CPAs ANALYZE FINANCIAL STATEMENTS IN DISSOLUTION CASES
What do forensic accountants look for when they review
financial statements of a business provided to them by counsel?
What are the signs that there are irregularities taking place?
What are the typical types of financial statements?
There are three standards and three types of financial
statements. The three standards are audits, reviews and
compilations. The three types are balance sheets, income
statements, and statements of cash flows (these sometimes
have other names).
This article will explain the standards, the types, and
then the techniques used to analyze them.
Keep in mind that these standards and types apply to financial
statements prepared under generally accepted accounting
principles (GAAP); the forensic accountant then studies
these financial statements and conducts certain testing
that will be described below, and he may report his findings
to a court in a format that does not conformto the above
standards and types.
Standards of Financial Statements
The first matter that is examined is what is called the
standard of accountants' services rendered in preparation
of the financial statement. Generally, the higher the standard
by the company's CPA's, the lower will be the intensity
of analysis by the forensic accountants. One therefore looks
to see what standard of financial statement is being presented
and who prepared them.
An audited financial statement is one that is tested
to the greatest degree by the company's CPA's; a reviewed
financial is tested to some degree, and a compilation does
not have to be tested at all.
A compilation (a compiled financial statement) can
simply be a presentation in the proper form of financial
statement of financial information taken directly from the
company's records without any further analysis. In other
words, to prepare a compiled financial statement, an accountant
can simply look at a company's general ledger or other financial
information, accept the company's numbers as being accurate.
The accountant then simply collects the company's numbers
and puts them together on a piece of paper that is in the
correct format of classical financial statements. There
is no requirement to actually analyze the numbers to see
that they are accurate. There are many accountants who prepare
compilations with much better quality than this - they demand
backup for many of the numbers and do other work, but that
is not required for a compilation.
The second standard of financial statement is a review,
and an accountant who prepares a reviewed financial statement
is required to perform various analytical testing of the
numbers so that the amounts appear reasonable.
The third standard is an audit, where the accountant performs
a much greater level of testing of the numbers.
To illustrate the differences between the three standards,
a company that sells goods on credit will have accounts
To prepare a compilation, an accountant need only call
up the company's controller/bookkeeper and ask what is the
amount of the accounts receivable. Whatever the controller/bookkeeper
tells him goes on the financial statement as the amount
of the accounts receivable.
To prepare a review, the accountant will probably look
at the company's accounts receivable printouts, will
compare this year's amounts with prior year's amounts, will
compare this year's amount of accounts receivables with
this year's sales, do the same for the prior year, and thereby
try to see if the amount of accounts receivable appears
To prepare an audit, he will not only do what is done at
a review level, but will actually send out letters to many
of the customers asking them to write him back confirming
that the amounts that the company said are owed are actually
Therefore, in a dissolution matter, if a forensic accountant
is given financial statements to analyze, he first tries
to ascertain the quality of the statements. He will perform
much more analysis if he is given compilations than if he
were given audited financial statements. He would also look
at the firm preparing the financial statements.
Types of Financial Statements
A balance sheet (many firms call it a statement of financial
condition) has two groups of numbers, both of which equal
each other: they "balance."
The first group of numbers identify the assets of the company.
The assets are reported on a cost basis, so that if, for
example, a building was purchased many years ago for $500,000,
and is worth two million dollars today, the balance sheet
would show a building with a cost of $500,000. (The forensic
accountant would then adjust the balance sheet to reflect
that the current value is two million.)
The second group identifies the liabilities and capital.
The theory is that assets are acquired by either borrowing
money or by investing money, and so the assets equal the
sum of the borrowings and the invested capital. Looking
at it a little differently, if one were to subtract the
liabilities from the assets, one would arrive at the amount
identified as "capital."
ASSETS = LIABILITIES + CAPITAL
ASSETS - LIABILITIES = CAPITAL
To determine the net worth of the company, one looks at
the capital amount; this represents the net assets that
are left after paying off, or deducting, the liabilities.
The capital on a financial statement would be what is called
"the book value" of the company, and it represents
the net worth of the company using historical costs. After
appraisal adjustments by the forensic accountant, the capital
would represent the real net worth, using current fair market
An income statement identifies the gross income or receipts
of a business and then the expenses incurred, arriving at
a number that represents the "net income" of the
A statement of cash flows identifies the financial history
of the company from a cash basis point of view. It will
also show how the cash flowed during the period - what was
borrowed, what was invested, etc.
A balance sheet presents the financial condition of the
company at a certain date -usually the last day of the fiscal
year. An income statement and a statement of cash flows
present a financial history of a period of time, usually
for the current fiscal year. Thus, a set of financial statements
for a typical company will be a balance sheet dated the
last day of the year, and an income statement and statement
of cash flows for the period of the past year.
What Does the Forensic Accountant Do with the Financial
As discussed above, the forensic accountant first tries
to determine the overall quality of the financial statement
so that he can ascertain how much analysis would be necessary.
In addition, the forensic accountant's analysis is often
towards a different objective than that of the CPA firm
that prepared the financial statements. Assuming that additional
analysis would be necessary, these are some of the steps
that would be taken.
First, one would prepare a spreadsheet listing the balance
sheets for the past five years, if available, and then another
spreadsheet listing the income statements for the same period,
and a third spreadsheet listing the cash flows, if available.
One would then study each spreadsheet, looking for unusual
items or developing patterns, or changes in patterns.
A usual example is that the legal fees of a business will
be consistent from year to year, either in dollar amounts
or as a percentage of sales, and then, in the year of divorce,
the legal fees will increase dramatically.
One would then
predict that the personal legal fees for the divorce are
being paid by the business and are being deducted as a business
expense by the business.
One then would obtain the paid
legal bills from the business to ascertain if the legal
costs are all business expense, or if they are what we call
If they are all business in nature,
one may discover that they are due to a new lawsuit that
may significantly affect the value of the business.
Similarly, one would look at the history of the gross profit
percentages of the company. Imagine a company that sells
the same items from year to year, and reports that in years
one and two, the cost of the goods that are sold cost 40%
of the sales price, for a gross profit of 60%. In year three,
the cost of goods sold is reported to be 30%, for a gross
profit of 70%. In year four, the costs are reported to be
45%, for a gross profit of 55%, as shown below:
Cost of sales
This chaotic pattern indicates that further analysis is
needed to see if the inventory numbers are incorrect, or
if there are unreported sales, or if the financial statements
are simply unreliable.
There are certain expenses which are usually business in
nature, and they are a good indicator of the sales level.
For a company that manufactures shampoos, for example, a
major expense would be utilities, since water is a key ingredient
of shampoos. If the utility expense is increasing from year
to year while sales are decreasing, and if there has not
been any significant utility rate increase, one would assume
that sales are being underreported. One would then look
for other evidence to support that assumption. An expense
as mundane as paper supplies may provide a clue to
activity that is not being reflected on the financial statements.
Close attention should be paid to payroll. There should
be a direct correspondence between sales and payroll expense,
so that if there is a recession and sales drop, there should
be a drop at some point in payroll. There may be a time
lag, but the pattern should appear.
The opposite would be true if sales increase significantly
over previous levels. If sales are flat and payroll is increasing,
it may be because management is hiring new people to either
develop new business or in anticipation of greater sales
- in either case, spousal support that is based on the current
situation may not be as favorable as it might be if the
projected new sales takes place.
On the other hand, the increased payroll may be due simply
to a desire to hide income from one's spouse, and so the
business manager is now issuing payroll checks to his new
girlfriend or to his friends and relatives, none of whom
is working at the business. A review with the out-spouse
of payroll tax returns and the endorsements of payroll checks
may help uncover this maneuver.
For smaller businesses, a review of the payroll and the
payroll tax expense may show that the payroll taxes paid
are insufficient. It may be that the employees are being
treated as independent contractors, and if that is improper,
there may be a large contingent tax liability to deal with
in the valuation. It will also show that the company takes
a very aggressive position regarding taxes, and this attitude
may reflect its position regarding perquisites.
A study of the history of the balance sheets may show that
inventory is constantly shrinking, year to year. If sales
are increasing during the same period, one would delve more
deeply, because usually, as sales increase, more inventory
is needed to be on hand to service those sales.
The balance sheets may show increasing borrowing from banks
or shareholders. If the income statement shows that during
the same period, sales and net income were increasing, one
would study the matter to see why there is a need to keep
borrowing when profits are rising. Further, if there are
new loans, there are probably new loan applications filed
with the bank. A subpoena of the bank's records will show
if the same tax returns and financial statements that were
given to the bank were also given to the spouse during the
dissolution proceedings. The loan application may also contain
a new personal financial statement prepared by the person
operating the business.
Quite often, that person will claim to his spouse that
his income is very low and that his assets are minimal;
the personal financial statement submitted to the bank often
shows a different picture. It may reflect income and assets
that the other spouse was not aware of. One then has to
conduct further analysis to determine the true reality.
The balance sheets may report certain assets which require
special treatment. There may be an asset called covenant
not to compete. This usually represents the portion
of the cost of a business that was allocated to a covenant,
usually for tax reasons. Thus, if a magazine publisher purchased
a magazine for two million dollars, he might report the
purchase as one million for a covenant not to compete and
one million for the subscription list. Both of these assets
could be amortized; i.e. deducted, for tax purposes.
If one were to encounter assets such as these, one should
obtain all of the details regarding the underlying transactions
so that those details could be used in a current valuation.
If, for example, the magazine publisher publishes five magazines
like the one that he purchased for two million, it would
be a good starting point in valuing the company to compare
and contrast each of his other magazines to the one
purchased for two million dollars.
There might be assets - such as patents - which may indicate
enormous financial potential. The asset may be reflected
on the books at a small amount, for that might be all that
was incurred to develop that patent. But the patent could
be very valuable by itself if it were to be sold, or it
could be an indication that the company is moving into a
lucrative direction, or into a new type of business.
All of this must be considered when valuing the company.
Finally, there are liabilities that should be examined
closely. Many businesses report a liability called deferred
income taxes, which represents a theoretical liability to
pay taxes that might never actualize. The footnotes to the
financial statements may mention contingent liabilities,
such as ongoing lawsuits, which should be evaluated as to
In summary, a study of the financial statements of a business
can itself provide important insights regarding the company
and the amount of discovery that will be needed.
By Mark Kohn, CPA, CVA