Goodwill Forensic Accounting Issues in Determining Business Value

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1 Goodwill Forensic Accounting Issues in Determining Business Value October 26, 2010 International Right of Way Association Jaime C. Holmes CPA, JD, CVA, ABV, CFF SingerLewak

2 Introduction SingerLewak was established in 1959 and has tremendous experience in the following industries: Technology Construction Media & Entertainment Life Sciences Real Estate Manufacturing & Distribution Retail & Franchise Transportation & Logistics

3 Introduction The Forensic Accounting, Business Valuation and Litigation Support (FABVLS) practice area includes experts with the following credentials: Certified Public Accountants (CPA) Juris Doctorate (JD) Certified Fraud Examiners (CFE) Certified in Financial Forensics (CFF) Certified Management Accountants (CMA) Certified Information Technology Professionals (CITP) Certified Information Systems Auditors (CISA) Certified Information Security Managers (CISM) Certified Construction Industry Financial Professionals (CCIP) Accredited Senior Appraisers (ASA) Accredited in Business Valuation (ABV) Certified Valuation Analysts (CVA)

4 Goodwill - Statutes Basis for Compensation of Goodwill (a) The owner of a business conducted on the property taken, or on the remainder if such property is part of a larger parcel, shall be compensated for loss of goodwill if the owner proves all of the following: (1)The loss is caused by the taking of the property or the injury to the remainder; (2)The loss cannot reasonably be prevented by relocation of the business or by taking steps and adopting procedures that a reasonably prudent person would take and adopt in preserving the goodwill; (3)Compensation for the loss will not be included in payments under Section 7262 of the Government Code; (4)Compensation for the loss will not be duplicated in the compensation otherwise awarded to the owner.

5 Goodwill - Statutes Basis for Compensation of Goodwill (b) Within the meaning of this article, goodwill consists of the benefits that accrue to a business as a result of its location, reputation for dependability, skill or quality, and any other circumstances resulting in probable retention of old or acquisition of new patronage.

6 Goodwill - Statutes Fair Value Based on Price on Valuation Date (a) The fair market value of the property taken is the highest price on the date of valuation that would be agreed to by a seller, being willing to sell but under no particular or urgent necessity for so doing, nor obliged to sell, and a buyer, being ready, willing, and able to buy but under no particular necessity for so doing, each dealing with the other with the full knowledge of all of the uses and purposes for which the property is reasonably adaptable and available. (b) The fair market value of the property taken for which there is no relevant, comparable market is its value on the date of valuation as determined by any method of valuation that is just and equitable.

7 Goodwill - Statutes Fair Market Value Not Including Changes The fair market value of the property shall not include any increase or decrease in the value of the property that is attributable to any of the following: (a) The project for which the property is taken. (b) The eminent domain proceeding in which the property is taken. (c) Any preliminary actions of the plaintiff to the taking of the property.

8 Calculation of Goodwill Goodwill Before Goodwill After Goodwill must exist Before to have lost goodwill Fair market value of the business Less: Fair Market of the Net Assets (Assets Liabilities) Equals: Goodwill of the business

9 Lost Goodwill Revenues go down (loss of patronage) Expenses go up (increased costs) - Must be caused by the take - Must not duplicate compensation otherwise awarded to the owner - Must not include avoidable betterment

10 Business Valuation Income Approach Market Approach Asset Approach

11 FORENSIC ACCOUNTING ISSUES Fictitious Information

13 Forensic Accounting Issues Journal Entries Accrual v. Cash Inventory Adjustments Prior Period Adjustments

14 600 TREND ANALYSIS

15 700 SALES TRENDS

16 MISLEADING GRAPHS

17 50,000 45,000 40,000 39,888 41,233 Trend Analysis Complete Data Set Utilized 42,365 40,233 42,358 43,655 45,989 35,000 30,000 29,787 25,000 20,000 15,000 10,000 5,

18 50,000 45,000 Trend Analysis Incomplete Data Set Utilized 42,358 43,655 45,989 40,000 40,233 35,000 30,000 29,787 25,000 20,000 15,000 10,000 5,

19 Criteria for Guideline Co. Selection Key Characteristic Do the underlying economics driving this comparable company match those that drive our company? Valuing a Business, The Analysis and Appraisal of Closely Held Companies, Third Edition by Pratt, Reilly and Schweihs

20 Criteria for Guideline Co. Selection The following factors are among those to consider in determining comparability: Capital Structure Credit Status Depth of Management Personnel Experience Nature of Competition Maturity of the business Tallichet v. Commissioner, 33 T.C.M., 1133 (1974)

21 Criteria for Guideline Co. Selection In Estate of Victor P. Clarke, the Tax Court emphasized that it is imperative that the characteristics of the subject company and the purportedly comparable company relevant to the question of value be isolated and examined so that a significant comparison can be made. In that case, the court cited the following as relevant factors: Products Markets Management Earnings Dividend-paying capacity Book value Position of company in industry Estate of Victor P. Clarke, 35 T.C.M., 1482 (1976)

24 2,500,000 ABC Paving Company, Inc. Financial Comparison with Guideline Public Companies 2,000,000 2,067,301 1,500,000 1,000,000 1,213,857 Guideline Public Companies ABC Paving Company, Inc. 500, ,761 30,527 2,523 Revenues EBITDA 101,896 EBIT 2,408 83,576 Cash Flow 1,560 68,711 1,445 Net Income 11,143 Total Assets 93,439 5,127 Tangible Net Worth (BV)

25 CASE STUDY Rebuttal of Opposing Expert s Report

26 Net Income % 10% 6% 11% 3% Carpet Company v. Carpet Cooperative Summary of Profit and Losses Per Tax Returns (Amounts in 000's) Nine Months Annualized Sales 2,900 2,700 3,300 2,625 Cost of Goods Sold 1,700 1,600 1,950 1,350 Gross Profit 1,200 1,100 1,350 1,275 Expenses ,195 Net Income GP% 41% 41% 41% 49%

27 Carpet Company Business Value Calculations (in 000's) Nine Months Annualized Sales 2,900 2,700 3, Cost of Goods Sold 1,700 1,600 1, Gross Profit 1,200 1,100 1,603 49% 1275 Expenses Net Profit Adjustments Reasonable Compensation Perquisites "But For" Profits 781 Capitalization Rate 0.20 Indicated Value 3,964 Date of Value 10/1/07

28 Carpet Company Capitalization Rate Build-Up Method Assumptions Source of Information Current Risk-free Rate (Rf) 4.6% 20 Yr. U.S. Treasury Bills Equity Risk Premium (Rm-Rf) 7.1% Long-horizon equity risk premium Size Premium (Rs) 5.0% Expected micro-capitalization equity size premium Company Specific Risk Premium (Rc) 10.0% Risk factors described in Exhibit 2 Discount Rate 26.7% Long Term Growth Rate 7.0% Capitalization Rate 19.7%

29 Forensic Accounting Issues Payroll Salaries and Wages Benefits Dividends and Distributions Loans Property Transfers Above Market Transactions Constructive Dividends

30 Forensic Accounting Issues Perquisites Meals & Entertainment Travel Promotion, Marketing, Advertising Autos Shareholder Loans Credit Card Statements Expense Reimbursements

31 Forensic Accounting Issues Constructive Dividends California Corporations Code 166 Distributions to its shareholders means the transfer of cash or property by a corporation to its shareholders without consideration, whether by way of dividend or otherwise

THE DIRTY LITTLE SECRETS ABOUT BUSINESS VALUATIONS: What Judges Should Know About Valuations In Their Courtrooms

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