Directors Resolution Changing Year End of Corporation

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					  Valuing Businesses In
  Matrimonial Disputes
               PRESENTED BY
        Brian Spence / Martin Berry
                   NIFA
Network of Independent Forensic Accountants
                  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
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
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
           WHICH METHOD TO USE?
Earnings          - Applies mainly to “whole company”
                    valuations and to controlling and
                    substantial minority shareholdings


Dividends 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
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
         Rights of shareholdings
Shareholding   Rights

10%            Can call meeting of shareholders

25.1%          Can block a special resolution

50%            Deadlock situation? Chairman’s
               casting vote?
50.1%          Can pass an ordinary resolution

75%            Can pass a special resolution

90%            Can buy out the minority in
               certain circumstances
              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?
          33.3% Shareholding
Consider the following two scenarios:-
a) 3 shareholders each owning 33.3% of the
   issued share capital
b) 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
THE VALUE OF A COMPANY‟S SHARE GENERALLY
DERIVES FROM ITS ABILITY TO EARN PROFITS
AND PAY DIVIDENDS
        EARNINGS METHOD

Steps:
    Identify sustainable earnings
    Capitalise sustainable earnings
    Separation of surplus assets
        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
 Company‟s worth based on its future profit
  stream
                  “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.
    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.
 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.
         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
 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
    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
    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)
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
              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 P&L, but sales made after the year end
  will fall into next year‟s accounts
Objective is to find any non-
justifiable adjustments made
to the accounts, especially
after the breakdown of the
marriage
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
           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?
Stock & WIP
                                         2004     2003
                                          £        £

Work in progress                        523,160 562,204
Finished goods and goods for resale     306,041 424,228
                                        829,201 986,432

Stocks have fallen as follows:

WIP                                         7%
Finished goods                             28%

This fall needs to be investigated

        1 High stock provisions?
        2 Stock at 3rd parties unaccounted for?
        3 Stock not counted?
                     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
Debtors
                                                  2004        2003
                                                   £           £
Trade debtors                                      782,521   1,007,028
Amounts owed by related company                    345,000     161,115
Prepayments                                         20,347      18,691
Other debtors                                        9,416           -
                                                 1,157,284   1,186,834

Points to investigate:

       1 Why have trade debtors fallen by 22%?

       2 Why is there a large increase in amounts owed by
         related companies? Funds being withheld?

       3 What are other debtors?
         OTHER DEBTORS
In accounts of a Limited Company they may
include:-
Loans to directors
- Should be disclosed separately in the
  accounts if > £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
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 director‟s
              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
EXAMPLE:-

Creditors falling within one year
                                     2004         2003
                                       £            £
Directors' loan account                  2,500      40,000
Tax payable                           149,218      261,968
Trade creditors                       902,612      923,014
Accruals                                 4,370        5,948
Dividends payable                      15,000       15,000
                                    1,073,700    1,245,930


Directors have withdrawn £37,500. Why?

Was money withdrawn and then paid back after the year end?

If not, where has the money gone?

Form E?

Need analysis of Directors' loan account
                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?
EXAMPLE:-

FIXED ASSETS

                      Freehold         Plant &             Fittings &
                      property        Machinery       Office equipment     Total
                           £              £                     £           £
Cost or valuation

At 1 April 2003          350,000           435,600            396,420     1,182,020

Additions                         -           6,000              3,700        9,700
Disposals                         -       (240,000)          (120,000)    (360,000)

At 31 March 2004         350,000           201,600            280,120      831,720


Depreciation

At 1 April 2003           28,000            249,600           189,994       467,594
Charge for the year        3,500             20,160             42,018       65,678
Disposals                                 (120,000)           (70,000)    (190,000)
At 31 March 2004          31,500            149,760           162,012       343,272


Net book value

At 31 March 2004      £ 318,500       £    51,840      £      118,108    £ 488,448
              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
    CAPITALISE EARNINGS
 Need to establish a suitable multiple

 Two methods normally used
    a) P/E ratio
     b) The investment approach
       – required rate of return
                       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
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
                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
Investment Approach


This approach assumes that the multiple
will reflect the rate of return a prudent
purchaser would reasonably require
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 company‟s 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
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)
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
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
Surplus Assets
   Value separately and add to the
    valuation

   Need to remove related income/costs
    from the valuation
Asset Valuation
   Often a fall back position in negotiation

   Non-trading company with substantial assets

   Companies with low earnings
              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
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
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%
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

				
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