What You Need to Know About Financial Statements and Family Law

Patricia Harris for The Lawyers Weekly

Review Financial Statements with a Family Lawyer to Ensure Your Best Interests are Met

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When money is involved, it is not surprising people will try their best to manipulate or leave out assets and expenses to favour themselves during a review of their business’s financial statements. It is also known that in some cases, people will include or exclude expenses and income in sections of the statement that will alter the end results.

To ensure complete transparency and accuracy, it is recommended to find a family lawyer and a valuation expert to provide you with knowledge and support.

Family Lawyer’s Assist in Identifying Red Flags When Evaluating a Business’s Financial Statement

Family Lawyers are trained in analyzing business financial statements to point out inaccuracies in business expense reporting and corroborate hidden assets. In many cases during a separation when one or both parties own a business, one will leave out trusts and other assets to not disclose all business transactions entirely.

Additionally, in many family law proceedings, there must be great consideration made towards the appropriateness of business expenditures. Advocating on your behalf, a family lawyer will be able to detect whether particular expenses like marketing, travel and entertainment are deemed appropriate to include. An expert’s ability to read between the lines and perform a proper analysis and assessment of the quality of the financial statements is essential.

It is important that both parties accurately prepare and exchange business financial statements. Your lawyer requires the full financial disclosure of both you and your spouse in order to properly advise you of your rights and obligations.

Patricia Harris has identified red flags to watch out for when reviewing business financial statements upon its initial receipt. Below is her article from The Lawyers Weekly.

February 19, 2010

When engaged in a family law case where one or both parties own a business, family lawyers must often conduct a preliminary review of the business's financial statements prior to calling a valuation expert.

Below are some items to review on initial receipt of financial statements from clients or opposing counsel. While reviewing these items will not take the place of seeking expert opinion, they will provide lawyers with a basis to better understand the financial status of the company.

Identifying red flags

  • Who prepared the statements? Are the financial statements internally prepared or externally compiled, reviewed or audited? "Mom and Pop" type businesses may not adhere to Generally Accepted Accounting Principles (GAAP) and therefore the financial statements may be less reliable;
  • Assurance: There are three types of assurance reports. They differ in depth of analysis and degree of assurance: A notice to reader (or compilation) provides the lowest level of assurance; a review provides mid-level and an audit provides the highest level, with significant analysis having been completed;
  • Historical records: Obtain at least the last three years of historical statements, including a balance sheet, income statement and notes to the financials. Statements should be available within three to four months of the year-end (but no later than six months). If current external statements are unavailable, request internal statements;
  • Accounts receivable: Are accounts receivable collectible? What percentage of the current year's sales remain outstanding?
  • Inventory: What is the fair value of the inventory compared to the book value?
  • Investments: A red flag to hidden value may be in investments. What is the nature of the investment and the percentage of ownership? For example, a $1 book value investment could be worth millions;
  • Capital assets: Are capital assets in need of replacement? Is an appraisal required?
  • Debt: Understand short and long-term debt covenants. Are there unrecorded liabilities? The absence of debt could represent a hidden asset;
  • Related party debt: This can be a significant liability of the business
  • Retained earnings: An assessment of the business may lead to an attribution of income to a spouse. Do funds need to be held in the company? Are there arm's-length shareholders? What is the dividend payment history?
  • Preferred share value: Preferred share value is deducted from the overall value of the company in order to determine the value of the common shares;
  • Intangible assets and goodwill: These are non-monetary assets without physical substance (for example, customer lists, patents and brand names). Assess existence and value of recorded and potential unrecorded intangible assets;
  • Revenue: Sources of revenue and the recognition policy are important. Economic dependence on a small number of customers means increased risk, whereas long-term contracts or recurring revenue means less risk;
  • Salaries: Operating salaries are usually for sales and administration staff. Manufacturing salaries are included in Cost of Goods Sold. Even GAAP statements may include "unreasonable" or "discretionary" amounts;
  • Management salaries and bonuses: Are these discretionary or unreasonable? The degree of management depth is a factor in the evaluation of business strength;
  • Personal expenses: Consider the extent to which discretionary/personal expenses flow through the accounts;
  • Foreign exchange: The existence of foreign exchange gains or losses may be a red flag of financial risk to the business;
  • Notes to the financials: These can provide invaluable information. Look for notes related to related party transactions, economic dependence, contingent liabilities and subsequent events.

International Reporting Standards (IFRS) and new Private Enterprise GAAP

By Jan. 1, 2011, all public companies will have transitioned to IFRS. Notwithstanding the implementation of IFRS for public companies, Canadian private companies can choose to adopt either IFRS or new Private Enterprise Generally Accepted Accounting Principles, which is similar to current GAAP.

IFRS and Private Enterprise GAAP differ greatly in how the financial health of a company is measured. Differences between the two standards include the valuation of assets, accounting for business combinations, financial instruments and income taxes. They result in two very different types of financial statements, for example in key performance measures such as EBITDA (earnings before interest, taxes, depreciation and amortization), net income and owners' equity.

Although your family lawyer should be aware of the standards under which the statements are prepared, the type of analysis conducted will likely remain relatively unchanged for smaller and mid-sized companies, who will most likely opt for Private Enterprise GAAP.

When business financial statements are obtained from a spouse or opposing counsel, consider the red flags and questions outlined above. You may be surprised at how much insight into the value of the business you can gain by asking a few questions on your initial review.

Patricia Harris is a senior manager of Fuller Landau Valuations Inc. in Toronto and practises exclusively in the areas of business valuation, damages quantification and forensic accounting investigations.
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