A real-life case can provide valuable insights into valuation issues and how to resolve them. Each case requires thoughtful analysis and the creation of a work program designed specifically for the situation at hand. This article was written by a CPA at Cowan, Gunteski & Co., P.A., a member of CPAmerica International located in Toms River, N.J.
The situation
Our firm, was recently retained by a wife in a matrimonial matter. Her husband owned a business in retail produce. In accordance with New Jersey case law for matrimonial cases, we typically value the business as of the date the complaint for divorce was filed. Depending on when we are brought into the case, this can mean that we are preparing reports a year or more after the complaint has been filed. This can lead to a lack of records or, at times, a lack of recollections.
Our starting point for a business valuation is the company’s prior five years of tax returns and financial statements. We research the industry, acquire benchmarking and market data on the industry for comparison, and analyze the company’s financial performance, as well as its assets and debt structure. These, along with our forensic analyses, help to identify, examine and, if necessary, make adjustments to the reported income stream upon which our valuation is based.
Our findings
Unreported Income – When considering an allegation of unreported income, we must look at the company’s income sources and determine if there is an opportunity for this to occur. Certain industries lend themselves to a greater possibility of unreported income. If opportunity is there, it is often difficult to quantify the exact income amount.
An analysis of the company’s bank records and the business owner’s personal bank accounts, personal assets and lifestyle should be performed to ascertain if the reported income is consistent with these items. When confronted with the “cash” allegation, it is important to remember that, regardless of the information provided, the business owner always knows how much income their business generates.
Our investigation into this company’s income sources – which were several retail produce locations – indicated the opportunity for cash income was significant. Our first step was to determine how the income reported on the tax return was calculated. We discovered the income reported was the total amount of deposits into the company checking account each year. Further analysis of the banking records for unreported income was not warranted.
Lifestyle – The husband reported a modest salary. Both parties were in their early forties, and they had three children. They agreed on the Case Information Statements that they spent approximately $30,000 per month. Their home was appraised for about $1.4 million, and they had two vacation homes collectively appraised at about $1.5 million. They had no credit card debt and a single mortgage of approximately $500,000 on all of the properties. In addition, they owned the property where the retail produce locations operated with minimal debt and had several investment accounts personally.
Debt – Often, when there is the appearance of an extravagant lifestyle and significant personal assets, there is the allegation of cash. This idea is also more prevalent when the parties seem relatively young to have acquired such assets. In most cases, there is some truth to the allegation of unreported income. Debt can be a useful tool to determine the extent or quantify the cash component. Generally speaking, a lifestyle funded by cash has little or no debt.
In this case, the personal assets acquired and the extravagant lifestyle with minimal debt indicate there is significant cash income being generated by the company.
The Estimate – How do we calculate cash income? It will always be an estimate or a range. Each case is different, and we have to use all the information we are provided, in addition to having discussions with the parties. Benchmarking data are often helpful.
As said earlier, the business owner always knows how much income is being generated. There is nearly always the proverbial “second set of books,” whether it is a separate bookkeeping system or handwritten calculations.
Sometimes, you get lucky with the information you are provided. In this case, we were. The wife found a spiral-bound notebook in their home after the husband left. In this notebook was six months of his “second set of books.” From this information, we calculated a range of cash income. When this was compared to the lifestyle and assets, we narrowed the range further. Inevitably, this calculation and our value led the way to a settlement in mediation.
Cash Expenses – Often, when the opportunity for unreported income is significant, the opportunity to pay expenses in cash is also significant. Most common is cash payroll or product paid in cash. It is important to include these expenses in an adjustment for unreported income.
Each case has nuances that require the keen analytical skills of the business valuation analyst. Careful planning and procedures can help assure that all the relevant data have been captured to issue a proper business valuation report.