Does Your Client Need a Business Valuation? Forensic Accounting? Or Both?

In diagnosing a client’s needs, discerning between a business valuation and a financial investigation can save you a lot of time … and your client a lot of money and frustration

Andrew D. Pappas, CPA

“The beginning of wisdom is to call things by their right names.” – Chinese proverb

In our September 2007 case study (“Due Diligence and the Role of Forensic Accounting”) we discussed a case in which an attorney asked us to perform a business valuation (a service that we don’t provide) when, as it turned out, what the situation truly called for was a financial investigation, which we do provide.

That’s not an uncommon occurrence. Among a surprising number of attorneys, “business valuation” has become a catch-all term that extends beyond valuation services to include – erroneously – financial investigation and its upscale cousin, forensic accounting.

To distinguish between business valuation and forensic accounting, consider these basic definitions:

Business valuation determines the fair market value of a company, or an owner’s interest in a company, using generally agreed upon methodologies. Key valuation factors include the value of assets (e.g., property, plant, equipment, receivables, inventory, intellectual property, customer relationships, goodwill, etc.), the projection of future income and cash flow, and the appropriate rate at which to capitalize future cash flows.

Forensic accounting is the integration of accounting, auditing and investigative skills that produces financial findings suitable for use in a court of law.

Confusion in applying those two disciplines is understandable, since some business situations require both valuation and investigation, while other situations call for one but not the other.

Forensic accounting only. Suspected embezzlement is a prime example of a forensic accounting-only situation. A business owner who believes his company’s cash situation should be healthier than its bank balances indicate may not be immediately concerned with his company’s market value, but he may bring in a forensic accountant to examine whether employees (perhaps in collaboration with vendors or customers) have manipulated cash receipts, banking procedures, payroll, purchasing, inventory controls, expense reimbursement, etc. for their wrongful gain. As we generally advise our clients, we approach such engagements with the assumption that “something is wrong, and someone is bad.”

Business valuation only. There are many purposes for business valuation, including business sales, shareholder disputes, regulatory compliance, divorce, estate and gift tax calculation, ESOP creation, buy-sell agreements, bankruptcy, recapitalization and so on. In most situations the starting point for the projection of future income and cash flows is the company’s historical financial information.

If the parties believe that the subject company’s financial information is reliable, there is probably no role for the forensic accountant, and a business valuation alone is satisfactory. (Note: Pappas & Company enjoys good relationships with Arizona’s top business valuation firms, and we are happy to recommend specific valuation professionals for engagements that require valuation expertise.)

Forensic accounting and business valuation. The key phrase in the preceding paragraph is If the parties believe that the subject company’s financial information is reliable. If there is a serious doubt as to the reliability of the financial records, then forensic accounting and business valuation form a critical one-two punch. It is a logical sequence that, after a forensic accountant determines the reliability of the company’s records, the valuation professional has a more solid foundation for determining the business’s fair market value.

The dual need can arise in various scenarios.

For example, if the prospective buyer of a business wants a valuation to help determine an appropriate purchase price, he may also need a forensic accountant to confirm that the underlying financial information is not misleading in a way that would cause the valuation to be higher than it should be. This could occur if the seller, for example, intentionally overstated sales in anticipation of the sale of the business.

Alternatively, in a divorce situation, the attorney for the spouse not receiving the business may need a forensic accountant to make sure that the underlying financial information is reliable in order to prevent the business valuation from being understated. This could occur if the controlling spouse was underreporting sales (by pocketing some of them rather than running them through the business’ books) or by overstating expenses, such as improperly including expenses from a related entity.

Bottom line. It is important for attorneys to determine whether the client needs a business valuation, a financial investigation, or both. In circumstances where it isn’t clear what is needed, a conversation with a forensic accountant before hiring either a business valuation expert or a forensic accountant may save you time, save your client money, and provide better information that will help you deliver a favorable outcome for your client. ●

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