Reflecting back on the performance of more than 1,000 business valuations over the last 20-plus years, I have observed the regular occurrence of an economic event in many divorce-related engagements that I have named the Pre-divorce Business Downturn Syndrome (“PBDS” for short). Businesses that otherwise have reported fairly consistent profit patterns experience an unexpected dip in reported performance in the period leading up to the divorce valuation date. Business appraisers, when faced with the symptoms described above, should explore the possibility of an outbreak of PBDS by undertaking additional due diligence.
Manipulating Cash Basis Businesses
Especially for businesses that report their performance on the cash basis of accounting (e.g. many professional practices), there can be a deferral of revenues into the next year and an acceleration of expenses into the current year. Paying all bills by the end of the year for a cash basis taxpayer can be characterized as good income tax planning. However, deferring revenues by holding off on normal billing practices in the last month of the year can cross the line of good income tax planning into the realm of the PBDS.
Accounting Estimate Inconsistencies
Moving away from businesses that use cash accounting, many businesses using accrual accounting can also reflect the telltale symptoms of PBDS. Estimates by company management are regularly required to applying accounting principles to develop financial statements. An example of this would be a construction contractor that must estimate the percent complete of each of its in-process jobs. Backing off on the reported percent complete of in-process jobs can defer revenues and gross profit from the current year to the next year.
Time Can Confirm PBDS
In the simplified examples described above, profits are not removed from the company, they are only deferred. As such, the next accounting period will often reflect an atypical jump in profit. While all post valuation-date profit increases are not necessarily always reflective of PBDS, the business appraiser should further test the period to period fluctuations to determine if in fact an outbreak of PBDS has occurred. Business appraisers must establish a valuation date in a divorce case, and determine the value of the business as of that date, typically based on what was known or reasonably foreseeable as of that date. Care must be taken to not place improper reliance on post-valuation date events, but due diligence should be undertaken to test whether apparent anomalies observed on or before the valuation date are corroborated by subsequent performance.
PBDS Symptoms Can Indicate Other Diseases
While the examples described above can be characterized as aggressive application, or misapplication, of accounting principles, they can also indicate the existence of a more serious issue such as fraudulent financial reporting. An example might include an undisclosed business entity to which business has been shifted. The engaging attorney and the client should be made aware if the business appraiser finds symptoms of PBDS to give the attorney and their client the opportunity to explore the issue further. While the business appraiser might not be engaged (or qualified) to undertake forensic examination of the books and records of a company, the symptoms of PBDS are often recognizable in the typical due diligence a business appraiser undertakes. A referral can then be made by the business appraiser to a specialist in forensic accounting to more fully understand the PBDS patient.