert to identify “baseline” data which can be used to identify unusual or unnecessary items. This allows the forensic accountant to put together questions to ask the subject company owner. These questions are one of the tools forensic accountants use during inquiry to uncover unknown or unidentified assets, liabilities, revenues or expenses.    

             Another forensic accounting technique is data driven. Vertical and Horizontal analysis is a helpful tool to also understand trends and deviations from historical data. Vertical analysis is the use of common sizing financial statements. These figures can be compared to industry benchmarks or other related companies to understand what, if any, deviations there are. This information can be used in horizontal analysis wherein you review data over a period of time to identify linear trends. Looking at figures in dollars or as percentages can give a unique insight and perspective for these comparative purposes. It also may identify relations between income statements and balance sheets. For example, it is not uncommon to see many expense line items “disappear”. However, when focusing on the income statement alone an individual may not identify that for some reason the subject company has capitalized these expenses. A second example to the above scenario can find changes in accounting procedures wherein an individual may decide to “hide” or book transactions to an equity account. 

The identification of trends, deviations or other occurrences helps forensic accountants not only piece together items that need further review but assist attorneys in forming questions for deposition or interrogatories. These questions are key to helping you and the attorney unravel some of the mess you are looking at. They also may impact other sections of the matter your working on such as hidden assets in a business that are personal (i.e. divorce) or the improper recognition of expenses that should be capitalized as assets (i.e. lost profits). 

Most well-trained accountants can identify the items described above. A forensic accountant is skilled in crafting questions. Knowing that the person being asked the question may not be truthful is always in the mind of a forensic accountant. Thus, it is imperative to develop questions that do not outright seek the answer by alerting the individual of what was found. Let me give a quick example. 

John CPA is working with Jane Attorney on a family law case and suspects the husband is hiding personal assets within the business. John identified this by noticing certain expense trends that were not found in prior years and an increase in office expense, but no changes in personnel or anything else operationally. Instead of asking husband directly about these items John asks, “I see that your net profits have decreased; this must be hard on you meeting personal objectives”. This is a subtle change, but what John has done is built a rapport with Husband. He indirectly lets him know he “feels his pain” and begins the process of opening the husband up as opposed to keeping the husband in a defensive position. It is important that during inquiries valuators do not try to “win the case” with a GOTCHA question; rather, an inviting nature can go a long way. Maybe you don’t get a direct answer, but you find out that the general ledger details that were not available suddenly are.

My point is that forensic accountants are trained to play chess. They understand that not every battle is won, but you have to give to get.