The economist often works with business valuation information.docx

1、The economist often works with business valuation informationTools to Apply to Financial Statements to Identify Errors, Omissions and Fraud in Business ValuationsTom Clevenger*Washburn UniversityandGary Baker*Washburn UniversityOften economists are asked to value businesses. Many times the informati

2、on provided is minimal and of questionable value. Data may be provided by parties wishing to bias the valuation. The financial statements typically provided are balance sheets and income statements. These sources can be fraught with errors, omissions and even fraud. The cash flow statements derived

3、from these statements can be misleading and any analysis from these spurious statements is sure to be questioned.A set of tools exist that can be used to establish the reliability of these financial statements. Reliability is usually taken for granted in basic accounting and finance and reality is o

4、ften not as assumed. The tool kit uses basic accounting and mathematical logic. This logic, teamed with basic accounting definitions and conventions, allows the economist some comfort that the statements provided for use in the business valuation are free of obvious misinformation. These tools can a

5、lso help uncover some less detectable fraud. For the analysis to proceed there must be two balance sheets and the intervening income statement. By applying the accounting conventions and definitions, real, probable and possible solutions are developed and explained. After examining the relationship

6、between the financial statements one is better able to value the business and be confident of the analysis.IntroductionMost schemes used to hide business values are deceptively simple in origin and operation. Being aware of the basic schemes makes the economist able to better judge a businesses valu

7、e. The existence of one or more of the schemes can lead the economist to seek further information. The amounts of frauds sum to staggering amounts estimated at $660 billion in annual losses in 2003.Fraud exists. This is easily seen in the recent financial failures of large corporations such as Enron

8、 to name one of many. Regulatory reaction to these has been the Sarbanes-Oxley Act. Regulatory action at such a level where professionals in accounting and auditing can be misled indicate that caution is required at all levels of business valuation. One can pick up any of the journals of the America

9、n Institute of Public Accountants “Journal of Accountancy”, the Institute of Internal Auditors “Internal Auditor”, the Institute of Management Accountants “Strategic Finance”, and the American Association of Certified Fraud Examiners “The White Paper” and “Fraud Magazine” and find reviews of the acc

10、ounting basics for these professionals related to fraud. Timely information is also found online through these organizations. (www.aicpa.org, www.theiia.org, www.imanet.org, ) The Wall Street Journal is another continuous source of financial misrepresentations. Frauds, large and small, usually are n

11、ot complex. Even the methods of manipulations are simple once exposed. Having some tools to assist in the early detection can be of great usefulness in business valuations for an economist.Basic accounting and finance usually make the assumption that the information presented is reliable. There exis

12、ts the potential that bias exists in financial information provided by those seeking to over value their assets or under value their business as the situation merits. One can use very basic assumptions to glean a comfort level about information the economist is given to use in a business valuation.A

13、ssumptionsThis paper makes several assumptions: The business being valued will continue in business for the foreseeable future; the financial information initially provided is minimal; the material received may be of questionable character; and the information provided by the business may be designe

14、d to bias the valuation.The economist valuing the business must understand the financial statements may be less than straightforward. Records and documents may be altered or created for purposes other than valuing the business. Accounting principles are subject to interpretation and the application

15、of the principles may be aggressive or conservative depending on the person creating the statements. The omission or addition of transactions may also alter the statements. The income statement goal is to match the expenses incurred to the revenue generated. This is the accrual method of accounting

16、and to do this method four adjustments to timing of revenues and expenses are needed whereby items are deferred or accrued. The adjustments when misused are in revenue timing manipulation, asset value manipulation, expense concealment or deferment and liability concealment.The evaluator need only re

17、cognize that the accountant is accelerating or slowing revenues or expenses appearance in financial records. These four accruals and deferrals are then offset to, or from, the balance sheet. Such adjustments to the accounting records are reflected in the ensuing financial statements. The preparer, b

18、y timing these adjustments near year-end, can change completely the final reported results in the short run. WorldCom accomplished by putting expenses on the balance sheet but even in doing so the revenues and earnings or net income and cash flow were moving at different rates and directions indicat

19、ing something was amiss.Income Statements and Balance SheetsThe income statement and balance sheets can be viewed as parts of a video game. The income statement can be viewed as series of frames of a game. Each frame represents an event or transaction. Revenues are points for the company and expense

20、s are points for the opponent. If the revenue for the period exceeds the expenses for the period the company wins. The excess of the period is profits. Unlike sports, the excess or deficiency carries over to new periods as retained earnings.The balance sheet records the standing of the team before a

21、nd after the game. Once the standing of the player is determined the game restarts. The outcome of the game is subject to manipulation by altering when the video stops and records the standings. The results of the accrual method and the cash method of accounting produce the same results in the long

22、run from open to close of a business.If the economist is concerned that the value of the business has been misrepresented then one should look to the income statement of see if revenues are overstated, expenses are understated, or both. The balance sheet needs to be examined to see if the value of t

23、he assets is inflated or the value of liabilities minimized. Normally the assets are undervalued on the balance sheet since the values are book values and not market values.Example of Income Statement and Balance Sheet Manipulation.The value of a company may be determined for several different reaso

24、ns: adding a new partner, a partner exits the business, a divorce, the sale of the business, bankruptcy, application for a loan, or loss of earnings. In this example, the GT Company sells and services products in a high tech field. The historical income statements and balance sheets are presented in

25、 tables I and II respectively.Table III presents selected ratios that suggest the firm is doing well. Assuming the value of the firm is estimated by capitalizing the firms cash flow, the value of the firm has increased each year. If the capitalization rate is 20%, the value of the firm has increased

26、 from $67,000 in 2001 to $727,000 in 2004. Regardless of the capitalization rate, the value of the firm has increased more than ten times from 2000 to 2004.There should be some concern with the ratios for 2004. The gross profit margin in 2004 indicates a significant decrease in the cost of goods sol

27、d. While this might be possible through technological advances, the change suggests further analysis is necessary.Five additional ratios should also serve as red flags. The ratios are credit card expense as a percent of sales, accounts receivable turnover, days accounts receivable outstanding, inven

28、tory turnover and number of days to turn inventory. These ratios are presented in Table IV.Credit card expense is the discount GT must pay the credit card company. Assume GT pays 10% for each dollar of credit sales. During the years 2001, 2002 and 2003 credit card expense was 5% of sales. In 2001 th

29、e credit card expense of $5,000 means that credit sales were $50,000 for the year. Credit sales for 2002 and 2003 were $75,000 and $105,000 respectively. In each year the credit sales were about half of total sales.In 2004 credit card expense was $13,000. If the same 5% applied then the credit sales

30、 would be $130,000. If credit sales were one-half of total sales then total sales should be about $260,000. However, sales are reported at $450,000. This means, a. errors exist, b. the firm had an enormous increase in cash sales, or c. someone is falsifying sales documents. (Check cashing company gu

31、arantee fees may also be used for such an indicator.)The accounts receivable turnover has decreased from 6.67 times a year, or every 54.75 days to 1.48 times per year or every 247 days. This mean that credit has been extended to a group of very poor paying customers or, perhaps the sales records are

32、 in error or are being falsified.Inventory turnover also indicates unusual activity. In 2001 the turnover was twice a year or every 183 days. But in 2004 inventory turned over 25 time or every 14.6 days.All of these ratios suggest that maybe games are being played in the sales area that is fraudulent. Industry ratios will also be helpful in this area for added analysis. Related Income Statement and Balance Sheet AccountsUnderstanding the relationship of income statement accounts and balance sheet related accounts lends understanding to a business valuation. Two separate groups of accounts