An article in The New York Times, which speaks of the "forensic accountant [as] a financial detective who can track down the assets of the most miserly of husbands, and experts fees, which can be as low as U.S. $300, but …appear to be an excellent value". A recent settlement in the State of New York of a U.S. $7.6 million marital estate of a Manhattan businessman involved fees of U.S. $275,000 for the business appraiser/forensic accountant.

John Stockdale and I will share some of our experiences with you in our capacity as business appraisers who are often commissioned to seek the truth by performing business valuations when we are "playing with less than a full deck".

In many cases, the business valuation expert retained in divorce litigation or shareholder and partner disputes, faces an uphill battle ?and so do the courts ?in trying to determine the facts and arrive at the truth. A few recent judgments of the family law courts in Canada ?which consider the same type of financial and valuation evidence as the U.S. courts ?provide a shining example of the frustrations and challenges faced both by business appraisers and the courts. For example, recently, the Quebec Court of Appeal unanimously affirmed the findings of the trial judge in a matrimonial matter which presented a host of impediments and challenges to any business valuator representing a wife in her claim for alimentary support.

This divorce case involved an array of financial, valuation and even forensic accounting expert evidence. Some of the comments of the trial judge are included below to show just how difficult and challenging a task the wife’s valuation expert had to confront.

There were 22 days of trial with 14 persons testifying, including the opposing business valuators. The husband ("Monsieur") filed 115 exhibits and his wife ("Madame"), 90.

As the trial judge noted at the outset of the judgment:

"This is an exceptional case; exceptional as to the meanness of the dispute, attributable to a very large extent to the conduct of [Monsieur].
"The Court uses the word ‘mean’ on purpose; it has a double significance: ‘nasty’ and ‘stingy’; the Court means both."

The following additional observations may help set the "flavor" of the frustrations of both Madame’s business valuator and the trial judge.

Madame’s business appraiser, an ASA and Canadian "CPA" (Chartered Accountant), included the following Scope Limitation in his expert’s report:

"We have been requesting …certain information and documents with respect to the various companies in which Monsieur owns shares directly and indirectly, including (but not limited to) Far East Trading Co. and Mexicana Corp. Notwithstanding numerous attempts to procure same, and that Undertakings were given by Monsieur, we have as of the date hereof still not been provided with such information or documents. These relate to a number of factors which would assist us in arriving at a more precise conclusion as to Monsieur’s (a) net worth and (b) real income before tax, in order to help establish his financial ability to pay a lump sum and alimentary pension to Madame. It may be that such documents will be provided to us subsequent to the issuance of this report, in which case we reserve the right to provide additional evidence in respect thereof during the continuation of the proceedings, with the permission of the Court.

"We should also note that certain documents and information were requested during the out-of-court Examinations of Monsieur as well as during the trial [which had actually commenced one year earlier but had been suspended after four days of hearing]. In a number of cases, as they were neither available nor produced during these Examinations, they were to be provided through Undertakings. As of the date hereof, they have still not been produced by Monsieur. Those Undertakings relate principally to Monsieur’s offshore assets, including (but not limited to):

• Shareholdings in Far East Trading Co.;
• Bank account(s) of Monsieur and of the said offshore company;
• Accounts in the Cayman Islands [which were revealed in earlier depositions]; etc.

"Accordingly, we reserve the right to revise our conclusions should such additional documents and/or information be provided to us prior to, or during, the continuation of the Court proceedings.

"By virtue of (a) management remuneration and other benefits emanating from Monsieur’s companies being of a non-arm’s length nature, (b) such amounts being largely discretionary and (c) there being substantial transactions in the Far East and Mexico with respect to which neither information nor documentation has been forthcoming, we arrived at Monsieur’s minimum net worth and minimum real income.

"Production and disclosure by Monsieur of such documents and information would enable us to revise the conclusions arrived at herein and comment upon his financial position and earning capacity during the course of the proceedings."

Even the Court made the following observations after hearing the evidence:

" …it was clear that [Monsieur] wanted a divorce on the terms he felt appropriate; when he realized it was not going to work out his way, he dragged his feet; he postponed; he was away on business and not available; documents were not provided; records did not exist; etc."
…
"What is clear, even striking, is the extent to which personal expenses were paid by the business, either directly, or indirectly, by cash, i.e., undeclared income generated by cash sales and, later, undeclared income from foreign business activities."
…
"Also, it is clear, as one goes through the credit card and travel statements, that [Monsieur] travels so much that most of his day-to-day expenses are carried by the business. It is true he maintains a home …, but he really is not there very much.
"As to the amount or level of cash supported expenses, the Court does not accept [Monsieur’s] testimony that there was never very much money in the home safe ….
"[Madame’s] testimony was that [Monsieur] brought cash home regularly and that there were thousands and thousands of dollars in the safe, which were available to her for the family’s needs; both the second house …and the third house …had a built-in safe".

Madame’s testimony was supported by a witness as well as by numerous exhibits illustrating the extent of cash payments for living expenses such as clothing, children’s camps, private schools, a TV set, a refrigerator, furniture, etc., which all emanated from undeclared cash sales from Monsieur’s business. As to the personal expenses paid through the business, evidence was provided regarding trips, purchases of furniture, household expenses, liquor, and company-purchased gift certificates at major department stores. As the Court stated:

"In summary, the …family unit lifestyle was to a large extent made possible by undeclared income (cash in the safe) and company supported expenses. In other words, [Monsieur] had the business pay for many personal expenses either directly, by passing it off as a legitimate business expense, or indirectly, through the non-declared cash revenues; consequently, he could afford to have the business pay him a low taxable salary.
"[Monsieur] himself confirmed this indirectly when he stated that company tax audits usually generated sizeable personal tax reassessments …".

In addressing the financial and valuation issues, the Court was skeptical, to say the least, of the information provided by Monsieur:

"In general, [his] testimony is to be examined with a very critical eye. He attempted to mislead the Court as to his capacity to pay. It took him a long time to realize that stonewalling, denying and not remembering would not work; for example, his interest in the [offshore] business; for example, the [offshore] bank account.
"[He] says what he thinks he can get away with. For example, concerning his bank account [offshore], he gave three successive versions …."

Evidence was filed with the Court, including faxes between Monsieur and his offshore company in the Far East (in which he had denied having an interest), referring to "my bank account and the bank book you are holding for me."

The judge then concluded: "[Monsieur] lied to the Court concerning his involvement in [the offshore company]".

While Monsieur denied that he owned an entity in the Far East, it was not until only a few weeks before the trial was scheduled to begin (which was three and one-half years after the launching of the divorce litigation), that he admitted that he "owned a few shares" and had been a shareholder for about five years.

Responding to Monsieur’s claim that he was unable to obtain financial statements of his offshore company from his co-shareholder, the Court stated:

"This is a very handy excuse: the refusal of the foreign partner …conveniently located in a jurisdiction sufficiently far away to make it improbable that any serious attempt would be made to verify [Monsieur’s] representations.  … the Court does not accept this explanation."
…
" …[Monsieur] is hard to pin down, even taking into consideration the fact questions related to events years past.
"[He] appears to be incapable of answering a question clearly the first time it is asked; his answers are always hedged; they are couched in terms that prevent us from getting a clear and unequivocal answer: ‘To the best of my recollection’, ‘I believe’, ‘I assume’, ‘I think’, ‘It was a long time ago’; he does not remember, he would have to verify, he would have to check, he can’t recall, it is either one or the other, etc.
"Moreover, in the vast majority of cases, a thorough and complete answer to a question only comes after three or four sub-questions are asked. In other words, a first question is asked and it is answered in a general, vague and hedged manner; this answer has then to be further refined by a series a sub-questions. But only when he is confronted with a document, something tangible, something he cannot refute, does [Monsieur] become forthright and his answers become clear.
"Another pattern of [his] mode of testifying is as follows: he will first make a statement which is false and will then, at a later time, after the break, later in the same day, or the next day, or at the next series of days of hearing, rectify or amend or modify or amplify the first original statement".

The two opposing business appraisers had each produced three reports over a three-year period, opining on (a) Monsieur’s net worth and (b) his (i) "disposable annual income", in the reports of Monsieur’s valuator and his (ii) "minimum real income before tax" (so-called "notional income"), in the reports of Madame’s business valuator. (Each successive valuation report was the result of information subsequently discovered; the first valuation reports were issued in mid-1989, with the latest reports being issued in the spring of 1994.) At trial, while each of the business valuators testified on the contents of his latest report, both experts nonetheless had to file various amending schedules because of still additional information being produced and/or uncovered with respect to Monsieur’s financial position and world income.

Even though Madame’s forensic valuator had been able to identify shares in a Far East operating business as well as bank account, the absence of any financial or bank statements made it impossible to even attempt to attribute any values thereto.

There were, of course, the typical opposing views expressed by the two business valuators as to the level of earnings of the Canadian business, the number of years to be used in the calculation of maintainable earnings, the capitalization rate, financial liquidity and so forth.

The following example is taken from the transcript of the proceedings before the trial court with respect to the offshore business interests which Monsieur had been hiding:

‘[Far East Trading Co.], have you ever head that name?’

Your answer:

‘Yes.’

Question at the bottom of the page:

‘What are your interests in that company?’

Answer on page 15:

‘I buy from them.’
‘Do you have an interest that company?’ What do you own in that company?’
‘I don’t own anything in that company.’
‘So you are saying that all you do is buy from that company, that’s all?’
‘Yes.’
‘Are you informed of the financial situation of that company?’
‘We are friends, and there are times that [the owner] might tell me something about the company.’
‘But not more than that?’
‘No.’
…

With respect to Monsieur’s bank account, the following excerpt from the transcripts is also revealing:

Finally, to "put the icing on the cake", Madame’s attorney and Monsieur had the following exchange:

In another, unrelated matrimonial case before the Quebec Superior Court, noting that the benefits enjoyed by the husband included vacation, travel, meals, golf-club dues and fees, clothing, sets of golf clubs, home repairs, antiques, furniture, paintings and other items of a purely personal nature ?identified by the wife’s business valuator ?the Court stated:

"[As] these charges as not taxed in [the husband’s] hands …, consequently these personal expenses must be ‘grossed-up’ to reflect what it would take in taxable salary to defray such expenses. Assuming [husband’s] marginal tax rate to be [35%], $50,000 in personal expenses requires an additional salary of [$77,000]".
…

"His [girlfriend] has been living with him for the past two years. She is on the [company] payroll …for translations that she does for the company. As well, she receives …in unemployment insurance every two weeks. Her previous employment as a secretary paid $25,000 per year. [Husband] admits that she travelled with him on 13 occasions in Canada, the United States (Florida), Europe and the Orient …at company expense.

"[The girlfriend] testifies that in Hong Kong she checked some translations and took phone messages. In past years [husband] travelled frequently to the Orient and he managed very well without a personal secretary on company expense. The Court finds that her expenses paid for by [the company] are part of [the husband’s] personal expenses.

"The Court accepts the [wife’s valuator’s] analysis that [husband’s] ‘lifestyle indicates an income far in excess of what is report on his tax returns as well as on the Statement of Revenue and Expenses filed by him with the Court’."

In a family law case tried in the Province of Ontario, the judge felt it incumbent upon him to report the undeclared taxable income to the Canadian tax authorities by sending Revenue Canada a copy of the judgment:

"During argument I asked the parties whether they thought it would be appropriate for me to send a copy of these reasons to Revenue Canada. Neither clearly objected although the idea obviously discomforted them.

"I noted that they not only evaded paying taxes ?part of which taxes are used by government to fund the court system ?but also they incurred significant public expense by exhaustively litigating their many disputes in the court system which they saw fit not to support with their share of taxes. They also seemed to take the position that I should not take into account the past evasion of taxes or assumed the evasion will stop in the future when I determine the value of the shares in the business and determine the amount of child support.

"I do not find this acceptable. I believe it would bring the administration of justice into disrepute if I were to simply ignore these matters.

"So far as I could, I have attempted to make my assessment as to past and future matters on the assumption that taxes will be paid. If the tax authorities do no learn of the evasion then these assumptions will not be realistic.

"I am discomforted by being put in a position where I feel I should bring the evasion of taxes to the attention of the authorities. On the other had, the evidence put before me was adduced in a public courtroom and any member of the public and any public official would be entitled to observe or to publish a report of the proceeding. All the evidence is now in the public domain.

"Simultaneously with their release, I am sending a copy of these reasons to Revenue Canada and the Ontario Ministry of Revenue. They may order a transcript of the evidence or review the exhibits filed at trial as they see fit."

Sometimes, in performing a forensic valuation when not having access to complete information and documentation, the business appraiser may consider some of the experiences of the Internal Revenue Service, in its Handbook for Special Agents, as well as the various IRS Market Segment Specialization Program Audit Technique Guides. There are 23 Guides available to date. These are listed in the Appendix and are available through the U.S. Government Information Sales Program, Government Printing Office, Washington, D.C. 20401.

In Canada, the Revenue department provides its tax auditors (field auditors) and special investigators with a Taxation Operations Manual. It is available to the public for inspection at various District Taxation Offices, but much of the sensitive data have been extricated. In any event, the types of conduct, symptoms or improprieties which might be uncovered by Revenue Canada’s tax auditors (the "front-line" troops for enforcement), possibly triggering an "audit" by agents of the Special Investigations Branch, include:

• Backdating;
• Misleading characterization;
• Oral (rather than written) agreements;
• Creating documents;
• Offshore wealth;
• Use of nominees or frontmen;
• Multiple financial steps;
• Unusual expenses;
• Special allowances;
• Alteration of records;
• Disregard for books and records;
• Using cash instead of bank accounts.

While none of the foregoing, or even a combination thereof, will necessarily trigger a special investigation, it will not doubt raise a "red flag", with the matter being addressed only at the field-audit level.

Under-reporting income and/or overstating expenses affects, among other things:

• The value of a business and, hence, a business ownership interest;
• The position of the company’s shareholders;
• The position of the company’s creditors;
• The position of the (divorcing) spouse of a shareholder;
• The public treasury.

I read an article in FairShare a few years ago about a forensic valuator in a matrimonial matter who was investigating a basic delicatessen operation which catered to a breakfast and lunch crowd and derived most of its income from the sale of pastrami, corned beef and other sandwiches as well as coffee and various small grocery items. With the husband-owner being sued for alimentary support, and being the type of cash business that it was, not everything was recorded in the deli’s books.

The business appraiser’s client, the deli owner’s wife, tipped off the appraiser that there were two cash registers with the proceeds of only one being reported. When confronted by this allegation, the husband acknowledged that he had two registers but one was "inoperable". He did, however, comply with the accountant’s request for a copy of the cash register tapes from the register that was operable. These tapes tied into the income reported on the husband’s tax return.

However, a physical visit to the deli by members of the valuator’s firm revealed that both registers were being actively operated. The husband, during his interview with members of the valuation firm, explained to them how much product goes into the sandwiches. Subsequently, other members of the valuation firm whom the husband had not seen before, went to the deli and ordered a few sandwiches to take out. The valuators took the sandwiches back to their office where they dismantled and weighed them on two separate postage scales. On this basis, they were able to calculate the cost of the ingredients that went into the sandwiches. This was used as a model for determining (at least with respect to the sandwich portion of the business) gross profit. The respective gross profits from other segments of the business were determined by applying other methods.

In reconstructing the cost of a sandwich, a breakdown was made as among:

• The roll;
• Meat (in ounces);
• Cheese (in ounces);
• Tomato, lettuce, oil and vinegar.

Naturally, different types of sandwiches have different ingredients and adjustments would be made as appropriate.

Having estimated the cost of a sandwich and knowing the selling price from the menu, the cost percentage can be determined which, when viewed in the context of the total business, can yield the weighted average cost percentage. For example, if the aggregate cost of the ingredients were $1.80 and the selling price of the sandwich $3.50, the cost ratio would be 51.4%. Assuming that sandwich sales equal 45% of the business, the weighted average cost ratio would be 23.13% (45% x 51.4%).

Separate calculations were made by the valuators with respect to potato chips and packaged cakes, soft drinks, cigarettes, milk, grocery and sundry as well as coffee. For example, the calculation with respect to coffee was analyzed on the basis of the number of packages and the yield in terms of cups (e.g., 80 packages yielding 560 cups). Milk, cream and sugar would be factored in so that a cost of 560 cups of coffee could be determined and, in a manner similar to that with respect to the sandwiches, a weighted average cost ratio could be determined. (Based on discussions and a review of various data, it was assumed that coffee comprised 6% of the total business.)

Finally, an "error rate" and "wastage allowance" was calculated at 6% of cost in arriving at the "reconstructed cost of goods sold as a percentage of total sales". This percentage was then applied to the total cost of sales during the period under review in order to determine estimated total sales, as reconstructed from the cost of goods sold. For example, if total cost of goods sold for a nine-month period is $150,000, and the cost of goods sold as a percentage of total sales is, say, 65% (based upon the weighted average cost ratio determined earlier), estimated total sales would then be $230,770. If reported sales for the period are $186,000, then implied unreported sales would be $44,770 ($230,770 - $186,000). For the full twelve months the implied unreported sales would be 12/9ths or $59,690. The matter was settled.

Incidentally, having two (or more) cash registers) with one (or more) being used for unreported sales as in the "deli case" is not unique. For example, in a Canadian case (which involved a retail video store operation), the judge commented as follows:

" …It is also in evidence and not contradicted that, in the operation of the business, two cash registers were used, one primarily for VHS cassettes and the other for Beta cassettes. Apparently it was agreed between the three partners that the Beta cash register would be used for unrecorded cash receipts and also by the partners in order to withdraw cash from the business. It also appears that certain expenses were paid from the receipts in this cash register. It is also in evidence and uncontradicted (and I must assume that this figure is correct), that each of the three shareholders withdrew from this cash register a sum of approximately $8,000 during the period aforementioned in partial repayment of the loans of $30,000 which each of them had made, leaving a balance owing to each partner of approximately $22,000."

Assuming that the forensic business appraiser is confronted with a similar situation, where complete disclosure is not forthcoming (whether in a divorce matter, shareholder dispute, or other purpose), the accompanying schedules and charts in the Appendix highlight some of the areas in which the appraiser might consider focusing particular attention. He or she must, in effect, "construct" or "reconstruct" the financial statements of the subject enterprise ?and, typically, this is only a starting point. I have used a detailed checklist geared to a restaurant and bar establishment as well as other, more general, areas requiring the use of "forensics" in the valuation process. As will be noted, I have not focused at all there is no focus on the balance sheet, as the assumed scenario is strictly income related. Naturally, each investigative analysis will be tailor-made. Thank you.