The economist often works with business valuation information.docx

The economist often works with business valuation information.docx

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Theeconomistoftenworkswithbusinessvaluationinformation

ToolstoApplytoFinancialStatements

toIdentifyErrors,OmissionsandFraud

inBusinessValuations

TomClevenger*

WashburnUniversity

and

GaryBaker**

WashburnUniversity

Ofteneconomistsareaskedtovaluebusinesses.Manytimestheinformationprovidedisminimalandofquestionablevalue.Datamaybeprovidedbypartieswishingtobiasthevaluation.Thefinancialstatementstypicallyprovidedarebalancesheetsandincomestatements.Thesesourcescanbefraughtwitherrors,omissionsandevenfraud.Thecashflowstatementsderivedfromthesestatementscanbemisleadingandanyanalysisfromthesespuriousstatementsissuretobequestioned.

Asetoftoolsexistthatcanbeusedtoestablishthereliabilityofthesefinancialstatements.Reliabilityisusuallytakenforgrantedinbasicaccountingandfinanceandrealityisoftennotasassumed.Thetoolkitusesbasicaccountingandmathematicallogic.Thislogic,teamedwithbasicaccountingdefinitionsandconventions,allowstheeconomistsomecomfortthatthestatementsprovidedforuseinthebusinessvaluationarefreeofobviousmisinformation.Thesetoolscanalsohelpuncoversomelessdetectablefraud.

Fortheanalysistoproceedtheremustbetwobalancesheetsandtheinterveningincomestatement.Byapplyingtheaccountingconventionsanddefinitions,real,probableandpossiblesolutionsaredevelopedandexplained.Afterexaminingtherelationshipbetweenthefinancialstatementsoneisbetterabletovaluethebusinessandbeconfidentoftheanalysis.

Introduction

Mostschemesusedtohidebusinessvaluesaredeceptivelysimpleinoriginandoperation.Beingawareofthebasicschemesmakestheeconomistabletobetterjudgeabusinessesvalue.Theexistenceofoneormoreoftheschemescanleadtheeconomisttoseekfurtherinformation.Theamountsoffraudssumtostaggeringamountsestimatedat$660billioninannuallossesin2003.

Fraudexists.ThisiseasilyseenintherecentfinancialfailuresoflargecorporationssuchasEnrontonameoneofmany.RegulatoryreactiontothesehasbeentheSarbanes-OxleyAct.Regulatoryactionatsuchalevelwhereprofessionalsinaccountingandauditingcanbemisledindicatethatcautionisrequiredatalllevelsofbusinessvaluation.

OnecanpickupanyofthejournalsoftheAmericanInstituteofPublicAccountants’“JournalofAccountancy”,theInstituteofInternalAuditor’s“InternalAuditor”,theInstituteofManagementAccountant’s“StrategicFinance”,andtheAmericanAssociationofCertifiedFraudExaminer’s“TheWhitePaper”and“FraudMagazine”andfindreviewsoftheaccountingbasicsfortheseprofessionalsrelatedtofraud.Timelyinformationisalsofoundonlinethroughtheseorganizations.（www.aicpa.org,www.theiia.org,www.imanet.org,）TheWallStreetJournalisanothercontinuoussourceoffinancialmisrepresentations.Frauds,largeandsmall,usuallyarenotcomplex.Eventhemethodsofmanipulationsaresimpleonceexposed.Havingsometoolstoassistintheearlydetectioncanbeofgreatusefulnessinbusinessvaluationsforaneconomist.

Basicaccountingandfinanceusuallymaketheassumptionthattheinformationpresentedisreliable.Thereexiststhepotentialthatbiasexistsinfinancialinformationprovidedbythoseseekingtoovervaluetheirassetsorundervaluetheirbusinessasthesituationmerits.Onecanuseverybasicassumptionstogleanacomfortlevelaboutinformationtheeconomistisgiventouseinabusinessvaluation.

Assumptions

Thispapermakesseveralassumptions:

Thebusinessbeingvaluedwillcontinueinbusinessfortheforeseeablefuture;thefinancialinformationinitiallyprovidedisminimal;thematerialreceivedmaybeofquestionablecharacter;andtheinformationprovidedbythebusinessmaybedesignedtobiasthevaluation.

Theeconomistvaluingthebusinessmustunderstandthefinancialstatementsmaybelessthanstraightforward.Recordsanddocumentsmaybealteredorcreatedforpurposesotherthanvaluingthebusiness.Accountingprinciplesaresubjecttointerpretationandtheapplicationoftheprinciplesmaybeaggressiveorconservativedependingonthepersoncreatingthestatements.Theomissionoradditionoftransactionsmayalsoalterthestatements.

Theincomestatementgoalistomatchtheexpensesincurredtotherevenuegenerated.Thisistheaccrualmethodofaccountingandtodothismethodfouradjustmentstotimingofrevenuesandexpensesareneededwherebyitemsaredeferredoraccrued.Theadjustmentswhenmisusedareinrevenuetimingmanipulation,assetvaluemanipulation,expenseconcealmentordefermentandliabilityconcealment.

Theevaluatorneedonlyrecognizethattheaccountantisacceleratingorslowingrevenuesorexpensesappearanceinfinancialrecords.Thesefouraccrualsanddeferralsarethenoffsetto,orfrom,thebalancesheet.Suchadjustmentstotheaccountingrecordsarereflectedintheensuingfinancialstatements.Thepreparer,bytimingtheseadjustmentsnearyear-end,canchangecompletelythefinalreportedresultsintheshortrun.WorldComaccomplishedbyputtingexpensesonthebalancesheetbutevenindoingsotherevenuesandearningsornetincomeandcashflowweremovingatdifferentratesanddirectionsindicatingsomethingwasamiss.

IncomeStatementsandBalanceSheets

Theincomestatementandbalancesheetscanbeviewedaspartsofavideogame.Theincomestatementcanbeviewedasseriesofframesofagame.Eachframerepresentsaneventortransaction.Revenuesarepointsforthecompanyandexpensesarepointsfortheopponent.Iftherevenuefortheperiodexceedstheexpensesfortheperiodthecompanywins.Theexcessoftheperiodisprofits.Unlikesports,theexcessordeficiencycarriesovertonewperiodsasretainedearnings.

Thebalancesheetrecordsthestandingoftheteambeforeandafterthegame.Oncethestandingoftheplayerisdeterminedthegamerestarts.Theoutcomeofthegameissubjecttomanipulationbyalteringwhenthevideostopsandrecordsthestandings.Theresultsoftheaccrualmethodandthecashmethodofaccountingproducethesameresultsinthelongrunfromopentocloseofabusiness.

Iftheeconomistisconcernedthatthevalueofthebusinesshasbeenmisrepresentedthenoneshouldlooktotheincomestatementofseeifrevenuesareoverstated,expensesareunderstated,orboth.Thebalancesheetneedstobeexaminedtoseeifthevalueoftheassetsisinflatedorthevalueofliabilitiesminimized.Normallytheassetsareundervaluedonthebalancesheetsincethevaluesarebookvaluesandnotmarketvalues.

ExampleofIncomeStatementandBalanceSheetManipulation.

Thevalueofacompanymaybedeterminedforseveraldifferentreasons:

addinganewpartner,apartnerexitsthebusiness,adivorce,thesaleofthebusiness,bankruptcy,applicationforaloan,orlossofearnings.Inthisexample,theGTCompanysellsandservicesproductsinahightechfield.ThehistoricalincomestatementsandbalancesheetsarepresentedintablesIandIIrespectively.

TableIIIpresentsselectedratiosthatsuggestthefirmisdoingwell.Assumingthevalueofthefirmisestimatedbycapitalizingthefirm’scashflow,thevalueofthefirmhasincreasedeachyear.Ifthecapitalizationrateis20%,thevalueofthefirmhasincreasedfrom$67,000in2001to$727,000in2004.Regardlessofthecapitalizationrate,thevalueofthefirmhasincreasedmorethantentimesfrom2000to2004.

Thereshouldbesomeconcernwiththeratiosfor2004.Thegrossprofitmarginin2004indicatesasignificantdecreaseinthecostofgoodssold.Whilethismightbepossiblethroughtechnologicaladvances,thechangesuggestsfurtheranalysisisnecessary.

Fiveadditionalratiosshouldalsoserveasredflags.Theratiosarecreditcardexpenseasapercentofsales,accountsreceivableturnover,day’saccountsreceivableoutstanding,inventoryturnoverandnumberofdaystoturninventory.TheseratiosarepresentedinTableIV.

CreditcardexpenseisthediscountGTmustpaythecreditcardcompany.AssumeGTpays10%foreachdollarofcreditsales.Duringtheyears2001,2002and2003creditcardexpensewas5%ofsales.

In2001thecreditcardexpenseof$5,000meansthatcreditsaleswere$50,000fortheyear.Creditsalesfor2002and2003were$75,000and$105,000respectively.Ineachyearthecreditsaleswereabouthalfoftotalsales.

In2004creditcardexpensewas$13,000.Ifthesame5%appliedthenthecreditsaleswouldbe$130,000.Ifcreditsaleswereone-halfoftotalsalesthentotalsalesshouldbeabout$260,000.However,salesarereportedat$450,000.Thismeans,a.errorsexist,b.thefirmhadanenormousincreaseincashsales,orc.someoneisfalsifyingsalesdocuments.（Checkcashingcompanyguaranteefeesmayalsobeusedforsuchanindicator.）

Theaccountsreceivableturnoverhasdecreasedfrom6.67timesayear,orevery54.75daysto1.48timesperyearorevery247days.Thismeanthatcredithasbeenextendedtoagroupofverypoorpayingcustomersor,perhapsthesalesrecordsareinerrororarebeingfalsified.

Inventoryturnoveralsoindicatesunusualactivity.In2001theturnoverwastwiceayearorevery183days.Butin2004inventoryturnedover25timeorevery14.6days.

Alloftheseratiossuggestthatmaybegamesarebeingplayedinthesalesareathatisfraudulent.Industryratioswillalsobehelpfulinthisareaforaddedanalysis.

RelatedIncomeStatementandBalanceSheetAccounts

Understandingtherelationshipofincomestatementaccountsandbalancesheetrelatedaccountslendsunderstandingtoabusinessvaluation.Twoseparategroupsofaccounts