Valuing Businesses In Matrimonial Disputes

1
Valuing Businesses In Matrimonial
Disputes PRESENTED BY Brian Spence / Martin
Berry NIFA Network of Independent Forensic
Accountants
2
Overview

• The role of a forensic accountant in
  matrimonial disputes
• Some concepts of value
• Methods of valuation
• Which method to use
• Earnings basis valuation
• - Sustainable earnings and true profit
• - Scope for manipulation
• Taxation issues

3
THE ROLE OF THE FORENSIC ACCOUNTANT

• To advise on the value of the business
• - Unincorporated goodwill
• - Incorporated the value of unquoted
  shares
• To identify any suppressed or hidden
  assets/wealth
• To gather the financial evidence
• To advise on specific areas such as pension
  considerations
• To advise on taxation issues
• To advise in settlement negotiations

4
VALUATION METHODS
Three basic methods-

• Earnings Method (based on future maintainable
  earnings)
• Net Assets Method
• Dividend Method
• There are other methods such as the discounted
  cash flow method

5
WHICH METHOD TO USE?
Earnings - Applies mainly to whole company
valuations and to controlling
and substantial minority shareholdings Dividen
ds Yield - small uninfluential minority
shareholdings Net Assets - used mainly
for controlling shareholdings in property
investment companies, investment trust
companies and where income return is
low in relation to assets employed 2 Types
of asset valuation
- going concern
basis
- break-up basis
6
WHICH METHOD TO USE? (continued.)

• Need to consider-
• Size, type and rights of shareholding
• - Articles of Association
• - Companies Acts
• Real influence of the shareholding
• - Relationship of shareholder to other
  shareholders
• - Does the shareholding hold the
  balance of power?
• - Shareholders agreements
• Specific requirements of the
  Articles of Association

7
Rights of shareholdings
8
50/50 Shareholders
Need to review Articles of Association and
statutory books and consider-

• Does Chairman have a casting vote?
• Is there evidence that a Chairman has
  been appointed?
• Can business be transacted without a
  quorum?(Regulation 41 Table A Companies Act
  1985)
• Are there pre-emption rights?
• How easy would it be to sell shares to
  an outside party?
• Can directors refuse to register a transfer?

9
33.3 Shareholding
Consider the following two scenarios-

• 3 shareholders each owning 33.3 of the issued
  share capital
• 2 shareholders, one owning 33.3 of the issued
  share capital and the other owning 66.7.
• The value of the 33.3 shareholding under
  scenario (a) is worth more than the same size
  holding under scenario (b) as it holds the
  balance of control if offered for sale

10
THE VALUE OF A COMPANYS SHARE GENERALLY DERIVES
FROM ITS ABILITY TO EARN PROFITS AND PAY DIVIDENDS
11
EARNINGS METHOD

• Steps
• Identify sustainable earnings
• Capitalise sustainable earnings
• Separation of surplus assets

12
SUSTAINABLE EARNINGS

• These are the expected future normal recurring
  net profits after corporation tax
• Logical to take into account the historical
  profits of a number of years i.e. between
  3 and 5 years adjusted accounting
  profits
• Must also consider the future profitability
  of the company
• Companys worth based on its future profit
  stream

13
TRUE PROFITS
The forensic accountant needs to establish the
TRUE profitability of the
business TRUE PROFITS NORMAL RECURRING
SUSTAINABLE NET
PROFITS He needs comparable historic profits, as
well as, evidence of the
likely comparable future profits of the
business. Invariably, adjustments will need
to be reported profits
to normalise the results and to establish the
true profits.
14
ESTABLISHING TRUE PROFITS

• The forensic accountant will review historic
  accounts and any current management
  accounts to-
• Identify and seek explanations for unusual
  variations in sales,cost of sales, gross profit
  and expenses
• Identify and seek explanations for unusual
  variations in balance sheet figures
• Ensure a consistent application of accounting
  policies and financial reporting standards
  to the preparation of the accounts
• Search for areas of manipulation and
  concealment
• Identify the adjustments needed to reported
  profits to ensure comparability
  from one year to the next in order to
  calculate normal sustainable profits.

15
UNUSUAL VARIATIONS IN THE PROFIT AND LOSS ACCOUNT
MAY ARISE FROM-

• Changes in circumstances
• Non arms length trading / parallel trading
• Non recurring and exceptional items
• Private expenditure included in P/L account
• Expenses covering more than one year
• Excessive directors remuneration
• Cut off errors
• and of course MANIPULATED figures
• Adjustments not made will lead to an over or
  under valuation of the business.

16
EXAMPLES OF CHANGE OF CIRCUMSTANCES

• Loss of major customer/contracts
• New major customer/contracts gained
• Change of premises/location
• Recent rent increases
• Changes in the Law, EC directives, regulation
  requirements

All of these can affect comparability of accounts
17
EXAMPLES OF NON-ARMS LENGTH TRADING/PARALLEL
TRADING

• Management charges receivable from or
  payable to a related business
• Sales/purchases at an under-value to or
  from a related business
• Diversion of sales to another business
• Effect will be to distort the profits of the two
  related businesses

18
EXAMPLES OF NON-RECURRING
EXCEPTIONAL ITEMS

• Exceptional contracts
• R D - capital or revenue
• Legal fees for drawing up a new lease, or
  partnership agreement
• Exceptional repairs e.g. major refurbishments,
  roof renovations or boiler replacement
• Costs arising from the discovery and treatment
  of toxic substances e.g.
  asbestos
• Uninsured losses
• Exceptional bad debts
• Accountancy fees re an Inland Revenue
  investigation

19
EXAMPLES OF PRIVATE EXPENDITURE

• Excess motor vehicle running costs - element
  of personal choice
• Excess depreciation on the above
• Private employees gardeners,nannies,
  and cleaners
• Home expenses
• Divorce costs in legal expenses!
• Accountancy fees
• Are these added back?
  
  
• In tax computations (unincorporated businesses)
• or declared on forms P11d (directors)

20
EXAMPLES OF OTHER ADJUSTMENTS

• Excessive Directors remuneration
• - adjust to reasonable level commensurate with
  duties
• Regular but not annual expenditure
• e.g costs of attending major exhibitions every
  two years - spread the cost evenly
• Business premises personally owned by
  proprietors/shareholders
• - arms length rental?
• - any rental?
• Cut-off errors

21
Cut-off errors

• Cut-off is the term used by accountants to
  describe the procedures set up around a year end
  or accounting reference date which are designed
  to ensure that transactions are recorded in the
  correct period.
• So, sales despatched before the year end should
  be in the PL, but sales made after the year end
  will fall into next years accounts

22
Scope for manipulation
Objective is to find any non-justifiable
adjustments made to the accounts, especially
after the breakdown of the marriage
23
Manipulation

• May occur from
• Accelerating costs (e.g. research and
  development)
• Deferring income (FRS5)
• Unrecorded cash takings
• Stock provisions not required
• Bad debt provisions not required
• Falsifying liquidity and directors loan
  accounts
• Charging capital items to repairs
• Provision for liabilities/over providing for
  costs
• Depreciation (changing useful lives and RVs)
• Disposal of fixed assets at an under-value

24
STOCK AND WIP

• Must be stated at the lower of cost and net
  realisable value
• This is an area where manipulation of the
  accounts could occur, through high stock
  provisions,which will
• - Reduce the stock and thus the net assets
• - Reduce the profit for the year
• Check how the provisions relate each year to
  gross stock value (before provision)
• - Have stock provisions increased since the
  marriage breakdown?

25
(No Transcript)
26
DEBTORS

• Another area where manipulation of the accounts
  could occur is through high bad debt
  provisions,which will
• - Reduce the debtors and thus the net assets
• - Reduce the profit for the year
• Check how the provisions relate each year to
  gross debtors (before provision)
• - Have provisions increased since the
  breakdown of the relationship?
• Note-
• Debtors note in the accounts will also include
  as a separate disclosure amounts owed by related
  companies

27
(No Transcript)
28
OTHER DEBTORS

• In accounts of a Limited Company they may
  include-
• Loans to directors
• Should be disclosed separately in the accounts
  if gt 5,000
• May be ignored in the accounts and included
• in other debtors!
• Often arise through the company paying private
  bills
• Hidden wealth? Obtain full analysis of loan
  account movements

29
CASH AND BANK BALANCES

• Levels will indicate the liquid position
  of the company
• Can they be made available for the settlement?
• Levels can be manipulated
• - Paying trade creditors early (investigate
  fluctuations)
• Buying machinery before the year end
• Withdrawing sums from directors loan
  accounts before year end and re-introducing
  them after the year end
• INVESTIGATE THE LEVELS OF BANK BALANCES
  THROUGHOUT THE YEAR TO IDENTIFY MANIPULATION

30
(No Transcript)
31
FIXED ASSETS Points to consider

• Beware of disposals of fixed assets where
  related parties are involved. Not disposed
  of at arms length value?
• Are the assets being written off too quickly?
  Has there been a change in the accounting
  policy for depreciation?

32
(No Transcript)
33
FINAL STEPS

• Review latest management accounts and
  any other management information i.e.
• - budgets
• - business plans
• Consider the effect of any major changes
  on future profits
• Decide whether true profits for the last
  3 to 5 years are representative of
  future profits
• - if yes - take a weighted average
• - if no - prepare a projection

34
CAPITALISE EARNINGS

• Need to establish a suitable multiple
• Two methods normally used
• P/E ratio
• The investment approach
• required rate of return

35
P/E Ratio

• Share price divided by earnings per share
• Uses price/earnings ratio of a comparable quoted
  company in the relevant industry sector or the
  price/earnings ratio shown by the Financial Times
  Actuaries Indices for the sector
• PROBLEMS
• Often impossible to find a suitable comparator
  company
• Generally applicable to minority shareholdings
  not suitable for controlling
  shareholding
• ASSUMES THAT
• Two companies in the same industry with
  broadly similar records, earnings, profits
  and risks will command similar stock
  ratings as expressed in their price
  earnings multiple

36
PRIVATE COMPANY PRICE INDEX (PCPI)

• Tracks P/Es currently being paid on sale of
  private companies
• Operated by BDO Stoy Hayward
• Based on available and sufficient information
  disclosed on completed private deals
• Tends to be based on large private deals
• P/E ratio needs discounting for smaller deals

37
P/E Ratio

• Applied to after tax profits
• You can work out the share price if you
  have the earnings figure
• Profits - 37,500 after tax of 30
• P/E ratio 7
• Total value of company 37,500 x 7 262,500

38
Investment Approach
This approach assumes that the multiple will
reflect the rate of return a prudent purchaser
would reasonably require
39
Rate Of Return

• Prospective purchaser will take into account-
• Rates of return available elsewhere in the
  marketplace
• The risk factors inherent in the
  activities of the business e.g. breadth of
  product range, its market and competition,
  quality of earnings - is the trade stable,
  fashionable,buoyant, or in decline?
• Quality of management.
• The potential for growth
• The companys ability to increase the return by
  paying higher dividends dividend cover
• The assets that would be acquired as part of
  the purchase price potential capital return
• The level of debt
• Lack of marketability of the share
• Dependency on key personnel

40
Shareholdings
The value of a shareholding will depend upon
the proportion held Usually need to discount
capitalised earnings value per share but
not for quasi partnerships (See G v G
(2002) EWHC 1339 (Fam)
41
Discounts

• Need to take into account inter alia-
• - Size of shareholding, influences, and extent
  of control
• Rights
• - Restrictions in the Articles of Association
  (i.e. pre-emption clauses)
• - Lack of marketability
• - Lack of dividends

42
Discount rates
In broad terms these are- Size of
Shareholding Discount 91 - 100 0 75 -
90 5 75 10 50 10 -
15 50 20 49 35 25 60
43
Surplus Assets

• Value separately and add to the
  valuation
• Need to remove related income/costs from the
  valuation

44
Asset Valuation

• Often a fall back position in negotiation
• Non-trading company with substantial assets
• Companies with low earnings

45
Conclusions

• Important to apply the correct basis of
  valuation
• Must fully investigate the business to
  establish the true sustainable profits
  and/or the value of the assets
• Provides an opportunity to assess the
  true liquidity position and the ability of
  the business to support further
  borrowings and pay increased dividends
• Provides an opportunity to find hidden
  wealth
• Always review entries in directors loan
  accounts
• Can be a complicated exercise

46
TAX IMPLICATIONS
Capital Gains Tax Business Assets

• Applies to the disposal of chargeable assets
• In year of separation asset passes for no
  gain/no loss
• After the year of separation to date of decree
  absolute transfers are treated as made at open
  market value (spouses still connected persons)
• Business taper relief may be available
• Capital gains annual exemption may be
  available (currently 8,500 pa)
• Net gain after reliefs chargeable at marginal
  rate of tax

47
BUSINESS TAPER RELIEF

• Available for disposals after 5 April 1998
• Chargeable gain reduced according to the
  length of time for which the asset has been
  held
• Maximum relief of 75 applies after 2 years of
  ownership
• For higher rate tax payer this produces an
  effective rate of 10

48
HOLD-OVER RELIEF

• Is hold-over relief for gifts of business
  assets available ?
• There was some doubt as consideration was
  deemed to be given by the spouse, to whom
  the assets are transferred in the form of
  surrendered rights, for their transfer
• Inland Revenue reviewed approach for new
  claims made on or after 31 July 2002 following
  comments made by Coleridge J in G v G (2002)
  EWHC 1339 (Fam)
• Hold-over relief now given where business
  assets are transferred between spouses under
  the provisions of a Court Order under the
  Matrimonial Causes Act 1973