Fact Pattern –
Kim had been a lawyer for over 20 years, and had owned her environmental law firm for the last 12 years. Since her firm had an in-house bookkeeper and an outside tax accountant, she’d essentially disregarded the distinction between business and personal account spending, assuming that her “accounting team” would put things in the right place. Unbeknownst to Kim, her bookkeeper had just been recording expenses as “business-related” if they were paid by business accounts, which was problematic since payments from business accounts included the monthly mortgage on Kim’s personal residence, family vacations, and a number of personal credit cards. Even worse, the firm’s tax accountant had just incorporated the accounting provided to him by the bookkeeper without any independent assessment of the business vs. personal nature of claimed expenses.
Since Kim is now looking to bring on a partner, and the firm’s operating agreement stipulates that the buy-in price for a potential partner will be based upon fair market value, she needs to have the firm valued. However, during the due diligence process it became apparent that any business value based upon uncorrected financial statements would be significantly understated because of misleading net business income (when business expenses are overstated, business net income will be understated, all else being equal).
Important Considerations –
In a situation such as this one, since the commingling of personal and business expenses have resulted in historical financial statements that do not correctly reflect the firm’s actual operations, the business valuation process will require forensic accounting to normalize the financial statements for comparative purposes. The normalization process will attempt to remove personal expenses, remove nonrecurring or extraordinary items, and remove other non-business items. The normalization process will also enable the assessment of representative earnings, which will be used to support and/or contrast projections of future operations.
The level of detail that is examined during the normalization process will depend upon the scope of engagement (such as the period of historical time to review or the types of items to review), the availability of supporting documentation for claimed business revenues and expenses, and the period of time available for the analysis.
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