ACCOUNTANT’S NOTES: Take time to read these. They refer to qualifiers and unknown items. If there are no estimated amounts, you may still want to consider risk. If you are not provided with notes, then you may be missing information basing the report. You may ask for notes. Lawyers are asked to weigh in on pending litigation and to assess the risk (for example: “no material adverse effect” and someone determines what is “material.”) Be careful about comparison with comparable companies. Is it true comparability? You can get commercially produced information and you can compare the company to norms and other companies in the industry. Make sure, however, that these comparisons are fair and that the dollar amounts are close enough in time to be comparable. If you are comparing sales with the past, then you may not be seeing change but rather change in the value of the dollar. Indexing allows comparisons in different years by having a base year and then doing comparisons based on that year.
COMMON SIZE FINANCIAL STATEMENT: This does not have any dollar amounts but only has percentages. This allows year-to-year comparison.
OTHER MEASURABLES: Liquidity aka current ratio (of current assets over current liabilities), profitability, return on investment (ROI), debt management aka debt to equity ratio (total debt over total equity), gross profit ratio. For example, if debt is increasing profits through purchase (known as “leveraging”) that shows health, but if the company is borrowing because that is the only way it can make money, then that is a concern. When doing profitability reporting by segment, you need to be concerned that each segment is properly allocated. For example, they may pick up expenses for other segments to show a lack of profitability. As for liquidity, you want to see if patterns give rise to concern. A good analytic is to measure how quickly receivables become collected and it is good to see average number of days to collect. A liquidity measurement can pinpoint this.
REVENUE RECOGNITION ABUSES: Companies selling on credit and being paid later can lead to misleading financial statements. Wrongful manipulation can make them look more or less profitable than they are.
It is more common for companies to shuffle paperwork to make it look like they are MORE profitable than they are (as opposed to less profitable). Here is a thought: if both parties to a divorce do this and know the value is inflated, how can the party who knows the value is actually less argue differently when they divorce?
So too when small companies fail to report cash sales or have two sets of books to avoid tax. People have been caught doing this a variety of ways including falsely deferring sales to a later date or over-expensing overhead. This can be called a cookie jar: saving up this year’s profit for another year (maybe after the divorce).
Abuses can occur with capitalizing and expensing. When going through a divorce, a party might go out and buy a big piece of machinery which should be capitalized over time and instead expenses it in one year (making profits for that year look less than they should be). This can be caught by comparing purchases with capitalizing and also by looking for reduced capitalized costs as opposed to during other time periods.
Monthly statements are helpful because this sort of “clear up” usually happens at year’s end. Looking at any “adjustments” may help pinpoint the red flags. Discovery and disclosures are great ways to obtain these documents, as is consulting with an expert who knows what to seek. This can be done affordably on a consultant or expert witness basis, often deferring any expense for testimony in the event the parties settle the proceeding.
How can the party who wants to show profits were higher than reported do so when they divorce? Does it matter if both parties filed returns and ran the business together? Does it make a difference if one party was shut out entirely? Can you seek innocent spouse relief or oppose your spouse’s effort to do so?
These are things to think about with a family business prior to or during divorce. An attorney can help you understand how to protect your rights (and perhaps seek expert assistance) when reality and financial records are inconsistent.
For one-on-one guidance through protecting your assets and small business in a divorce, contact Beth Andersen at Andersen Law PC today at firstname.lastname@example.org or call 720-922-3880.