If you are getting a divorce and your spouse has a closely held business that receives a significant amount of revenues in cash, you should be concerned about cash taken out of the business that is not reported. What can be done to account for this missing income, especially if your spouse is less than co-operative in revealing this information?
Here are some points to think about:
If the business appraiser is allowed to talk to various personnel during the site visit, he will obtain from them information about how revenue is collected, the extent of cash sales and how are they handled and recorded. It takes a careful eye to observe the types of transactions that are most likely to be omitted from the books. For example, in a manufacturing plant, is the cash received from the sale of scrap materials being recorded on the books? Does the company engage in any bartering transactions? Who prepares the deposits for the company, and is the daily cash received reconciled to the deposits? Do the deposit slips reflect any cash being deposited?
The type of company being valued will dictate the types of issues that need to be considered. For example, consider a coin operated laundry business. To determine if the sales reported on the tax returns are different than what is actually received, you can try to tie sales to other direct operating activities, such as the amount of water being used. If you know the type of washing machines used in the laundry business, there are specifications as to the amount of water used per load by each machine. The next step would be to subpoena the water bills for the business. Dividing the monthly water usage (in gallons) by the amount of water used per load will provide a good approximation of the number of loads of wash that were done for the month. Multiplying the calculated number of loads by the average price charged per load would result in a good approximation of what is the monthly income generated from washing machines. Naturally, you would also consider other sources of income, such as the use of dryers, sales of laundry supplies, vending machines, etc.
Another well known type of cash business is a restaurant. This is another situation where the "actual income" may be greater than the amount reported on the tax returns. If the restaurant owner makes the mistake of not reporting all the income, but continues to report all of the direct operating expenses related to the income, this could lead to a red flag. There are many sources that provide statistical data on the normal operating expenses for various types of restaurants. By reviewing these studies you can notice if the subject restaurant's expenses, as a percentage of sales, are out of line with the rest of the industry. In estimating what the actual sales should be, you can divide the direct expenses, such as the cost of food and beverages, by the average cost of sales percentage from the restaurant industry studies. The resulting answer represents an estimate what the actual level of sales should be.
Another way to estimate the actual sales, in conjunction with the above analysis, is to review the daily cash register tapes or customer checks and total them for the year. This total can be compared to the amount of sales calculated through the use of the statistical data. On newer cash registers, the daily receipts are closed out in a manner that summarizes the revenues by breakfast, lunch and dinner. The receipts are then further broken down by the type of sales, such as food and beverage. It is possible to find that two sets of books are maintained by the business owner, with one set tying directly to the cash register tapes.
Additional procedures for verifying the reasonableness of reported sales include comparing the usage of product to the sales reported. For example, in analyzing a sub shop, if you are able to obtain records from the bakery as to the amount of bread purchased for the year, you can estimate the number of sub sandwiches sold for the year. Multiplying the number of sandwiches sold by the average price per sandwich produces an estimate of the sales that should have been reported. All of these methods individually, or in combination, can provide further evidence that the restaurant is under-reporting sales.
A common analytical technique used in valuing a business involves the preparation of "common size" financial statements. This is done by simply expressing the dollar amount of each expense item as a percentage of sales. By reviewing these percentages over a number of years the financial expert may be able to spot trends that will raise flags for further investigation. For example, large swings in the cost of sales percentage or gross profit percentage are signs that there may be some type of accounting problem. The common size financial statements can also be compared to industry statistics in order to determine if other companies are experiencing the same types of trends as the company being valued.
Another way to look for under reported income when valuing a cash business may be to look at the underlying documentation. This can be a very exhausting and extensive process, requiring a significant number of hours and resulting in a high cost. For example, in a distributorship, purchase orders can be sorted and compared with deposits on a monthly basis. If purchase orders exist for which no deposits have been made, further investigation should be done.
In a medical practice, the day sheets can be compared with deposit slips and the entries in the appointment books. If discrepancies are found, they can be further traced into the patient's receivable records.
In a home remodeling business, each customer's contract can be reviewed to compare the contract price with the amount actually received or deposited. Taking this a step further, a confirmation letter might be sent to customers verifying the amounts they paid for a particular job. If the job was financed through a finance company, the job cost can be compared to the amount financed. Examining the underlying documentation can sometimes turn up skeletons, as owners many times do not take the time, or have the ability, to alter the transaction all the way through the paper trail. The problem with this type of analysis is that it may prove to be cost prohibitive. The time and expense involved in obtaining and comparing the data may exceed your budget, and may also exceed the benefits received. For this reason, determining the true earnings of the business, may be cost prohibitive.
While determining the true economic income of a cash business may be a tedious and time consuming process, it can be done and should be considered when the benefits are thought to significantly outweigh the costs involved. The only way to make this decision is to review the known facts of each case have a frank and specific conversation with an experienced financial expert, at an early stage of your divorce.
Since 1980, Bruce Richman (CPA/ABV, CVA, CDFA™) has been actively involved in valuations, mergers and acquisitions and other financial and tax consulting matters. In his current position, Mr. Richman is responsible for various valuation projects and consulting services in the United States and, for U.S. clients, internationally.