In the article, the author discusses when to expand an engagement to include specific forensic procedures. This need arises when the financial statements are misleading, incomplete, or appear manipulated. These factors, alone or in combination, can significantly distort the concluded value of a business.
When a business valuation is necessary in a litigation setting, determining the value of the business is often one of, if not the most, critical pieces of the overall puzzle. One question often sits at the center of the conflict: What is the business worth?
The process to arrive at this answer may seem straightforward—review the financial statements, apply accepted valuation methods, and determine the business value. However, business valuation depends heavily on the foundational assumption that the company’s financial records are accurate, complete, and fairly present the company’s performance.
When that assumption does not hold true, the valuation process becomes far more complex. Financial statements that are misleading, incomplete, or manipulated can significantly distort the concluded value of a business. In these situations, counsel may consider expanding the scope of the expert’s engagement to include specific forensic accounting procedures.
The Starting Point: Historical Financial Data
The business valuation process begins with a review of the company’s historical financial statements and/or tax returns. These documents typically include:
- CPA-prepared financial statements (audited, reviewed, or compiled)
- Management-prepared internal financial statements
- Federal and state income tax returns
The documents above form the foundation for analyzing trends in revenue, profitability, and cash flow, which are key drivers of business value. However, even CPA-prepared financial statements rely on underlying transactions and information provided by management. If the underlying records are incomplete, inconsistent, or intentionally altered, the financial statements and tax returns may not accurately reflect the company’s economic reality. For this reason, experienced valuators often approach historical financial data with a degree of professional skepticism, particularly in litigation settings.
Diving into the Financial Records
Financial statement irregularities can take many forms and may result from poor recordkeeping, informal accounting practices, cut-off reporting issues, aggressive tax strategies, or in some cases, intentional misconduct. Regardless of the cause, these issues may lead to a materially different valuation conclusion if not considered. Forensic accountants and valuation professionals are sometimes tasked with examining not only what appears in the financial statements, but also the underlying transactions comprising the reported balances.
Valuation experts generally rely on the information provided by the company and its representatives. This means valuation experts are not required to audit or assess the veracity of the financial information provided to them by the subject company to be in compliance with valuation standards. In other words, valuation analysts do not provide an opinion on the accuracy of underlying financial statements used in their analysis. If there are questions regarding the accuracy of the financial statements, though, counsel may consider having forensic accounting procedures performed to provide additional support for the valuation conclusion. Such procedures are oftentimes outside the scope of the valuation analysis itself and may include:
- Reviewing general ledgers
- Reconciling cash receipts to bank deposits
- Analyzing credit card statements, bank statements, and third-party records
- Examining related-party transactions or owner benefits
Personal Expenses and Adjustments
A frequent issue in closely-held business valuations is company payment of personal or discretionary expenses that are not required for operations. This may be done out of convenience, for tax planning, or to reduce income and company value. Examples might include personal meals and entertainment, travel, auto expenses, home-related expenses, etc.
While these items are reflected as business expenses in the financial statements and tax returns, they may not represent the true operating costs of the company. Because these expenses reduce reported profit, they can make a company appear less profitable and, therefore, less valuable than it is. To address this, valuation experts prepare what are known as normalizing adjustments, which adjust a company’s earnings for personal and discretionary expenses in addition to non-operating, one-time, and non-recurring expenses to determine the company’s true earnings capacity.
Additionally, from a balance sheet perspective, the company may own vehicles that are used personally by the owners and their families while not being necessary to operate the business. Adjustments may also be necessary for related-party loans to or from the company that are not expected to be repaid.
Identifying these expenses, assets, and liabilities often requires looking beyond the financial statements and interviewing the company’s management to understand the nature of certain transactions. It may also be appropriate to review supporting documentation for certain transactions to understand their relevance to the business and whether a related valuation adjustment may be necessary.
Other Common Financial Distortions
In addition to personal expenses, several other financial reporting issues can affect business value if not accounted for in the valuation analysis.
- Underreported Revenue—In some cases, particularly in cash-intensive businesses, revenue may not be fully reported in the accounting records. Comparing deposits, sales records, and tax filings can sometimes reveal discrepancies between reported and actual income.
- Cut-Off Between Periods—Income or expenses may be accelerated or delayed between reporting periods, intentionally or otherwise, which can misstate profitability during certain periods. Reviewing a company’s general ledger detail may reveal expenses for future, or past, periods.
- Excess or Deficient Owner Compensation—In many cases, owners are not compensated at fair market value rates for their roles. Owner compensation in excess of fair market value would result in a lower business value if not normalized. On the other hand, deficient owner compensation will overstate the company’s benefit stream, which will, in turn, overstate the company’s value.
- Related-Party Rent or Management Fees—Understanding and determining the relationship between related parties is essential in determining the value of a business. If an owner pays above market rent to a related party for the space occupied, this would artificially deflate company value. The same goes for management fees that may not be necessary or in excess of fair market value. An expert may request copies of any agreements between the related parties as well as recent real estate appraisals, which may include market rental rates for the company’s leased space.
From Investigation to Valuation
Once potential financial issues are identified, the findings can directly influence the valuation process. Many valuation methods are based on the company’s adjusted earnings or cash flow. If those earnings are understated due to personal expenses, related-party transactions, or unrecorded revenue, the resulting valuation may be distorted.
Even modest adjustments can have a substantial impact since every dollar of income translates into a multiple of value. As a simple example, if valuation and forensic analysis reveals that a company’s reported earnings were understated by $150,000 and the applicable valuation multiple is five times earnings, the value could increase by $750,000. Therefore, it is critical that any financial statement normalizations made are appropriately supported, which may call for some level of forensic analysis.
Looking Beyond the Numbers
Financial statements are often treated as objective representations of reality. In most circumstances, they are a reliable starting point for understanding and valuing a business. However, reported financial results can sometimes tell incomplete, or even misleading, stories. Therefore, recognizing the intersection between forensic accounting and business valuation is increasingly important. When financial records are in question, determining value requires more than applying valuation formulas. Such situations may require looking beyond the numbers themselves and performing additional forensic analysis.
This article provides general information and illustrative examples only. Procedures and conclusions depend on specific facts, engagement terms, and court directives. Nothing herein should be construed as an opinion on any matter or as legal, tax, or accounting advice.
This article was previously published by the Cleveland Metropolitan Bar Journal, 2026, and is republished here by permission.
Ashley Mercuri, CPA, ABV, CVA, is a director in the Forensic Consulting Group at CBIZ. She began her professional career as a CPA and pivoted into a practice concentrated in the areas of business valuations, litigation advisory services, financial reporting, complex damages analysis and modeling, strategic planning, and succession/estate planning. Throughout her career, Ms. Mercuri consistently demonstrates her industry expertise through speaking engagements and the authoring of articles on valuation and litigation-related topics.
Ms. Mercuri can be contacted at (216) 242-0872 or by e-mail to Ashley.Mercuri@cbiz.com.
