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Beyond the Numbers: Valuation and Forensic Accounting

In everyday conversation, it's common to hear that 'x' person or company is 'worth n number of dollars'. When people make these sorts of statements they are engaging in valuation. They are making a statement about the worth of a company or person (or an asset, as the case may be). Valuation can be a very useful undertaking, especially in the context of a forensic investigation, but behind every valuation is a series of assumptions that we seldom consider.

Valuation is essentially the art of applying a model, and an analysis of the same, for the purpose of determining the worth of a given asset or enterprise. There are a number of situations where a forensic accountant with valuation experience can be useful, including, for instance:

  • Calculating damages in the context of litigation.

  • Insolvency and bankruptcy proceedings.

  • Recapitalisations.

  • Venture capital funding.

  • Management buyouts.

  • Allocation of purchase price on acquisitions.

  • Tax matters.

  • Business liquidations.

  • Reviewing the valuation provided by an opposing party's expert.

  • Calculating the value of an opposing party's assets for litigation purposes (e.g. in divorce proceedings).

  • Valuation of a target company in an M&A context.

  • Estate matters.

There are three general sorts of valuations:

  • Asset-based valuations: Typically useful for asset-intensive businesses as it focuses on determining the value of assets.

  • Income valuations: Focus on how much money the business can generate. These can be useful for services or consulting companies that tend to have less assets.

  • Market valuations: Focus on the market and what others have paid for similar businesses.

The above categories cover a few different techniques, but the key point is that all valuation models have limitations and drawbacks; they all rely, to some degree, on assumptions.

A proper valuation (as well as the exercise of examining an existing valuation model) requires an understanding of the limitations of the models used and of the assumptions involved in the particular valuation methodology. It is entirely acceptable--even good practice--to combine techniques and adapt to the context of the target being valued. It is equally important to keep in mind that market context--macroeconomic, regional, and industry performance, for instance--can be very important in a business valuation. In other words, how is the target company performing compared to its industry and/or local peers?

Another critical point--that goes directly to the question of a forensic accountant's 'value add' in the context of a valuation--is that over-reliance on stated numbers in books, records, and, certainly in financial statements, can prejudice the valuation exercise. In many cases, it may be necessary to make adjustments for nonrecurring events or discretionary expenses by the company in question.

Given the above, a proper valuation should be coupled, where possible, with some measure of examination of the company's books and records. After all, overstatement of revenue or manipulation of expenses can affect multiples of turnover or profit used in say, an income valuation. Overstatement of assets can skew an asset-based valuation as can asset misappropriation or improper depreciation. Any such fraud examination should be broad, properly planned, and as thorough as possible. Such an exercise may also require 'traditional' investigative work such as surveillance (to gauge the volume of clients at a retail business or restaurant/bar, for instance) or a financial/behavioural profile of the business owner. Above all, it's important to approach any valuation exercise with an understanding of methodologies, an eye for context, and a nose for fraud.

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