financial accounting...1 chair: peter weinstein, cpa, ca ifa, cbv, mba, managing director, ksv...

chair

Peter Weinstein KSV Valuations Inc.

December 6, 2016

FINANCIAL ACCOUNTING for Civil Litigators

*CLE16-0120101-a-puB*

DISCLAIMER: This work appears as part of The Law Society of Upper Canada’s initiatives in Continuing Professional Development (CPD). It provides information and various opinions to help legal professionals maintain and enhance their competence. It does not, however, represent or embody any official position of, or statement by, the Society, except where specifically indicated; nor does it attempt to set forth definitive practice standards or to provide legal advice. Precedents and other material contained herein should be used prudently, as nothing in the work relieves readers of their responsibility to assess the material in light of their own professional experience. No warranty is made with regards to this work. The Society can accept no responsibility for any errors or omissions, and expressly disclaims any such responsibility.

© 2016 All Rights Reserved

This compilation of collective works is copyrighted by The Law Society of Upper Canada. The individual documents remain the property of the original authors or their assignees.

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Library and Archives Canada Cataloguing in Publication

Financial Accounting for Civil Litigators

ISBN 978-1-77094-182-3 (Hardcopy)ISBN 978-1-77094-181-6 (PDF)

1

Chair: Peter Weinstein, CPA, CAIFA, CBV, MBA, Managing Director, KSV Valuations Inc.

December 6, 2016 9:00 a.m. to 12:00 p.m.

Total CPD Hours = 2 h 30 m Substantive + 30 m Professionalism

Donald Lamont Learning Centre The Law Society of Upper Canada

130 Queen St. W. Toronto, ON

SKU CLE16-01201

Agenda

9:00 a.m. – 9:05 a.m. Welcome and Opening Remarks

Peter Weinstein, CPA, CAIFA, CBV, MBA, Managing Director, KSV Valuation Inc.

9:05 a.m. – 9:35 a.m. Overview of Financial Statements

David Fabian, CPA, CA, LPA, Partner and National Co-Leader, Private Mid-Market, Ernst & Young LLP

FINANCIAL ACCOUNTING FOR LITIGATORS

2

9:35 a.m. – 10:15 a.m. Analyzing Financial Statements

Dennis Leung, CPA, CA, CBV, CF, Partner, Valuations Grant Thornton LLP

Jodie Wolkoff, CPA, CAIFA, CBV, CFF, Senior Investigator, Professional Conduct, Chartered Professional Accountants of Ontario

10:15 a.m. – 10:50 a.m. Looking Beyond the Financial Statements –

Spotting Red Flags

David Sieradzki, CPA, CACIRP, LIT, KSV Advisory

Edward Nagel, CPA, CAIFA, CBV, nagel + associates inc.

10:50 a.m. – 11:00 a.m. Coffee and Networking Break

11:00 a.m. – 11:20 a.m. Using the Financial Statements To Prepare A Business

Valuation

Paul Mandel, CPA, CACBV, MBA, Partner, Litigation Accounting and Valuation Services, Collins Barrow Toronto Valuations Inc.

11:20 a.m. – 11:50 a.m. When You Spot Trouble- Strategies and Ethical

Considerations (30 minutes )

Sheila Bruce, B.A., LL.B., S. Bruce Family Law Office

Farley Cohen, MBA, FCPA, FCAIFA, CIRP, FCBV, ASA, Cohen Hamilton Steger & Col. Inc.

Jeffrey Larry, LL.B, MBA, Paliare Roland Rosenberg Rothstein LLP

Douglas Smith, Borden Ladner Gervais LLP

11:50 a.m. – 12:00 p.m. Go Ahead and Ask Us – Question and Answer Panel 12:00 p.m. Program Ends

http://www.collinsbarrow.com/en/toronto-ontario/

http://www.collinsbarrow.com/en/toronto-ontario/

December 6, 2016

SKU CLE16-01201

Table of Contents TAB 1 Overview of Financial Statements……………………………………..1 – 1 to 1 – 2

David Fabian, CPA, CA, LPA, Partner and National Co-Leader, Private Mid-Market, Ernst & Young LLP

TAB 2 Analyzing Financial Statements………………………………………..2 – 1 to 2 – 12

Dennis Leung, CPA, CA, CBV, CF, Partner, Valuations, Grant Thornton LLP

Jodie Wolkoff, CPA, CAIFA, CBV, CFF, Senior Investigator, Professional Conduct, Chartered Professional Accountants of Ontario

TAB 3 Looking Beyond the Financial Statements – Spotting Red

Flags………………………………………………………………..…………………3 – 1 to 3 – 5

David Sieradzki, KSV Advisory


TAB 4 Using the Financial Statements to Prepare a Business Valuation……………………………………………………………………………4 – 1 to 4 – 9

Paul Mandel, CPA, CACBV, MBA, Partner, Litigation Accounting and Valuation Services, Collins Barrow Toronto Valuations Inc.

FINANCIAL ACCOUNTING FOR LITIGATORS

TAB 1

Overview of Financial Statements

David Fabian, CPA, CA, LPA, Partner and National Co-Leader,

Private Mid-Market, Ernst & Young LLP

December 6, 2016

Financial Accounting for Litigators

Who are the users of financial statements?

• Creditors

• Bankers

• Potential investors

• Canada Revenue Agency (CRA)

• Shareholders

Why are financial statements prepared?

• Regulatory requirements

• Tax authority

• Shareholder agreements

• Banking requirements

What are the different types of Assurance?

1. Management prepared Internal financial statements

2. Notice to reader Compiled by external accountants

3. Review engagement Limited assurance provided by external accountants

4. Audit Reasonable assurance provided by external auditors that the financial statements are free from material misstatement

Overview of financial statements

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2067306 ED NoneThis publication contains information in summary form, current as of the date of publication, and is intended for general guidance only. It should not be regarded as comprehensive or a substitute for professional advice. Before taking any particular course of action, contact Ernst & Young or another professional advisor to discuss these matters in the context of your particular circumstances. We accept no responsibility for any loss or damage occasioned by your reliance on information contained in this publication.

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Overview of the different reporting standards

Name of standard IFRS ASPE/Can GAAP US GAAP

Who uses the standard? Public companies Canadian private companies Public and private companies in the US – limited use in Canada

Where is it used? International jurisdictions and Canada Exclusively in Canada North America

Who requires the standard?

Common reporting standard used globally, accepted by the CRA and by the Canadian Securities Commission

Common standard used in Canada and accepted by the CRA

Required by the SEC

Ease of use Highly sophisticated, detailed and the most costly standard to use

Least complex of the reporting standards

Complex standard generally used by companies who have US affiliates or are US public companies

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TAB 2

Analyzing Financial Statements

Dennis Leung, CPA, CA, CBV, CF, Partner, Valuations, Grant Thornton LLP

Jodie Wolkoff, CPA, CAIFA, CBV, CFF, Senior Investigator, Professional Conduct, Chartered

Professional Accountants of Ontario

December 6, 2016


Analyzing Financial Statements

Jodie Wolkoff, CPA, CA.IFA, CBV, CFF Senior Investigator, Chartered Professional Accountants of Ontario Dennis Leung, CPA, CA, CBV, CF Partner, Advisory Services, Grant Thornton LLP

Understanding and analyzing financial statements can give litigators a solid grasp of material

financial matters relevant to the advice being sought by clients. This paper will provide

guidance for a litigator to assess, at a high level, the financial health and profitability of a

company which may assist in identifying areas which require for further analysis.

Litigators may encounter financial statements while retained on a variety of matters including:

Commercial disputes

Mergers and Acquisitions

IPO’s

Family Law matters

Bankruptcy proceedings

Loan agreements, covenants etc.

Financial statements can be used to assess the financial health of a company. A reader of a

financial statement can learn a lot about the company’s profitability, liquidity, growth trends,

and more. It is important to remember that when reviewing financial statements, the financial

data has been prepared for a particular purpose, which may inform the picture that is being

presented.

As a starting point, a “trend” or “benchmarking” analysis can be helpful to identify areas that

raise concerns or require further inquiry or analysis. For example, analyzing several years of

financial statements for a corporation should identify trends or unexpected changes in

significant accounts. The result of this analysis could demonstrate areas that require further

review or examination.

Corporations also review key performance indicators (KPI’s) compared to other corporations or

industry benchmarks. For example, key KPIs for a cable television company could be its

subscriber count and subscriber churn.

When reviewing a balance sheet, it’s helpful to look at the types of assets recorded to assess

the stability or riskiness of a company. As an example, a company’s assets could be primarily

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tangible (i.e. equipment) or intangible (i.e. goodwill). Furthermore, identifying trends in assets

or liabilities could indicate growth. For example, if assets are increasing, it might be that the

corporation is investing in assets (i.e. growth). Or if liabilities are growing, a company may be

leveraging themselves which might cause problems in the future. This analysis needs to be

done while looking at the big picture of the company’s financial health.

Using ratios to analyze financial statements will assist in investigating the relationships between

difference pieces of financial information. Below are examples of ratios frequently calculated

to assess a company’s financial health and to analyze a company’s liquidity, profitability and

solvency.

Profitability ratios – Profitability ratios evaluate the success of a company at generating profits.

The most common profitability ratios are as follows:

Gross Profit Margin (%) – how much revenue is available to cover operating

costs after accounting for the direct costs related to earning revenue. A higher

gross profit margin is generally more desirable, but should not be considered in

isolation or other financial indicators.

o Gross Profit Margin = (Sales – Cost of Goods Sold)/Net sales

Earnings per share –represents the portion of profit allocated to each

outstanding share of common stock issued.

o EPS = (Net Income – Preferred Dividends)/Number of Common Shares

Return on Equity – measures profitability based on amount of money invested

by shareholders.

o Return on Equity = Net Income/Total shareholder’s equity

Return on Assets – is a measure of profit per dollar of assets.

o Return on Assets = Net income/Average total assets

Turnover/efficiency ratios - The turnover ratios below describe how efficiently a corporation

uses its assets to generate sales.

Accounts receivable turnover – indicates the number of times during the period

that the corporation collects its accounts receivable. A relatively higher ratio

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shows that the corporation has strong collection policies and effective collection

practices.

o Accounts receivable turnover = net credit sales/average accounts

receivable

Average collection period (days) – represents the average number of days that

credit sales are outstanding and uncollected. A low collection period could

indicate collection issues or too restrictive of a credit policy. This ratio is

expressed as number of days in the period.

o Average collection period (days) = 365/Accounts receivable turnover

Inventory turnover – may indicate the quality of inventory reported on the

accounting records and the corporations efficiency in inventory management. A

higher ration often indicates efficient inventory management, while a decreasing

ratio might flag obsolete inventory or overstocking

o Inventory Turnover = Cost of Goods Sold/Average Inventory

Inventory on hand (days) – indicates how often inventory is being replenished,

expressed in number of days.

o Inventory on hand (days) = 365/Inventory Turnover

Liquidity ratios – Liquidity refers to a corporation’s ability to convert its assets to pay liabilities.

Higher ratios are generally favourable as it indicates there is sufficient liquidity to cover debts

etc.

Current and quick ratios assess a company’s ability to meet short-term financial

obligations as they come due. These ratios are most reflective when compared

to previous years or competitors.

o Current Ratio = Current Assets/Current Liabilities

Inventory may have slow moving or overstocked inventory which may distort the

relative liquidity measured by the current ratio. To account for this, the quick

ratio can be used to further evaluate liquidity, while eliminating inventory

values.

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o Quick Ratio = (Current Assets – Inventory)/Current Liabilities

Solvency ratios – Solvency ratios analyze the ability of a company to meet its obligations over

the long-term. Examples of solvency ratios include:

Debt-to-equity – measure of a company’s leverage (i.e. what portion of equity

and debt is the company using to finance its assets

o Debt-to-equity = Total liabilities/(Total equity)

Debt-to-asset ratio – measures the proportion of a company’s assets which are

financed through debt

o Debt-to-asset ratio = Total liabilities/average total assets

Interest coverage ratio – measures the ability of a company to meet its interest

payments

o Interest Coverage Ratio = EBIT/Interest Expense

Accounting income vs taxable income

When analyzing financial statements, the differences between accounting income and taxable

income should be considered. Accounting income is reported in the company’s financial

statements, while taxable income is the income reported for tax reporting purposes (i.e. to

Canada Revenue Agency for Canadian corporations). On a corporation’s financial statement,

the difference between accounting income and taxable income is recorded as deferred tax. The

Income Tax Act dictates when and how revenue and expenses are reported for tax purposes,

which may differ from a corporations reporting for financial statement purposes.

Accounting income and taxable income differences can be considered permanent differences

or timing differences. Timing differences reverse or even out in later periods, while permanent

differences do not.

The most common example of a timing difference results when a corporation utilizes differing

depreciation methods for financial reporting purposes compared to the capital cost allowance

(CCA) it deducts for tax reporting purposes. This could result in different amounts being

deducted on the financial statements compared to that reported for tax purposes. Other

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examples of timing differences can be the timing of revenue recognition, unused tax losses, tax

credits, deferred warranty expenses and pension costs.

Permanent differences arise when the difference between accounting income and tax income

will not reverse in the future. Examples of permanent differences are non-taxable gains (i.e.

non-taxable portion of a capital gain) or non-deductible expenses for tax purposes (i.e. meals

and entertainment).

Notes to the financial statements

The notes to the financial statements contain information that is pertinent to the analysis of the

financial statements as a whole. The notes contain the accounting policies used to prepare the

statements, details that provide the reader with an understanding of the amounts recognized

on the financial statements, and information that has not been reflected on the financial

statements (e.g. contingent liabilities).

The following is an overview of notes that will provide the reader with important information

when performing an analysis of business entity’s financial statements.

Nature of business

The “Nature of Business” note is typically the first note disclosure in the financial statements,

disclosing general information about the company:

country of incorporation;

legal form of the entity;

nature of the entity’s operations/principal activities; and

name of the parent company/ultimate parent of the group of companies (if

applicable).

Significant accounting policies

The “Significant Accounting Policies” note discloses the basis of presentation and accounting

policies for all material components of the financial statements.

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The basis of presentation sets out the accounting standards the financial statements are

prepared under; i.e. International Financial Reporting Standards (IFRS) or Accounting Standards

for Private Enterprises (ASPE). IFRS is mandatory for publicly traded companies and relies

heavily on the use of fair value accounting, whereby assets and liabilities are measured based

on their fair value. ASPE is generally applied in the case of private companies and as it is usually

simpler to apply. ASPE is less stringent than IFRS in that it allows management greater flexibility

in the accounting treatment of certain assets and liabilities.

The significant accounting policies disclose the major accounting policy choices made by

management, including but not limited to:

Revenue recognition: For each major revenue stream, the company will disclose the

point at which the entity will record revenue, which may or may not differ from the

point at which the associated cash is received by the company.

Income tax: Includes disclosure of how the company accounts for income taxes, which

may be under the deferred taxes method, or the taxes payable method. Under the

deferred taxes method, the company would calculate deferred tax based on the

differences between accounting for tax purposes and accounting for financial reporting.

Property, plant and equipment: Provides details as to how each class of property, plant

and equipment is accounted for, including the depreciation method and depreciation

rates.

Inventories: Provides details as to how the cost of inventory is calculated, which may be

under a first-in-first-out method, or weighted average method.

Trade and other receivables: Details how the company records amounts receivable

relating to sales or other in-flows of cash, including how the company determines

whether a receivable is impaired, or not fully recoverable.

Trade payables: Includes details of how payables are recorded, including foreign

currency payables and how associated gains and losses are accounted for.

Additionally, the significant accounting policies section will also include information on areas

particularly susceptible to judgments and estimates. For example, the assessment of

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impairment of certain assets or liabilities may be based on significant assumptions that may

change in the near future. This allows the reader to understand the uncertainty attached to the

related asset values.

Accounting for investments

An entity may account for equity investments under a number of different methods, described

below. The “Investments” note on an entity’s financial statement will describe its investments

in public and privately held securities.

Equity method: The equity method generally involves including the entity’s proportionate share

of the investee’s profit or loss in its own profit or loss, and increasing or decreasing the carrying

amount of the investment accordingly.

Consolidation method: When an entity controls another entity (subsidiary), it may account for

its subsidiary under the consolidation method, which involves consolidating the investee’s

activities into its own financial statements.

Fair value: If an entity holds an equity investment in a publicly listed entity, it would likely

record the investment on its financial statements at its fair value, with reference to the amount

listed on the public exchange as at the financial statement date.

Cost method: Under ASPE, an entity is able to account for investments under the cost method,

which involves initially recording the investment at its cost, and recognizing earnings from that

investment only to the extent they are received or receivable.

Employee compensation

Companies often utilize stock-based compensation to compensate some of their employees

(usually senior executives and management). For example, the CFO of an entity may receive

options to buy stock of the company in the future at a particular price. Given that the stock

options have value at the time they are granted, it must be recognized as an expense. The

employee compensation note will include information regarding share based compensation

issued to employees. In this regard, the entity must disclose:

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The number, weighted average exercise prices, range of exercise prices and range of

remaining contractual lives of options outstanding at the end of the year and

options granted during the year;

The number and description of the terms, which includes any performance

conditions, of equity instruments other than options, such as shares of non-vested

stock, granted during the year;

Total compensation cost recognized in income for stock-based employee

compensation award, which reflects the actual expense incurred by the company

with respect to the stock-based employee compensation issued during the year;

Amounts credited to share capital with respect to stock-based employee

compensation awards; and

The terms of significant modifications of outstanding awards, if applicable.

Related party transactions

When a transaction occurs with another related party, the entity must disclose the following

information about its transaction:

A description of the relationship between the transacting parties. This includes whether

the parties are under common control, common significant influence, etc.;

A description of the transaction(s) that occurred during the period, including those for

which no amount has been recognized (e.g. if an entity provides a related party with

management services without receiving consideration in exchange);

The recognized amount of the transactions classified by financial statement category

(revenue, purchases, expenses, etc.);

The measurement basis used. A related party transaction may be recorded at the

amount actually exchanged between the two parties, or at its fair value, depending on

the conditions surrounding the transaction;

Amounts due to or from related parties and the terms and conditions relating thereto;

Contractual obligations with related parties, separate from other contractual

obligations; and

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Contingencies involving related parties, separate from other contingencies.

Economic dependence

An economic dependence note is required when the ongoing operations of an entity depend on

a significant volume of business with another party. The other party may come in the form of a

sole or major customer, supplier, franchisor, franchisee, distributor, etc. A note disclosure is

required when the business with this other party is so significant, that the viability of the

reporting enterprise depends on the continuance of such business. The note would detail the

amount of the transactions with these parties, and provide an explanation of whether the

volume of such transactions is normal for the enterprise and the industry in which it operates.

For example, an entity relying on the continuation of a contractual relationship for a significant

percentage of sales may disclose the following: “The company’s operation consist of supplying

catering services. The contract with one customer accounts for 75% sales in the current year

(2015 – 71%) and is due for renewal in December 2018.”

Contingent liabilities

A contingent liability exists when there is a situation involving uncertainty as to possible loss to

an enterprise that will ultimately be resolved when one or more future events occur or fail to

occur. Resolution of the uncertainty may confirm the reduction of a liability or the incurrence of

a liability.

Where there exists a contingent liability, the entity must disclose, at a minimum:

the nature of the contingency;

an estimate of the amount of the contingent loss or a statement that such an estimate

cannot be made; and

any exposure to loss in excess of the amount accrued.

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Subsequent events

Given the time and effort involved in preparing and (if required) auditing financial statements,

they are usually not issued until sometime after the date of the fiscal year end. As such, there

are events that occur during the period between the fiscal year end, and the date at which the

financial statements are issued that may have an impact on the financial statements

(“subsequent events”), depending on the nature of these events. There are two types of

subsequent events that can impact the financial statements.

The first, is that which provides additional evidence about conditions that existed at the date of

the fiscal year end. For example, an entity with a fiscal period ended September 30 might

determine, while preparing its statements in October, that a significant customer has declared

bankruptcy. Therefore, it is likely the case that as at year end (September 30), this customer

was already in severe financial difficulty and the amounts receivable from this customer were

likely not fully recoverable. In this scenario, the entity would adjust the amounts in its

September 30 financial statements by recognizing a loss to reflect the information learned after

the period end.

The second type of event is that which does not provide additional evidence about conditions

that existed as at the date of the fiscal year end. For example, if the entity described above

(with a year-end of September 30) purchased equipment in October that required significant

financing, this should be disclosed in the financial statements in the subsequent events note.

The logic is that this transaction would impact a reader’s interpretation of the financial

statements due to the impact of the new financing on the entity’s capital structure.

Going concern

When preparing FS, management shall make an assessment of the entity’s ability to continue as

a going concern (i.e. a company that operates without the threat of liquidation for the

foreseeable future). This is usually a straight-forward assessment for a “regular” business that

generates consistently predictable profits. For other entities, the conclusion may be subject to

significant doubt, depending on factors that cannot be assessed with certainty at the time the

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statements are prepared. For example, it may not be possible to anticipate whether the entity

will be capable of raising sufficient financing or self-generating cash flows to meet its needs

over the coming year. Financial statements are prepared on a going concern basis unless

management intends to liquidate the entity, or has no realistic alternative but to do so.

If there are material uncertainties relating to events or conditions which may cast significant

doubt on the company’s ability to continue as a going concern, these uncertainties must be

disclosed. For example: “These financial statements are prepared on a going concern basis

because the holding company has undertaken to provide continuing financial support so that

the Company is able to pay its debts as and when they fall due.”

When the financial statements are not prepared on a going concern basis, that fact shall be

disclosed, along with the basis on which the financial statements are being prepared and why

the entity is not considered a going concern. For example: “These financial statements are

prepared on a realization basis because management intends to liquidate the Company within

the next 12 months from the balance sheet date”. Furthermore, items of property, plant, and

equipment may be presented differently if the Company is not expected to continue as a going

concern. If it is known the Company will cease operations within one year, it is not useful to

assume the equipment has a remaining life of five years. Instead, these items will more likely be

measured with their fair value less costs to sell.

Accounting policies and assumptions

The accounting policies and assumptions adopted in the preparation of a financial statement

are based on professional judgement. The selection of the policies and assumptions may

significantly affect a business entity’s reported income in the financial statements. Below are

examples of policies that may impact a business entities reported income.

Revenue recognition – The industry in which an entity operates and method it uses

to generate revenue has a significant impact on how that revenue is recorded. The

point at which an entity records revenue may or may not be the point at which the

entity received consideration for the goods or services provided. For example, an

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entity that recognizes revenue from selling goods, such as a retail store, would

recognize revenue when it has transferred to the buyer, the risks and rewards of

owning the goods This likely occurs when the buyer has the product, and has paid or

committed to pay. However, an entity that provides a subscription service that

involves payment for a year’s subscription up front, may not record all of that

revenue during the year, depending on the timing of the subscription and the

entity’s fiscal year end. In this regard, if the company has only provided 6-months of

service as at year end, it would likely only record 6-months’ worth of revenue, and it

would record the other 6-months’ worth as a liability on the balance sheet. Similarly,

revenue recognition may be impacted by the number of products/services provided

for a single sales price. I.e., if an entity provides a software license and associated

service agreement, the entity must separately recognize the revenue associated

with the software license and the service agreement.

Capitalization of expenses – Similar to revenue recognition, the industry in which an

entity operates will likely impact how the entity records its expenses. For example,

entities in the retail space would only capitalize expenditures incurred in relation to

the acquisition of significant property, plant, and equipment. However, the

recording of expenses in a company involved in research and development can be

more complex. The accounting standards prescribe that costs incurred before an

entity can demonstrate technical and commercial viability of an asset must be

expensed when incurred. Therefore, costs incurred during the research stage of a

given project should be expensed as incurred, whereas costs incurred once the

entity has demonstrated commercial viability of the product (i.e., development

stage), would likely be capitalized and recorded as an asset (to be expensed over the

life of the property). The “Significant Accounting Policies” note in the financial

statements will often provide full disclosure of how the entity accounts for its

expenditures.

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TAB 3

Looking Beyond the Financial Statements – Spotting

Red Flags

David Sieradzki, KSV Advisory


December 6, 2016


Law Society of Upper Canada Financial Accounting for Litigators Session: Looking Beyond the Financial Statements – Spotting Red Flags

Presenters: David Sieradzki, Edward Nagel

1. There are two types of errors that can result in the manipulation of financial statements:

• Unintentional errors – without the knowledge or intent of the person entering the transaction (e.g. key punch errors, incorrect formula, etc.)

• Intentional errors – deliberate misstatement or omission of transactions or disclosures in financial statements intended to deceive financial statement users or to conceal illicit activity (e.g. improper journal entries, creation of fake vendors/employees, etc.)

2. There are also typical indicators on financial statements of a Company’s insolvency.

3. Focus of today’s session is twofold: (a) intentional errors, otherwise known as fraudulent financial reporting; and (b) insolvency warning signs.

Fraudulent Financial Reporting

4. Why do people overstate business performance?

• To increase the value of a company in connection with a shot-gun clause • To meet or exceed the earnings or revenue growth expectations of stock market

analysts, investors and the public • To comply with loan covenants • To increase the amount of financing available from asset-based loans • To support the stock price in an anticipated merger, acquisition or sale of a

personal stockholding • To meet a lender’s criteria for granting/extending loan facilities • To meet corporate performance criteria set by the company • To meet personal performance criteria • To trigger performance-related compensation

5. Why do people understate business performance?

• To reduce the value of an owner-managed business that is used to calculate an equalization payment upon marital dissolution

• To defer “surplus” earnings to the next accounting period • To take all possible write-offs in one “big bath” so that future earnings will be

consistently higher • To reduce expectations now so that future growth will be better perceived and

rewarded • To preserve a trend of consistent growth, avoiding volatile results • To reduce the value of a corporate unit whose management is planning a buyout

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6. How is fraudulent financial reporting carried out:

• Falsification, alteration or manipulation of material financial records, supporting documents or business transactions

• Material intentional omissions or misrepresentations of events, transactions, accounts or other significant information on which financial statements are based

• Deliberate misapplication of accounting principles, policies and procedures used to measure, recognize, report and disclose economic events and business transactions

• Intentional omissions of disclosures or presentation of inadequate disclosures regarding accounting principles and policies and related financial amounts

7. What are some of the ‘red flags’ or potential indicators of fraudulent financial reporting?

• Adjusting journal entries lack authorization/support • Expenditures lack supporting documents or are unauthorized • Unusual time, date and personnel recording journal entries • Unusual amounts recorded (e.g. large, round numbers), particularly around

period-end • Transactions involving questionable parties – arm’s length? • Recurring cash flow problems when the company consistently reports profits • Significant bank accounts or subsidiaries in tax haven jurisdictions • Unusual improvements in debt covenants or other key indicators

8. Common types of manipulation #1 - Fictitious/misrepresented revenues

Schemes

• Recording sales that did not occur • Sales with conditions/side agreements • Shifting revenue between periods (i.e. timing differences)

Red Flags or Potential Indicators

• Rapid growth • Unusual profitability • Negative cash flow, yet positive net income • Related party transactions that lack substance • Increase in the number of days’ sales in A/R • Complex transactions • Surge of new sales to unknown customers

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9. Common types of manipulation #2 – Concealed Liabilities/Expenses

Schemes

• Liability/expense omissions or additions • Capitalized expenses • Improper accounting for warranties and contingencies • Inclusion of fictitious expenses • Co-mingling of personal/business expenses • Fictitious or ‘ghost’ employees


• Inconsistency between cash flow and profitability • Significant estimates that lack substance • Unusual spikes in gross margins • Reduction in number of days’ purchases in A/P • Metrics out of line with competition/industry

10. Common types of manipulation #3 – Improper Asset Valuations

Schemes

• Manipulation of accounts receivable (including refreshing aging) • Improper accounting for business combinations • Fixed asset manipulation • Manipulating of inventory valuation – price, quantity or both


• Unusual increase in gross margins • Unsubstantiated reduction in allowance for bad debt, inventory obsolescence • Increase in assets, when competitors/industry are trending towards down

11. Common types of manipulation #4 – Improper Disclosures

Schemes

• Omission of significant, known liabilities • Related party transactions, particularly with non-spouses that are not business-

related • Changes in accounting policies without basis

Undisclosed significant events

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• Domination of certain C-Suite (e.g. majority shareholder) • Weak board • Rapid growth in the business, coupled with usual profitability (as compared to

prior years) • Transactions with offshore entities • Existence of offshore bank accounts • Overly complex organizational structure

12. Key documents to ask for to assess the reliability of financial statements

• Internal accounting - General ledger, sub-ledgers, internal financial statements • Banking records - bank statements, deposit slips, cancelled cheques, wire

confirmations, etc. • Source documentation – invoices, receipts, contracts, purchase orders, shipping

records, bills of lading, inventory records, tender documents • External auditor working papers – including year-end entries, trial balance and

financial statements

Insolvency

13. Insolvency “red flags”

Qualification in audit opinion “Going Concern” note to the financial statements Change of auditors Change of bank Negative working capital Highly leveraged (debt to equity ratio) Bank covenant breach (important to check bank indebtedness note to the

financial statements) Negative equity Low or negative EBITDA Declining margins, earnings, accounts receivable, sales, etc. relative to prior

year Growing liabilities Long term debt classified as current for various reasons, including

default/demand which would be included in the notes to the financial statements

Is EBITDA sufficient to cover debt service costs (principal and interest), capital expenditures and any other non-operating expenses?

Change in key accounting policy (where the prior policy would have significant implications on ratios or other solvency tests)

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14. What the financial statements do NOT reflect

Aging of accounts payable – key to understanding Company’s liquidity is to determine if they are “stretching” trade vendors and whether they are under vendor pressure

Using “Deemed Trust” monies to fund operations (i.e. source deductions, HST, etc.)

Cash flow forecast and/or pending liquidity crisis Aging of accounts receivable Pending deadline for key operational contracts (supply agreements, customer

orders, etc.) Major suppliers/customers leaving The realizable value of assets – often large discrepancy between the book value

of certain assets for accounting purposes and the realizable value of those assets (i.e. intellectual property, goodwill, fixed assets, future tax assets, prepaid expenses, etc.)

Litigation risk for contingent liabilities Weak management Union issues Change in directors and officers The “availability” or “margin surplus/deficit” reflected on the Company’s

borrowing base certificate in an asset based lending context “Off-balance sheet” obligations, including landlord/lease obligations,

contingent liabilities and certain employee obligations (i.e. severance/termination)

15. What financial information should be requested to understand a Company’s solvency (other than financial statements)

Cash flow projection Accounts payable aging report Accounts receivable aging report Credit agreement Borrowing base certificate (if company uses ABL facility) Non-normal course transactions (i.e. sale/leaseback, asset dispositions, etc.) PPSA registrations (understanding secured creditors and “waterfall” is often

important to understanding pressure points and next steps of key stakeholder groups)

Meeting with management – understanding the business is key to understanding whether the company will be able to discharge its obligations and continue to operate in the normal course (and for how long)

Employee obligations – severance/termination, vacation pay, etc. Tax returns

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TAB 4

Using Financial Statements to Assess the Value of a

Business

Paul Mandel, CPA, CACBV, MBA, Partner, Litigation Accounting and Valuation Services, Collins

Barrow Toronto Valuations Inc.

December 6, 2016


Using Financial Statements to Assess the Value of a Business

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3

What is the first document a business valuator is likely to review at the commencement of a valuation?

a) Financial statements at incorporation

b) Globe and Mail business section

c) Financial statements for the fiscal year immediately preceding the Valuation Date

d) Financial statements for the fiscal year following the Valuation Date

POLLING QUESTION

4

The starting point of every valuation is the financial statements.

ASSESS THE VALUE OF A BUSINESS

ASSETS LIABILITIES + EQUITY

=

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INCOME OR ASSET APPROACH?

5

• The financial statements are not always a clear indicator

• Factors to consider:– Nature of business / industry

– Profitability

ASSET APPROACH

6

Adjusted Book Value – Begin with Shareholders’ Equity

– Eliminate goodwill and intangible assets

– Assets restated to value in continued use or market value

– Deduct income taxes on year-to-date pre-tax earnings

Examples of businesses:– Investment funds

– Real estate holding companies

– Holding companies

– Businesses with negative earnings but positive equity

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INCOME APPROACH

7

• Generally a multiple of income

• Income can be measured as:– Earnings

– EBITDA

– Cash Flow

• Examples of businesses:– Grocery stores / retail

– Manufacturing companies

– Any business / venture that is expected to earn income

POLLING QUESTION

8

True or False – An Asset Approach will always lead to a higher value than an Income Approach?

a) True

b) False

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NORMALIZATION OF EARNINGS

9

Pre-Tax Earnings from Operations

•

Adjustments to normalize earnings for a notional purchaser:

• Normalize salary / compensation• Non-arm’s length payments such as rent or charges• Management fees / bonuses• Personal expenses• One-time / non-recurring• Income associated with non-operating / redundant assets• Foreign exchange gains/losses

EBITDA

10

EBITDA

=

Earnings Before Interest, Income Taxes and Depreciation / Amortization

• To calculate:– Add back interest

– Add back amortization / depreciation

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CASH FLOW

11

Calculate cash flow:

– Start with pre-tax income

– Add back non-cash expenses such as amortization/depreciation

– Pre-tax or after-tax

PERSONAL EXPENSES

Expense items which may contain a personal component:

– Meals and Entertainment

– Advertising and Promotion

– Vehicles

– Travel

– Salary to Family Members

– Homes

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POLLING QUESTION

13

Which of the following would be an income normalization adjustment for a car manufacturer?

a) Legal fees associated with union negotiations

b) Recall costs around fixing faulty ignition switch

c) Corporate aircraft operating costs

d) Salary to president’s daughter

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INCOME APPROACH

15

Which Normalized Income to Use?

– Trailing twelve months

– Analysis of trend of income

– Normalize 5 years

– Weighted average

– Judgement / subjectivity

– Pick a range or point based on historic results and budgets

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Paul Mandel, MBA, CPA, CA, CBV, CFF, Valuation and Litigation Support Partner,

t. 416.480.2498, e. [email protected]

Paul Mandel has 20 years of full time valuation and litigation support experience. Hereceived his CA at a national accounting firm in 1997 and his Chartered BusinessValuator (CBV) designation with an international accounting firm in 1998. In 2003 hejoined a regional accounting firm to found their business valuation and litigation supportpractice. In 2010 he joined Collins Barrow where he is currently a partner in the litigationaccounting and valuation practice and is the national practice leader for businessvaluation for the Collins Barrow cooperative. He has presented expert testimony in courtclose to 20 times on family law, business valuation and commercial damagesmatters. He has written numerous articles and was most recently published in theCanadian Consulting Engineer magazine for his article on minority shareholder value andrights.

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About Collins Barrow

With offices from coast to coast, Collins Barrow is one of Canada’s largest associations of chartered professional accounting firms and the eighth largest group of chartered professional accountants in the country. Known as Canada’s mid-market alternative for audit, tax and advisory solutions, we have developed a reputation for being a real choice for quality and value-added financial advice, due to the depth and breadth of our in-house skills, customized offerings and service excellence.

We serve companies at all stages of their development, from large publicly traded companies to emerging and owner-managed businesses. Our clients come from a cross-section of industries, including private equity, manufacturing, industrial, wholesale, retail and distribution, professional services, farming and agriculture, financial services, real estate and land development, hospitality and entertainment, technology and communications, energy and mining, biotech and not-for-profit. Our understanding and first-hand knowledge of the trends impacting these industries continue to prove that our professionals are well- positioned to offer valuable and effective solutions.

Collins Barrow is an independent member of Baker Tilly International, the world’s eighth largest accountancy and business advisory network by combined fee income. Together, we offer clients an established platform and access to the highest quality resources in the global marketplace. Independent, responsive and trusted, we are the true national alternative. Collins Barrow, Clarity Defined®.

To learn more, please contact one of our practice leaders at toronto.collinsbarrow.com

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financial accounting...1 chair: peter weinstein, cpa, ca ifa, cbv, mba, managing director, ksv...

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