Forensic Case Study Summary: Calculating Fair Market Value
Reconstructing gross profits
Mr. Kremer provides an overview of the techniques utilized in a shareholder oppression action where he was engaged to calculate the fair market value of the company. The challenge in this forensic and valuation engagement was that the company collected a substantial portion of the revenues in cash, and the reporting did not appear to be accurate.
Several years ago, I was asked to conduct a valuation of a $100,000,000 ethnic food distributor by the attorney for the distributor’s oppressed dissenting one-third shareholder. ¬†I attended an initial meeting, where I was presented with the historical facts of the action and a description of the subject business. After reviewing the last few years of subject business’ tax returns, it became crystal clear that the accounting was incomplete and a valuation based on the financial information presented would not yield a fair market value as defined by case law for valuation of this entity.¬†
Therefore, I recommended a review of the bookkeeping and forensic analysis of gross profits and business expenses. ¬†On its tax return, the entity reported a gross profit of 0.8 percent and net taxable income of 0.3 percent.¬† The attorney agreed and proceeded with filings. ¬†With respect to my document request, I was allowed but one week to review 55 boxes of three years’ worth of financial, accounting, and tax records at the company’s premises.
Assignment: Determine Oppression, If Any, by the Majority Controlling Shareholders
Because of substantial time constraints, it was therefore critical to laser focus my attention to areas that were most vulnerable to dollar. ¬†Accordingly, I directed my efforts in the following areas:
General Condition of the Books and Records
My focused review of the records raised serious questions about the validity, credibility, completeness, and reliability of the financial information.¬† It was my opinion that a reliable verification of the financial information would require considerable time, if reasonable and reliable verification were even possible.¬† The credibility and completeness of the information would be validated only through painstaking and costly reconstruction of the records.¬† I was particularly concerned about the substantial lack of internal accounting controls and reliable systems.¬† Specific matters could be quite difficult to verify because of the lack of system integrity.¬† There can be no reasonable assurance that all transactions are reflected in the books and records made available or that all the books and records have, in fact, been made available.
Management Actions and Conduct of Controlling Shareholders
The controlling shareholders managing the business and finances acted as if they were operating the businesses from their own personal checkbooks.¬† In addition to the manner in which the books were manufactured many months after the fiscal year end, there were many undocumented transactions with related entities, numerous undocumented related-party cash transfers, both in and out of the company, and many direct and indirect cash payments.¬† There were thousands of dollars of undocumented or insufficiently documented expense reimbursements to the controlling shareholders. ¬†Considerable travel and entertainment expenses, automobile expenses, meals, and other expenses had no legitimate business purpose. ¬†Corresponding balances of related-party advances and loans were not reconciled or in agreement.
Cash Transactions and Undeposited Cash
The company collected a substantial amount of its revenue in cash, estimated to be between 80 percent and 90 percent of all collections.¬† Collections in cash could conceivably have amounted to over $80,000,000 for the entire year of 2001.¬† The customer cash collections were not deposited intact into the bank accounts.¬† The general ledger books reflected undeposited cash at December 31, 2001, of almost $500,000, after many journal entries were prepared by the company’s CPA.¬† I was unable to trace cash collected from customers to deposit tickets. ¬†The undeposited cash account was not reconciled to amounts collected from customers or to the general ledger account, and thus was not susceptible to any verification.
Diverted Sales Revenues and Distorted Gross Profits¬†
A review of the 2000 and 2001 financial statements and the corporate tax returns filed for the years 1996-2001 raised a degree of analytical concern about historical reported gross profits.¬† After adjusting for certain tax entries and eliminating other capitalized inventory costs, the pure financial statement gross profits percentages for each of the years 1996-2001 ranged from 2.60-3.89 percent.
I expanded my investigation of reported gross profits.¬† Detailed analysis and development of gross profit statistics could not easily be performed for several reasons: detailed records were unavailable, the prices of a perishable commodity type of inventory fluctuated on almost a daily basis, and specific identification of product sales and related product purchases needed better information than what was available.
I tested individual invoices of the products sold and computed the gross profits per individual sales as the only reliable way possible, given all the accounting, bookkeeping, supporting documents, and other information learned ¬†as well as the time constraints surrounding the investigation.¬† From the documents produced, I obtained the counted and priced inventory as of December 31, 2000, prepared and submitted by company personnel. ¬†The inventory balance was reflected in the December 31, 2000 reviewed financial statements prepared by the CPA.¬† Since inventory consisted of perishable foods, the sales on January 2, 2001 had to reflect the sales of those products included in the December 31, 2000 company-priced inventory.¬† I traced every different product sold, or 29 different products, covering over 70 sales invoices on January 2, 2001 to the priced and counted inventory and computed a realized gross profit amount on a weighted average basis of 11.64 percent.¬† Every product but one, beef trim, had a gross profit greater than that reflected in the 2001 product gross profit analysis as computed.¬†
Because the accounting records and books provided did not produce sales information by individual product and I was not sure how the gross profits were underreported, I conducted further corroborating tests and analyses.¬† Either “underpricing inventories and/or understated sales” would result in the underreporting of gross profits.¬† All of the products priced except one appeared in the inventory.¬†
Since sales journals were not provided, I physically took and added approximately 3,000 sales invoices produced in each of two consecutive months, July and August 2001.¬† Added sales invoices computed sales as $259,840 greater in July 2001 and $369,006 greater in August 2001 than the amounts recorded in the general ledger books, or 3.8 percent greater in total.¬† Accordingly, I concluded that sales provided to the company’s CPA for entry into the general ledger books were understated for the year by a similar amount of sales required to produce the calculated gross profits‚ÄĒthe difference between the sales required to produce the correct gross profits and the sales reported in the general ledger was an amount considered to be diverted sales.¬† An additional analysis was prepared refining the priced-out product gross profits, after eliminating extremes at both the high and low ends, and eliminating products which appeared not to have substantial sales, the calculation produced a gross profit of 6.22 percent, which was reasonable, but certainly unlikely to be overstated under the circumstances.¬† It can be argued from the foregoing analysis that a higher gross profit, say 7.6 percent, is also reasonable; however, this analysis was conducted to demonstrate that the reported financials were misrepresentative, and the actions of the controlling shareholders represented self-dealing, mismanagement, disproportionate enrichment, and defeated the realization of the dissenting shareholder’s reasonable expectations of returns and use of capital.
Based on a realized gross profit of 6.22 percent, diverted cash resulting from underreported sales in year 2001 was $2,433,900.¬† Product costs, assuming fully represented in the general ledger books, of $91,432,000 would have produced sales of $97,497,300 as opposed to the reported $95,062,400, or $2,434,900 greater.¬† If I was to assume that a similar underreporting consistently occurred in years 1996-2000, underreported sales and diverted cash would have aggregated $14,863,100 for the years 1996-2001.
I was able to thus conclude that management and actions of the controlling shareholders of the company resulted in the diversion of corporate assets; the controlling shareholders realizing disproportionate special advantages having no legitimate business purposes; and financial statement and financial misconduct.
[author] [author_image timthumb=’on’]http://www.fairfieldfvs.com/images/dennis.jpg[/author_image] [author_info]Dennis B. Kremer, CPA/ABV/CFF/CGMA, CVA, CFE, FCPA, is partner and owner of¬†Fairfield Forensic and Valuation Services, LLC, located at 145 Bedford Rd., Suite 201 Armonk, NY 10504. ¬†Mr. Kremer‚Äôs firm serves New York City, Garden City, and Long Island.¬†[/author_info] [/author]