Undisclosed Cash and Personal Expenditure
Business Valuation: the thorny issue of undisclosed cash and personal expenditure
Business valuations in shareholder disputes and matrimonial cases often highlight undisclosed cash takings and personal expenditure hidden in company accounts. It can also be relevant when considering the valuation of a company for strategic planning or a business sale.
When dealing with disputes, including divorces, it is not uncommon for one party to raise concerns about undisclosed cash or personal expenditure and the impact they have on the valuation. At the same time, the other party may dispute the existence, extent or relevance of the transactions.
Undisclosed cash takings
Historically, cash-based industries provided an opportunity to not record all takings and to either spend the cash personally or bank it in a private account. The move to a cashless economy has made it more difficult to divert cash income in this way. However, we do come across situations where certain types of business sales are omitted completely from the records and sales receipts are diverted to a private bank account.
Quantifying undisclosed cash takings is difficult unless the parties are willing to provide an estimate that we can use in our calculations. In some industries, we may be able to estimate a figure based on, for example, diary entries or booking records. Clearly if the undisclosed takings are banked in a private account, we can use statements from those accounts to quantify the amount omitted from the accounts.
We have had cases where both parties are fully aware of a long-term practice of undisclosed sales and it only becomes an issue at the time of the divorce. We also need to consider the implications in respect of underpaid tax, VAT and penalties.
In terms of the impact on valuation, it depends on valuation basis in our instructions. If instructed to provide an “open market valuation”, we may decide not to include undisclosed takings in the valuation calculation. This may be because, in our view, the undisclosed takings cannot be reliably estimated or because an external buyer will not be prepared to pay for profits that are not recorded in the accounts. An external buyer may in fact discount the valuation due to the potential tax issue.
Alternatively, if instructed to provide an “equitable basis” valuation, we may decide to include the undisclosed income to arrive at a fairer outcome where one party is going to retain the company and future undisclosed profits.
In a divorce case, undisclosed takings may also be relevant in assessing future sustainable income if it is expected that the undisclosed takings will continue.
Personal expenditure within business accounts
In family companies it is common for personal or discretionary expenses to be paid through the company. In the first instance, the valuer needs to determine whether the expenditure has been charged to a director’s loan account or whether it is charged within the profit and loss account.
If expenditure is charged to a director’s loan account, then there is no impact on the valuation of the business. In effect a cash balance is replaced by a debt in the company. It may, however, be an adjustment if the director is unable to repay an overdrawn loan.
The expert may be instructed to investigate the level of private expenditure in the accounts or it may be identified through analysing the profit and loss variances. But it can be difficult to identify, particularly if hidden in “cost of sales”.
If the expenditure is in the profit and loss account and can be quantified, there is likely to be an impact on valuation – potentially significant. For example, let’s assume that the personal expenditure in the profit and loss is £100,000 annually. A value based on future maintainable earnings/EBITDA and a multiplier will increase: if we adopt a multiple of, say, 5X, then the valuation in this case increases by £500,000.
Again, in divorce cases, personal expenditure within the profit and loss account will impact the assessment of future sustainable income as well as valuation.
Personal expenditure within the profit and loss account may also raise potential issues in terms of potential future tax liabilities.
In commercial valuations for a potential sale of the business, the seller will provide an estimate of personal and discretionary expenses which a buyer is unlikely to continue paying. They will seek to add these back in the assessment of the company’s market value. Such adjustments typically include family wages and other benefits to directors which exceed an assessment of the commercial salary for the role.
Conclusion
Undisclosed takings and personal expenditure are typically sensitive issues but can have a significant impact on a business valuation. If instructing an expert, it is helpful to engage early with the expert and to provide clear instructions on how the issue is to be dealt with. Valuations can be prepared based on alternative assumptions.
Getting in Touch
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