Business appraisals and financial audits are necessary, but sometimes the numbers just don’t add up. If you suspect that everything isn’t being properly accounted for, you may have to call upon the services of a forensic accountant. But what is a forensic accountant? We have one on with us today in this edition of “Deal Talk.” Darrell Dorrell is a CPA and principal at Financial Forensics who has delivered more than 100 addresses on financial topics to many national bodies, including the FBI, the Department of Justice and the Bankruptcy Bar Association. He’ll explain how a forensic accountant can potentially uncover hidden value for your company.
When we see a set of financial statements we consider financial statements written confessions.
- Darrell D. Dorrell
You may be completely happy with the job your CPA is doing for you and your business. They keep a tight watch over your financials, provide you with a lot of valuable guidance and have even saved you a lot of money over the years - all good things. However, if your business has dealt with a lot of changes, been a part of a major transaction, is up for sale, or even if you just feel the need to do a sanity check you may need to call upon the services of a forensic accountant. What is that you ask? Well, we have one on board today so we're going to let him tell you. His name is Darrell D. Dorrell and he is a CPA and principal at Financial Forensics in Lake Oswego, Oregon. He is a nationally recognized speaker and author, and has delivered more than 100 addresses to many national bodies on financial topics including the FBI, the Department of Justice, and Bankruptcy Bar Association among others. He's also published more than 50 articles and has been cited in Bloomberg Wealth Manager and BusinessWeek, just to name a few. Darrell Dorrell welcome to Deal Talk. Nice to have you sir.
Darrell: Delighted to be here Jeff.
Jeff: Darrell to start with, let's talk about financial forensics. Tell us what it is and how that differs from the services that most CPA's provide.
Darrell: Sure Jeff. I'm glad you asked that question. It's foundational to the profession and to the public. When we define forensic accounting or financial forensics, our definition is the art and science of investigating people and money. We used that definition for over 25 years. There's some confusion in the accounting profession about forensics. It's often mistakenly equated to fraud. Now, we do fraud work, which requires forensics expertise, but when we're doing transactional work such as valuation, litigation, or other matters, that's a far broader field that encompasses the forensic realm. So a typical accountant would be involved in transactions like preparing cash returns and completing auditor reviews. We spend most of our time looking into, or investigating the work done by other accountants in those transactions.
Jeff: When you say investigating work by other accountants, are you contacted most often by the business owners themselves or are you actually contacted more often by other legal entities, law enforcement, and so forth to come in and take a look at these types of issues?
Darrell: Good question. There are three different contact points that we encounter. One would be law firms. And a law firm could be representing a client and let's say a dispute of some sort, or even a planning matter such as estate planning, gifting and so forth. Second category would be business owners themselves. And the third category would be, we'll call it regulatory, and that could be law enforcement, that could be regulators like the FCC, etc. It just varies on who needs the assistance and expertise.
In that case it was a post-mortem to identify the errors that were made and why a business combination like that would fail after just 90 days.
Jeff: What are some of the common themes these phone calls that you receive, and these investigations that you go out and take a look at? We can't obviously talk about specific companies. But what are some of the things that your company goes out and deals with on a regular basis in terms of the types of questions, and issues, and matters that come up? Why do you get those calls most often Darrell?
Darrell: Good question, I would call it a difference between expectations and disclosure. Let me give you a good example. There were two businesses in Oregon that were mostly in the North West geographic area. One had been around about 100 years and was an agricultural business. It's been around a hundred years, or about 100 million in revenue. Another business, a competitor of theirs started about 6 years prior to our involvement. They did almost exactly the same thing, the types of products, customers and so forth, but they were only about 40 million. You’ve a 100-year old company and you have six year old company. One's 100 million, one's a 40 million. The $100 million company was stagnant. The $40 million had reached the maximum of its funding. They started talking and it made sense to them to look at a merger. They both hired big four accounting firms and each had their own very reputable law firm. And most of them spent over an 18-month period in expensive due diligence, from the attorneys, to the accountants, the internal people, etc. They did it right. No questions about it. And it cost a fair amount of money to do that, a few hundred thousand dollars. They merged, let's say on a certain day, it was May 17th of a certain year.
After 18 months of expensive due diligence by the most capable people you can find. And merging on May 17th; in 90 days they were bankrupt, and I mean the doors are shut, the people are gone, the business does not exist. We got involved. The attorney said, "What in the world happened? We did everything right. Tell us what went wrong?" In that case it was a post-mortem to identify the errors that were made and why a business combination like that would fail after just 90 days.
Jeff: Now, those post-mortems as you call them, are those commonplace? Is that something that you guys deal with often times or are you... Obviously it would seem to be a preference that people would call you before you get to that point because they want to discover. "Hey look, we have to start turning over some stones here. We need to find out why we're losing all of this money. We don't want to end up like that." Do you find that those post-mortem types of inquiries are commonplace in your area of business?
Darrell: They are commonplace Jeff, almost just as common though. We call it a pre-mortem for lack of a better term is having us look at the nature, the content, the likelihood, the outlook, the prospect of a planned sale, or purchase, or combination of some sort on an independent basis to effectively look over the shoulders of other advisors. The advisors typically aren't very enthused about that but business owners who want to maximize likely their success are.
Jeff: I was just going to say Darrell, I'm sorry I didn't mean to interrupt. Are those the most common types of business inquiries that you get? You have a situation where you have businesses that are kind of in queue to be passed along to another owner. And they're just trying to get your take, your sense of areas, maybe issues that need some resolution before those business can in fact be sold.
Darrell: That's a good way to characterize it Jeff. In fact, we categorize it as a transitional business. A transitional business could be moving from one level to the other, from growth to maturity, so on and so forth. It could be moving generationally, which is a very common circumstance. It could be moving because the owner doesn't have a successor or a succession in place, a succession plan in line. So it could be any, or all of those. And initially troubled companies. Those that for whatever the reason are now in serious trouble, typically because sales are declining, the cost are increased, or their funding is inadequate. It's interesting, the same tools that resolve troubled companies are also the same tools that apply to those issues about the transitional businesses. There's some very simple, very basic tools we had aided them. The three most common, one is what's called a rolling cash flow that we can put into place. It's a one page Excel spreadsheet and I could talk literally Jeff for two hours about what a difference that tool was made. Another was called Daily Task Clarity, again, one a page Excel document that can almost guarantee increased revenue. So there's some very fundamental tools that we just typically don't find in place of business that can make a world of difference, sort of like Aspirin to a third world country.
The three most common, one is what's called a rolling cash flow that we can put into place. It's a one page Excel spreadsheet and I could talk literally Jeff for two hours about what a difference that tool was made.
Jeff: Darrell D. Dorrell is a CPA and principal at Financial Forensics in Lake Oswego, Oregon. You're listening to Deal Talk, my name is Jeff Allen. Darrell rules of thumb or general guidance as to when mergers are likely to face challenges. What are the red flags that a business owner could probably see if they could just look up and take a closer look around?
Darrell: That's a good question Jeff. The intangible example I would give you is unrealistic expectations. That could be from an owner who thinks that a $3 million business is worth $30 milliion. That could also be from a buyer's perspective thinking that I know all there is to know and I can make this business successful. Additionally, what I call "opening the kimono." If there's a combination of some sort, or a buy or sell, the skeletons in the closet that the seller or the buyer is trying and hope no one will see will be indeed found. And when they are they are, that typically lights a fire that causes concern and dissension among the parties here. And it has to be resolved somehow. So those different expectations and lack of real disclosure.
Jeff: How do you protect essentially a transaction from post-closing types of challenges. You talked about one a short time ago about the company that closed everything. It was a fantastic three months, it was out of business, the new company. Are there ways to protect a company from going through that and actually seeing clearly enough to prevent something like that from happening so quickly?
Darrell: There are Jeff. One phrase we use which the accountants typically don't like is this. When we see a set of financial statements we consider financial statements written confessions. When we see an audit, or we see an 1120 S or a schedule C, in our view that's a written confession. It's confessing that the owner is telling the truth, or it's confessing that the owner is not selling the truth. The problem occurs when buyer, seller, or both take at face value the documents that are given, such as an audit, or tax returns, and so forth. Bear in mind that those documents are what are known as self-reported documents. And just because tax return has been signed, or an auditor has signed off on a clean opinion can have almost nothing to do with the reality of the business. That can upset sometimes accountants and attorneys. But the reality is unless you apply some basic forensic tools you won't know until it's too late that those financial statements don't reflect the reality.
Jeff: Can a regular CPA be called upon to take a look at those documents and basically just through doing some basic due diligence uncover some issues or not. I guess that there's a reason that companies like yours exist, right?
Darrell: Yeah, you're right, and sad but true. There are two and a half million publicly practicing CPA's in the country, and probably two and half million of them think they're forensic types. That's not a slam on them but the accounting profession has told them they could do forensic work without giving them the tools and the guidance how to do so. That surprises most people in the public. But for example, I spent a great deal of my time and so does my partner, other people here in the firm training CPA's, regulators, law enforcement, Department of Justice, FBI, FCC around the country in how to use and understand these tools. You'd think that those tools that have been around 70 or 80 years would be common knowledge in the accounting profession. For whatever the reason Jeff they have not made their way to the profession. And I can tell you, if you gave us a set of audited financials, in about an hour or so we can tell you whether or not those statements are likely manipulated, and if they are manipulated to what extent. It's not just the numbers on the financial statements, that's a piece of it. We can use tools like the Sloan method, and others to identify, but we also in public companies and those that have auditor reviews, quantifying the words and the notes to the financial statements become important too. There are techniques called stylometry and forensic-lexicogy psychology where you can determine that the notes to the statements are probably engineered to try to justify a place otherwise questionable transaction.
if you gave us a set of audited financials, in about an hour or so we can tell you whether or not those statements are likely manipulated, and if they are manipulated to what extent.
Jeff: We're talking about forensic accounting with Darrell Dorrell and you're listening to deal talk, I'm Jeff Allen, and I'll have more after this.
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Jeff: Welcome back to Deal Talk I'm Jeff Allen with Darrell D. Dorrell, CPA and principal at Financial Forensics, and we're talking about accounting, but not your granddaddy’s type of accounting, no indeed. We're talking about the kind of accounting that can keep your business out of trouble, perhaps even increase its value. Darrell, how important is it to have your CPA involved, maybe not necessarily a company like yours but to have your CPA involved in the process of having the business appraised. You can speak obviously from experience. You’ve probably been involved in that process. How critical is it to have your accountants standing by when that appraisal process is underway?
Darrell: It is critical Jeff, particularly if that accountant has been a valued advisor for a number of years. They have a depth and breadth of them with regard of the nature and the history of the business, and that's just essential. That history lends itself of course to discussions and decisions about any transaction. But it also ties into the impacts of transactions, such as whether there's a stock sale or an asset sale, how to structure things like non competes, and goodwill elements, other components. If you’re CPA has any background whatsoever in your company, I strongly recommend that you get them involved right away.
Jeff: When it comes to having those people in the background there and they're so important to have as it is to have an attorney also, in working with an attorney. CPA's though, they do in fact have their roles. They can't really actually perform a business valuation though. Can they Darrell, from your background and your experience?
Darrell: Well, that's a good question. Most CPA's think they can. And not necessarily being critical of my accounting brethren here but I just met a guy in my office this week who is a CPA, he specialized in the medical industry and had been doing valuations and as a CPA he wanted to learn more about them. He had no idea about the requirements like SSVS1 and other guidance that he had to follow. So he in effect was a shade tree mechanic, a very competent CPA type but had no clue other than general knowledge. Now, part of the problem that in the evaluation profession, there are multiple and competing certifications and credentials. So a CPA by itself does not qualify someone to do evaluations. In fact, there's a guidance document called SSVS1 that tells the CPA to comply with the requirements of that document. Now, the problem with that is there are other certifications like American Society of Appraisers, ASA, Institute of Business Appraisers, there's the CBA, and the National Association of Certified Valuation Analyst who have what we call the CVA, Certified Valuation Analyst. As I say that the credentials are competing and sometimes contradictory. A CPA without any credentials, with all due respect to them, just cannot do the work.
A CPA without any credentials, with all due respect to them, just cannot do the work.
Jeff: If I'm selling my business Darrell and I'm kind of confused. I'm not sure which way to go, whether to sell it, structure the sale as an asset sale or a stock sale. Is this something that my accountant can help me decide in terms of which would be best for my particular business and my particular situation?
Darrell: Yes. In fact I recommend to anyone listening who... Say you're a business owner who's either buying or selling, there's a publication on Thompson's internet site and it's called, How to Buy and Sell a Business. It's a two volume set, it's about $200. It's a practitioner tool, but it is extraordinary background for anyone buying or selling their business. I probably sent dozens and dozens of people to that publication, but it'll start to address some of the things you're talking about, it has fantastic checklists and other resources. Your question is the perennial one in regarding buying and selling a business. If we assume for a second we have a corporation and I own it and I'm selling it to you. I want to sell stock whereas you want to buy assets. That's a generalization, but the reason is typically taxation impact on the asset versus a stock ownership. So it's a constant struggle. I want to sell something, you don't want to buy. And you want to buy something I don't want to sell. So that's where it's essentially the attorneys and the accountants involved to protect yourself with regard to the outcome of the transaction.
Jeff: You touched on tax implications, so let's talk on that a little bit. We'll camp out right there. What are some of the most common taxes associated with selling a business Darrell that really business owners need to be mindful of and need to prepare for?
Darrell: Yeah, it falls into two categories. One taxation category is capital gains, the other one is ordinary income. And that's back to the asset versus stock sale. So you want to pay capital gains because it's a lower rate, whereas someone else from selling stock that could indeed cause me to incur ordinary income. But that's where the structure and things like non-compete, other intangibles come into play to try to somehow minimize that for both parties. It is doable, but it's a challenge, that's why you need expert advice on both sides.
Jeff: These kinds of questions here now I have for your Darrell are more kind of for those people listening right now, who are just kind of starting out, for entrepreneurs and maybe they are guys who have done their own accounting but now they're growing, and maybe they've grown across borders. And maybe they own a manufacturing company. They need someone who's going to come on in and help them oversee their financials. How are accountants fees typically calculated and billed? And particularly if I'm planning on selling my business how does that work?
Darrell: The fees of course will range a wide range of fees, often related to firm size, or a sole practitioner might charge $100 an hour. A big four firm could be upwards of several hundred dollars an hour. That doesn't mean that there's a one-to-one connection between capability. You need to talk to a few, perhaps through or four different CPA's to get a sense of their expertise. With regard to selling you also need CPA's who've gone through that selling process, not just from the standpoint of selling a client that they have but also buying on the other side of the equation. Or at least the CPA recognizes that they need to get up to speed very quickly with respect to that issue. Likewise attorneys, a lot of clients we know and encounter have entrusted council that they use for things like transactions, estate planning, and so forth. But that's a very different animal than an actual buy or sell transaction. So that experience becomes essential.
Your other questions about how will they bill, they typically bill on an hourly basis for the number of hours spent with regard to advising. And of course it's going to vary widely. So it's typically going to be on an hourly basis and not some kind of a percentage.
A big four firm could be upwards of several hundred dollars an hour. That doesn't mean that there's a one-to-one connection between capability. You need to talk to a few, perhaps through or four different CPA's to get a sense of their expertise.
Jeff: Darrell D. Dorrell, CPA and principal of Financial Forensics, and you're with Jeff Allen, also here on Deal Talk. We were going to kind of start to wrap things up just a little bit Darrell but I did want to find out from you if the CPA has to know well in advance that I'm considering selling my business or should I just wait until I receive an offer? Is there a benefit to informing my CPA about the sale before I actually receive that offer?
Darrell: You're exactly right Jeff, the sooner the better. You need to start talking to people, hopefully some kind of an advisory board or if not, an unofficial group of people you can talk to confidentially without others finding out, not just as employees. But if the CPA's been involved for a number of years, the longer the better. We have strong relationships with CPA's throughout the northwest who have been advising businesses sometimes 40 years through their entire firm. And so getting them up to speed very quickly almost always benefits the business owner.
Jeff: Darrell you have a lot of skin in the game. You've been there, done that. What are some takeaways from our discussion today, or maybe even things we haven't necessarily talked about, but things that you believe are really important that business owners need to know from your perspective as a forensic accountant that may help them gain a better, more clear understanding of how important it is to keep sound financials and to make sure that they're maintained?
Darrell: That's a huge question. I'll try to summarize that. I recall from entry level accounting that accounting is considered the language of business. It's akin to your health vital signs like blood pressure, blood chemistry, metabolism, so on and so forth. Business owners often tend to drift from the content of financial statements into one or two measurements. I know a guy who ran a small chemical company and his measurement of success was to have a million dollars in his checking account. That made no sense. The bank had even advised him, "We can't ensure your…..." But that was his way of running the business.
Jeff: That makes perfect sense to me. I‘d like to have a million dollars in my checking account.
Darrell: Exactly. And if he went below a million he would start pumping the sales. It's a measure but it's not everything. And just like being a human body you can't rely on just one vital sign, it has to be a combination. And that's where the CPA comes in again. You can talk with your CPA to effectively have them train the business owner about the three, or four, or five key things to watch to give you a comprehensive view of the overall health of the business.
They can check our internet site. It's called financialforensics.com
Jeff: Darrell, if anyone should have any questions for you, maybe they've seen some things in their own business that need looking into, or they have some concerns, or they're about to sell their company, what should they do and how can they reach you?
Darrell: They can check our internet site. It's called financialforensics.com, call me 503-636-7999. Somebody here can answer the question. Also, questions, we've probably written almost 100 different types of articles, and publications, and presentations that often we can just send you a copy of to give you all the background you need, not to mention some of the other tools. We're in the business of providing service, but that doesn't start until we provide you the service. We're happy to do all this as a courtesy.
Jeff: So financialforensics.com, and I'm sure that Darrell's office staff would be happy to add you to an email listing if they have any kind of updates or anything to share with you that might benefit your business in some way. And of course, Darrell I've had a chance to talk to your people there at your office and they're very, very helpful, and very courteous. I want to thank you very much for taking time out of your busy calendar. I know that you've got a lot going on and joining us today on Deal Talk. It certainly has been a pleasure.
Darrell: Sounds good Jeff, thanks for having me.
Jeff: Darrell Dorrell as a CPA and principal at Financial Forensics in Lake Oswego, Oregon.
Deal Talk is presented by Morgan & Westfield, a nationwide leader in business sales and appraisals. If you'd like more information about buying or selling a business call Morgan & Westfield at 888.693.7834 or visit morganandwestfield.com. And make it a point to check in with us again soon for valuable information and insight from our growing list of small business experts on Deal Talk. Until we meet again, my name is Jeff Allen, I'll talk to you again soon.