Turning Standard Business Valuations Into a Fidelity Investigation
February 23, 2009
There are a number of reasons forensic accountants are engaged to perform business valuations. Most often, they are sought to provide valuations related to litigation. However, business valuations are also required in matters pertaining to the buying and selling of businesses (mergers and acquisitions), as well as for compliance issues. Whatever the reason, all business valuation engagements can benefit from the use of forensics. Generally, there are four areas of forensics — the “Four Fs”: Forensic Accounting, Fraud, Fidelity and Forensic Technology. Previous articles focused on Forensic Accounting and Fraud. Here, we look at Fidelity.
Fidelity is defined as “faithfulness to obligations, duties or observances.” Forensics comes into play when fidelity is questioned, most often when employee dishonesty or embezzlement occurs. The case study that follows illustrates how a standard business valuation, used in tandem with forensic investigation, uncovered employee embezzlement.
Business Valuation Concepts
In previous articles, the definition of Fair Market Value (FMV) was determined and the three generally-accepted approaches to the valuation of assets were defined as asset, income and market. While all of the approaches may be used to determine the FMV of an entity, it is up to the valuator to determine the appropriateness of each approach in the particular valuation engagement. This article reveals the Merger and Acquisition Guideline Company Methodology, a market approach. The market approach can be defined as follows:
Market Approach — is based upon the principle that in a free market, supply and demand factors will converge at a price equilibrium and that a prudent investor will pay no more for the subject asset than the prevailing price for an asset of like utility. It is an indication of value by using one or more methods that compare the risk and return characteristics of similar investments that have been sold in the marketplace. The value is determined by an analysis of recent sales of similar entities or by using multiples or comparable companies. These multiples can then be used as a benchmark for deriving multiples to be applied to the entity being valued.
The Merger and Acquisition Guideline Company Methodology uses market transactions in businesses, business ownership interests or securities to develop valuation measures that can be used to value the subject business. Guideline companies are companies that provide a reasonable basis for comparison to the characteristics of the subject company being valued. Transactions from sales of these guideline companies can derive market multiples such as the price to revenue multiple.
Case StudyRGL Forensics was engaged by an electronics distribution company to determine its value. The company was a nationwide distributor offering customers a range of production capabilities including cable assembly, panel assembly and box-build. As part of the engagement, RGL requested and received the standard business valuation financial documentation, and summarized and reviewed the company’s balance sheet and income statements for the last five years. A preliminary review determined that the company was reasonably profitable.
Utilizing the market approach, we researched various databases for market transactions in the company’s industry, and several transactions with similarity to the subject company were found. A thorough analysis and calculation was performed and we derived a price to revenue multiple for use in the business valuation. While we focused on the price to revenue, other multiples, such as the price to earnings multiple, could also be derived.
Since the price to revenue multiples use revenues as the company parameter, the revenues of the subject company were closely scrutinized — particularly revenues by month for the last three years. Upon review, it became evident that several months’ collected revenues were lower in comparison to the other months. Since this anomaly could be explained by seasonal or other factors, the situation was discussed with the owner of the company. He was perplexed and had no good explanation for the contrast in monthly revenues. Based on the interview, we decided to take a closer look at the revenue figures.
Additional documentation in the form of customer invoices and cash receipts for the previous three years was requested. A close review of these documents revealed that various customer invoices were not paid. However, according to the accounting system, the customer invoices were no longer outstanding. In fact, the invoices had various adjustments posted to them to show paid in the system but no cash had been collected. At this point, it became clear to us that our business valuation engagement had turned into a Fidelity investigation.
Further investigation revealed an embezzlement scheme whereby various customer checks were not deposited into the company account, but were instead cashed by an employee of the company who had stolen them and deposited them into his personal bank account. Thus, the mystery of the company’s understated revenue figures was solved. We adjusted the company’s revenues to a more normalized state and completed the business valuation. The end result was an increase in the value of the company.
As part of a standard business valuation, RGL Forensics could have taken the financial performance of the company on its face value. However, a forensic accountant‘s job is to investigate and analyze all available financial information to determine the accuracy and completeness of the disclosures. This forensic investigation revealed Fidelity issues that directly impacted the subject company’s value.
Forensics can, and should, be used when business valuation projects are completed.
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Steven J. Hazel, CPA, ABV, ASA, CVA, CMC, is a Director in the Denver office of RGL — Forensic Accountants & Consultants. With more than 25 years of accounting experience, he is highly credentialed in the area of business valuation.