What Issues are Impacting Independent Experts as a Result of the Global Financial Crisis?

Michael McDonaldPrincipal, Moore Stephens

Joanne WebbForensic Consultant, Moore Stephens

Objectives

• Understand the impact that the Global Financial Crisis has on determining the Value of a Business subject of a matrimonial (or any other dispute)

• Identify the ‘red flags’ of fraudulent behaviour that may affect the integrity of the financial information provided

• Understand fundamental factors that impact Business Valuations

Outline

• Financial information required to conduct a Business Valuation

• How this financial information may be manipulated

• Fundamental factors affecting Business Valuations– Date of Valuation– Valuation Methodologies

• Effect the Global Financial Crisis has on:– Future Maintainable Earnings– Capitalisation Rates

Manipulation of Financial Information

Is the Global Financial Crisis being used as a scapegoat or smokescreen

for a mixture of sins?

Financial Records Required for all Valuations

• Complete financial statements for the last three (3) financial years

• Management accounts for the financial year to date

• Copies of Income Tax Returns (ensure the ‘bona fides’ of the financial statements)

• Profit and Loss / Future Cash Flow Projections

However, what if this information has been manipulated to show a diminished position?

How Accurate are the Financial Results?

• Observations of and opinions about fraud in a weakened economy

• Cressey’s Hypothesis – “Fraud Triangle”The classic model for the occupational offender:

PRESSUR

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OPPORTUNTI

Y

RATIONALISATION

‘Red Flags’ of Fraudulent Behaviour• Intent to understate revenue and assets and overstate expenses

and liabilities

• Revenue:• Sales Skimming (Unrecorded Sales)

• Cash Register Manipulation

• After Hours Sales

• Receivable Collection Procedures

• Fraudulent Write-offs or Discounts

• Expenses• Billing Schemes

• Cheque Tampering

• Payroll Schemes

• Expense Reimbursement Schemes

• Register Disbursement Schemes

‘Red Flags’ of Fraudulent Behaviour

• Assets• Undervalued assets

• Unrecorded assets (i.e. options)

• Loans to related parties

• Liabilities• Overstated liabilities

• Loans from related parties

‘Red Flags’ of Fraudulent Behaviour

• Detection• Does the subject have a perceived opportunity?

• Expected v’s actual (remember the GFC may not be a legitimate explanation for a decrease in sales and increase in expenses)

• Audit log reports

• Third party confirmations

• General ledger detail

• Discussions with client and the Managers of the business

Personal Characteristics

• Unusually high personal debts

• Living beyond one’s means

• Excessive gambling habits

• Alcohol/drug problems

• Feeling of being underpaid/insufficient recognition

• Overwhelming desire for personal gain

• Unreliable communications and reports

Instructing Your Forensic Accountant

• You and/or your client has identified issues that require further investigation

• Define the scope of the engagement

• Define the period under investigation

• The Forensic Accountant to provide details of information required to conduct the investigation

Fundamental Factors Affecting Business Values

Consideration must be given to …

• Date of Valuation v’s Date of Order/Settlement• Weldon v Union Trustee Co of Australia Ltd (1925) 36 CLR 165• Spencer v The Commonwealth, 5 CLR 418

• Valuation Methodologies• Discounted Future Net Cash Flows – “Cost of Equity” Method• Discounted Future Net Cash Flows – “Weighted Average Cost of

Capital” Method• Capitalisation of Future Maintainable Profits “Cost of Equity”

Method• The Combination Discounted Future Net Cash Flows and

Capitalisation of Future Maintainable Profits “Cost of Equity” Method

• Rules of Thumb

Capitalisation of Future Maintainable Profits “Cost of Equity” Method• Future Maintainable Profits of the Business

• Projecting a normalised amount of economic income

• Capitalisation Rate• The rate of return expected by the Owners of a Business on the

funds they have invested in it, and,• The risk attached to the Business actually maintaining a given

Future Operating Profit

• The Capitalisation Rate is applied to those Future Maintainable Profits, in establishing the Value of the Business.

Effect of the Global Financial Crisis (Valuation dates after September 2008)

• Future Maintainable Profits• Are past results representative of Future Maintainable Earnings?

• Impact on different industries:

– Those showing a positive impact

– Those showing a negative impact

• How long will the Global Economic Crisis affect the Business subject to valuation?

• Is this just a ‘Blip’?

• Budgets and forecasts prepared by the owner at the date of valuation

• Cost saving methods implements by the Owner(s). Will this improve the ‘bottom line’?

Effect of the Global Financial Crisis (Valuation dates after September 2008)

• Capitalisation Rates• Most accountants simply say “I have adopted a Capitalisation rate

of (e.g.) 25%”, with limited explanation of considerations and factors that resulted in that conclusion.

• An appropriate approach is a combination of ‘art and science’ methodology

• Factors affecting the building of a capitalisation rate:

– Long Term Bond Rate

– Market Risk Premium

– The Business Risk related to the Assets (ß)

– Small Company Risk Premium

– Expected Future Inflation Rates

Summary – As a result of the Global Financial Crisis …

• There is an increased risk that financial information provided may not be accurate

• Valuations with an instructed Date of Valuation before September 2008 may be materially different from it’s current value

• The reliance on past results in determining Future Maintainable Profits may not be appropriate

• Capitalisation Rates applied must be supported by proven methodologies and appropriate assumptions

Questions ?

Thank you.