Watch out for financial misstatement

A valuation is only as accurate as its underlying financial data. Some unscrupulous business owners employ creative accounting techniques to hide assets or lower profits.

When these smoke-and-mirror tactics go undetected, they reduce the company’s appraised value. Financial misstatement is especially common when the business is involved in contentious litigation, such as a divorce or an oppressed minority shareholder case.

Although not exhaustive, the following list outlines some of the common ways deceitful controlling shareholders can massage the numbers:

Misreporting revenues or expenses - Revenues and their corresponding expenses should be “matched” in the reporting period in which they were earned or incurred. But if an owner delays revenue recognition or accelerates expense recognition, he or she will artificially lower profits in the current accounting period. Failing to properly adjust owners’ compensation and related-party transactions. Owners’ compensation is among the most common valuation adjustments. By comparing an owner’s compensation to industry benchmarks or various compensation studies, the valuator can assess whether it appears reasonable. Valuators also identify related parties and evaluate whether related-party transactions, such as rental payments and management fees, occur at arm’s length.

Mishandling of business expenses - Many private business owners treat their companies’ checking accounts as their own personal accounts. For instance, the business might fund the owner’s legal fees or excessive meals and entertainment.

Mishandling of quasi-business assets -  On the other hand, owners sometimes report personal assets, such as art collections or vacation homes, on their companies’ balance sheets. Like other non-operating assets, these items (and, if applicable, their corresponding income and expenses) should be isolated. The valuator then makes a last-minute adjustment to his or her value conclusion for the fair market value of the quasi-business asset.

When valuing private businesses, valuators traditionally don’t investigate for fraud. Instead, they assume that the subject company’s financial statements are complete and accurate. They customarily disclose this assumption in an addendum to the written valuation report.

Parties who suspect foul play should discuss these concerns with their valuators. Nonmonied spouses and minority shareholders are especially helpful at directing valuators to the specific assets or expenses that controlling shareholders have manipulated.