Forensic accountants are often retained to support special investigations related to a broad range of subjects. A number of skills and techniques are required to reconstruct the facts, and business valuation remains one of the most prominent services.

While forensic accountants are often sought to provide business valuation work in relation to litigation assignments, all business valuation engagements can benefit from forensic investigation. Generally, there are four areas of forensics — what we like to call the "Four F's" — that can be helpful in business valuations: Forensic Accounting, Fraud, Fidelity and Forensic Technology. Here' we'll look closer at forensic accounting.

Business Valuation Concepts

A clear understanding of Fair Market Value is the foundation of any business valuation endeavor. Fair Market Value is the most widely used and accepted standard of value in the United States. The term is defined by the Internal Revenue Service in Revenue Ruling 59-60 as follows:

… price at which the property (business) would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.

With this definition in mind, there are three generally accepted approaches to the valuation of assets: the (cost) asset, income and market approaches. These approaches to value are defined as follows:

Cost (Asset) Approach — is based upon the principle that a prudent investor would pay no more for an investment than the cost to obtain, either by purchase or construction, an investment of equal utility. This amount can be equal to the current replacement cost of the asset, less deductions for physical, functional and economic factors. Another option is to estimate the fair market value of all entity assets, including off-balance sheet items such as goodwill, and reduce this by the value of entity liabilities, including off-balance sheet liabilities.

Income Approach — is based upon the principle that value is based upon the expectation of future benefits. It is an indication of value using one or more methods that convert anticipated economic benefits into a present single amount. Value calculations are performed by either discounting future projected benefits to the present or by capitalizing normalized historical benefits.

Market Approach — is based upon the principle that in a free market, supply and demand factors will converge at a price equilibrium and that a prudent investor will pay no more for the subject asset than the prevailing price for an asset of like utility. It is an indication of value by using one or more methods that compare the risk and return characteristics of similar investments that have been sold in the marketplace. The value is determined by an analysis of recent sales of similar entities or by using multiples or comparable companies. These multiples can then be used as a benchmark for deriving multiples to be applied to the entity being valued.

While all of these approaches may be used to determine the Fair Market Value of an entity, it is up to the valuator to determine the appropriateness of each approach in the particular valuation engagement. A common method under the asset approach is the Net Assets Method. The Net Assets Methodology is based on the premise that value of an entity is based on the Fair Market Value of the individual assets and liabilities of the entity. The case study below focuses on the asset approach, utilizing the Net Assets Methodology.

Case Study

RGL, a forensic accountants and consultant firm, was engaged by the government to determine the value of a limited partnership interest of a family business in a case involving a discount for marketability and minority interest applied to the partnership's assets. The partnership owned various commercial properties and a single-family home in Wisconsin. It also owned a vacation home in Utah. Using the Net Assets Method, all assets were adjusted from their book value to fair market value. All of the known properties had been recently appraised and the balance sheet "adjusted" to fair market value to determine the total asset value of the partnership. At this point, a typical discount study could have been completed. As some CPA Insider™ readers may already know, a discount study calculates the lack of marketability and control (minority interest) of the limited partners in the partnership. A marketability discount is applied in situations in which the ability to sell a business interest is limited due to the absence of a ready market. A minority interest is applied in situations when the minority owner cannot control decision-making of the entity.

However, a forensic accountant's job is to investigate and analyze all available financial information to determine the accuracy and completeness of the disclosures. In this case, upon investigation of the partnership's tax returns, two additional vacant land parcels were discovered. The balance sheet, therefore, did not reconcile to the depreciation schedules provided. Furthermore, the newly-discovered properties were recorded on Form 8825, the by-property income/expense statement on a tax return. Various expenses were recorded for these vacant land parcels with no revenue.

Since these parcels were not included within the real estate appraisals, they were not included in the net asset value of the partnership. Without a complete forensic accounting investigation, the true value of the limited partner share would have been understated.

Conclusion

Forensics can, and should, be used when business valuation projects are completed. We've examined how forensic accounting can assist with the proper valuation of a family limited partnership using an asset based approach to valuation. Future articles will discuss the other three "F's" of forensics: Fraud, Fidelity and Forensic technology.

Steven J. Hazel, CPA, ABV, ASA, CVA, CMC, is a Director in the Denver office of RGL — Forensic Accountants & Consultants. With more than 20 years of accounting experience, he is highly credentialed in the area of business valuation.