Forensic Technology and Business Valuation
How forensic accountants fit in the puzzle.
May 26, 2009
There are a number of reasons forensic accountants are engaged to perform business valuations. Business valuations are required in the buying and selling of businesses (mergers and acquisitions), compliance financial reporting, tax issues and for myriad litigation purposes. 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, Fraud and Fidelity. This final article focuses on Forensic Technology.
Forensic technology refers to the review and analysis of electronically stored information (ESI) that exists on a computer in the form of native files, e-mails, documents, archived content and even deleted content. Forensic technology services are often requested in response to e-discovery matters, and may include digital evidence recovery, forensic data analysis and disclosure management services. However, the use of forensics, including forensic technology, can be helpful in business valuation. The following case study illustrates how a standard business valuation, used in tandem with forensic technology, uncovered fraudulent revenue reporting.
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. The income approach is often utilized, and can be defined as follows:
Income Approach — based upon the principle that value is based upon the expectation of future benefits. It is an indication of value using one or more methods that convert anticipated economic benefits into a present single amount. Value calculations are performed by either discounting future projected benefits to the present or by capitalizing normalized historical benefits.
The Capitalized Earnings Methodology is based upon the premise that the value of a company can be determined by assessing the future cash earnings that will be derived from the ongoing operations of the business. The assessment of such future cash earnings requires that the risks associated with the company's operations be analyzed and reflected in the calculation. In essence, the capitalized earnings methodology attempts to measure what a buyer would be willing to pay currently for the future cash-generating potential of an entity.
Known as a single-period discounting technique, this methodology seeks to derive a "normalized" or "typical" (i.e., free of unusual, non-recurring financial events) single-period (i.e., annual period) cash-flow for the company that a buyer would believe could be expected in the next period. This single period is then assumed to be indicative of all future periods, with provisions for expected future nominal growth (i.e., including inflationary growth) being made through an adjustment to the discount rate.
RGL Forensics was engaged to perform a business valuation of a brokerage company that offered wealth management services. We were hired by a minority shareholder of the firm. The brokerage company provided investments in private and public mutual funds. As part of the engagement, RGL requested and received the standard and customary business valuation financial documentation, and summarized and reviewed the company’s balance sheet and income statements for the previous five years. A preliminary review determined that the company was very profitable.
Utilizing the income approach, we performed an analysis to determine the “normalized” cash-flow from the company. This involved reviewing the revenues earned by the company from the investments in the private and public mutual funds. We determined that the public mutual funds investment growth was stagnant, while the proprietary private mutual funds showed remarkable growth. We discussed this with the shareholder to determine if he could offer a reasonable explanation for this anomaly, but he could not. Since the cash-flows are ultimately generated from gross revenue, we decided to review those revenues in greater detail. Therefore, we requested investor records for all the proprietary mutual funds, including management and performance fees earned for each fund.
Normally, the necessary financial information to perform this task would be readily available. However, when we asked for the documents we were told that the electronically stored information (ESI) had been destroyed during the conversion to a new accounting system. At this point, our suspicions were elevated. Upon further requests for production, the company advised that all further inquiries should be directed to the company’s attorney. Thus began the litigation.
Standard discovery requests were made as the litigation process began. Again, we were told that the requested documents did not exist. At this point, we asked for e-mail records and hard drives from appropriate employees. Using forensic technology, we were able to obtain accounting database files from the former accounting system that had been deleted from the hard drives. In addition, attachments to emails, including commission reports, were pieced together to determine all investments that were channeled into proprietary mutual funds by investors. With the help of the old accounting software, we printed and analyzed recorded investments into the funds. We cross-referenced those investments with the commission reports and found unusual investments with “house” listed as the salesperson. Upon further review, and with the help of the shareholder, we were able to determine that the investments were bogus. Therefore, the revenue was bogus as well — and greatly overstated.
At that point, the business valuation was the least of our concerns. However, the shareholder was appreciative of the uncovering of the fraudulent activity by company management.
As part of a standard business valuation, RGL Forensics could have accepted the historical financial information available without further investigation. 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 technology investigation revealed revenue recognition problems that would have directly impacted the subject company’s value had they not been located.
Forensics can, and should, be used when business valuation projects are completed.
Steven J. Hazel, CPA, ABV, CFF, ASA, CVA, CMC, is a Director in the Denver office of RGL Forensics. With more than 25 years of accounting experience, he is highly credentialed in the area of business valuation.