Common Documentation for Business Valuations
Financial Statements
According to the American Institute of Certified Public Accountants (AICPA), financial statements refer to a presentation of financial data, including accompanying notes, derived from accounting records and intended to communicate an entity’s economic resources or obligations at a point in time or changes therein for a period of time in conformity with a comprehensive basis of accounting. AICPA Professional Standards and Statements The three most frequently requested financial statements for a business valuation are:
- Balance Sheet: Presents the company’s assets, liabilities, and equity at a specific point in time, providing a snapshot of the company’s financial position.
- Income Statement: Details the company’s revenues, expenses, and profits (or losses) over a specific period, typically a year, helping evaluate the company’s profitability and operational efficiency.
- Cash Flow Statement: Reflects the cash inflows and outflows from operating, investing, and financing activities over a specific period.
Tax Returns
- Federal and State Tax Returns: These documents are essential for verifying the reported financial performance of the business. Tax returns help ensure that the financial statements are accurate and comply with tax laws and regulations.
- Schedule K-1s: This is a federal tax document used to report the income, losses, and dividends for a business’ or financial entity’s members, partners, or S corporation shareholders. The K-1 form is also used to report income distributions from business entities to its interest holders.
- Fixed Asset Depreciation Schedule: A fixed asset depreciation schedule typically includes a description of the asset, purchase date, cost, estimated useful life, and depreciation method.
Detailed General Ledgers
- Detailed general ledgers are the cornerstone of accurate and effective financial reporting. By meticulously recording all financial transactions, the general ledger provides a complete and accurate picture of the company’s financial activity. They allow a deep dive into balance sheet and income statement accounts, verifying the integrity of the financial data and supporting the preparation of the company’s financial statements.
- General ledgers provide a more granular view of the financial accounts that may not be evident in the financial statements. This level of detail may aid in identifying potential normalizing adjustments to reflect the company’s true earning capacity. A deeper dive into the importance of detailed general ledgers is included in a later section.
Accounts Receivable and Payable Aging Reports
- An accounts receivable report provides details on outstanding receivables and their aging. It helps assess the quality of the receivables, the effectiveness of the company’s credit policies, and potential cash flow issues.
- An accounts payable report lists the company’s outstanding payables and their aging. It helps evaluate the company’s payment practices, financial obligations, and cash flow management.
Contracts and Agreements
- Lease Agreements: Provide information about the company’s fixed costs and long-term obligations.
- Employment Contracts: Provide information about key employees and their compensation, which can impact the company’s valuation.
Business Plans and Projections
- These documents outline the company’s strategic goals, growth plans, and anticipated financial performance. They are essential for assessing the company’s future prospects and play a pivotal role in determining the company’s value.
Organizational Documents
- Articles of Incorporation and Bylaws: These documents provide legal and structural information about the company. They help in understanding the company’s governance and ownership structure.
- Shareholder Agreements: Detail the rights and obligations of shareholders and can impact the valuation by outlining potential risks and benefits associated with ownership.
Employee Payroll Records
- Payroll records help assess the company’s labor costs and workforce management. They provide an understanding who is being paid by the company and if compensation is reasonable.
Detailed Bank and Credit Card Statements
- Bank statements provide an independent verification of the company’s cash position and financial transactions. They help validate the accuracy of the financial statements and identify any discrepancies or irregularities.
- Credit card statements provide an independent verification of the company’s transactions. Typically, a valuator will ask for copies of all credit cards paid for by the company (whether it is a business or personal card).
- Collecting and analyzing these documents is crucial for a comprehensive and accurate business valuation. By thoroughly examining these documents, valuation experts can make well-informed decisions and deliver reliable valuation assessments.
Quality of Information and Need for Forensic Accounting
Larger, or more complex, companies may have audited financial statements meaning that a CPA firm has verified the numbers as accurate. Audited financial statements provide a level of assurance regarding the accuracy and completeness of the financial data presented. Therefore, a deep dive into the financial transactions and related source documents may not be necessary. However, many companies valued in divorce matters do not have audited financial statements. Smaller, or less financially sophisticated, companies may simply have internally prepared financial statements which may be provided to an accountant to construct the financial statements and the corporate tax return. It is these types of businesses where valuators may spend a significant amount time analyzing the documentation and conducting some level of forensic accounting.
Forensic accounting involves the application of accounting skills to investigate potential fraud or analyze financial information for use in legal proceedings. One important aspect of forensic accounting is the review of financial statements and tax returns for business valuation purposes. The following will cover the steps involved in a forensic review of financial statements and tax returns for business valuation.
The forensic review of financial statements and tax returns for business valuation involves several steps:
Initial Assessment
- Understanding the Business: Familiarize yourself with the business, including its industry, operations, and financial history. This helps in identifying any unusual patterns or discrepancies in the financial data.
- Gathering Information: Collect all relevant financial documents, including financial statements, tax returns, bank statements, copies of checks and deposits, credit card statements, invoices, contracts, and other financial records.
Preliminary Analysis
- Reviewing Financial Statements: Examine the financial statements for consistency and accuracy. Look for any unusual or significant changes in revenue, expenses, assets, and liabilities. Compare various financial ratios to the subject company’s industry.
- Comparing Tax Returns and Financial Statements: Compare the information reported in the tax returns with the financial statements. Ensure that the revenue, expenses, and other financial data are consistent between the two sets of documents.
- Identifying Red Flags: Look for any discrepancies that may indicate potential fraud or financial manipulation. This may include unexplained variances, unusual transactions, or significant changes in financial ratios.
Interviews and Inquiries
- Interviews with Management: Conducting interviews with management to gain a better understanding of the company’s operations as well as the financial activity included in the financial statements and tax returns. Inquire about any fluctuations, unusual transactions, discrepancies, or red flags identified during the preliminary analysis. Also, discuss processes for recognizing personal expenses paid for by the business.
Adjustments
- Make any necessary adjustments to the earnings stream of the business valuation based on the forensic review findings. This may include adjusting the revenue, expenses, assets, or liabilities to reflect the true financial position of the business. These adjustments can impact the valuation and the owner’s true economic benefit from the business.
These steps are critical in the business valuation process to ensure that the outcome of the business valuation is free from financial manipulation and provides a reliable conclusion of value.
Importance of Detailed General Ledgers in Business Valuation
A detailed general ledger is a fundamental accounting document that records of all financial transactions within a company over a period of time, reflecting changes to assets, liabilities, equity, revenue, and expenses. It is the backbone for creating financial statements and tax returns for a company. The general ledger serves as an audit trail, verifying and validating the accuracy of the financial data. Maintaining a detailed general ledger helps establish robust internal controls by ensuring every transaction is recorded and can be traced back to its source. In a typical business valuation, and certainly in divorce matters, analyzing the general ledger often results in the discovery of personal expenses paid on behalf of an owner and classified as business expenses.
Components of a Detailed General Ledger
- Account Name and Number: Each account in the general ledger is assigned a unique name and number for identification. Common categories include assets, liabilities, equity, revenue, and expenses. These categories, which are further broken down into sub-categories such as cash, costs of goods sold, operating expenses, distributions, wages, etc.
- Date: Each transaction is recorded and dated to provide a chronological order of financial events.
- Payee: Name of the payee involved in each transaction.
- Description: This section includes a brief description or memo explaining the nature of the transaction.
Characteristics of a Good General Ledger vs.a Bad General Ledger
Understanding the characteristics that distinguish a good general ledger from a bad one is essential for maintaining the integrity of financial data. A well-maintained general ledger ensures detailed, accurate, and consistent recording of transactions, providing a clear audit trail. Conversely, a poorly managed general ledger can lead to incomplete records, inaccuracies, and delayed entries, ultimately compromising the valuation of the company and increasing the cost of the engagement.
Good General Ledger
- Detail-Oriented: Includes a comprehensive record of all transactions with adequate descriptions.
- Accuracy: Reflects precise amounts for every transaction.
- Audit Trail: Includes references or document numbers that trace back to original source documents.
Bad General Ledger
- Incomplete Entries: Missing or partial records of transactions.
- Inaccuracies: Contains erroneous amounts or misclassifications of transactions.
- Weak Audit Trail: Lacks references to original source documents, making it difficult to verify transactions.
In this entry, the company has recorded a single lump sum payment of $25,000 to the credit card without breaking down the individual transactions that make up this amount. This lack of detail is problematic. As seen in the table, the credit card payment was booked under cost of goods sold and various other operating expenses. Without the details, the valuator has to review all of the credit card transactions and attempt to reconcile what was booked under the various expense categories, which take a great deal of effort and time, resulting in significant costs.
If a business owner is really trying to be deceitful, they might break up one charge and spread it around into various expense categories. Other tactics by business owners include not providing details for other types of bank debits and checks. For a well-maintained general ledger, each individual transaction should be recorded separately to provide a clear and accurate financial picture.
The chart that follows shows how the entry should ideally look with transaction-level detail. This detailed approach provides clarity on what the credit card payment was for, enhancing transparency, accountability, and the overall quality of financial reporting. This example doesn’t imply that the business expenses are legitimate, but this level of detail in a general ledger should decrease the time, effort and cost in conducting an analysis. Verification is still needed by the valuator regarding the legitimacy of the expenses.
Impact of General Ledger Analysis on a Company’s Earnings Stream and Value
A forensic analysis of the general ledger can have a dramatic impact on a company’s earnings stream and overall value. Consider an example of a small business where the owner has been recording personal travel expenses, dining bills, and luxury purchases as business expenses. Over the span of a fiscal year, these personal expenses amount to $200,000.
The reclassification of expenses has a direct impact on the business valuation. Business valuations often rely on EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) or other profitability metrics. By removing non-business expenses from the ledger, the business’s true profitability becomes evident. For instance, if the business originally reported an EBITDA of $500,000, the exclusion of $200,000 in personal expenses would increase the EBITDA to $700,000. This enhanced profitability directly translates to a higher business valuation.
For example, if the business were valued at five times EBITDA, the original valuation would be $2.5 million. With the increased EBITDA of $700,000, the valuation rises to $3.5 million—a significant $1 million increase in the value of the business.
A thorough business valuation is not just about assessing numbers but understanding the broader context of the company’s operations and market presence. By meticulously analyzing key documents such as financial statements, tax returns, general ledgers, and other critical records, valuation experts gain invaluable insights that paint a comprehensive picture of the business’s financial health and future potential. Furthermore, forensic accounting plays a pivotal role in the valuation process. By delving into detailed examinations of financial records and uncovering any inconsistencies or irregularities, forensic accounting ensures the integrity and accuracy of the valuation.
