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Finding Hidden Assets and Unreported Income


The business valuation and forensic accounting disciplines often intersect when valuing a business for divorce or shareholder disputes. Controlling shareholders may, for example, try to hide assets or downplay cash flow to minimize buyouts of their spouses or minority shareholders. Valuation experts are on the lookout for these situations and know how to unearth and adjust for financial misstatement.

Look Beyond the Financials

Financial statements and tax returns are important sources of information when valuing a business. But it’s also important to look for public sources of information, as well as to conduct site visits and management interviews. These steps can be especially important in adversarial situations to ensure that controlling shareholders aren’t hiding assets, underreporting income, or overstating liabilities and expenses.

Nowadays, Internet and social media searches can help reveal financial misstatement. Take this example: A valuation expert discovers that her client’s spouse had secretly set up a separate corporation to expand his business into a neighboring town. How is this scam revealed?

The valuation expert follows the company on social media for about a month, shortly after she’s been assigned to the case. When the company posts an invitation to the grand opening of a new facility on Facebook, along with a promotional coupon, the expert calls her client, who is shocked by the news.

Further investigation reveals that the controlling shareholder has run more than $25,000 in start-up expenses for the new location through his old business, which is part of his marital estate. To make matters worse, the old corporation has purchased equipment for the new location, taken on additional debt and then leased the equipment to the new business at below-market rates. In short, the controlling shareholder is draining resources from the old business to benefit the new business his spouse was unaware of.

Involve Experts Early On

Patience and diligence are key elements to unearthing hidden assets and income. So, it’s critical to involve a financial expert during the discovery phase of the case. Even if a divorce or shareholder dispute starts out amicably, the situation can quickly change as the details of the case unfold and the parties see how much money is at stake.

Early on, the expert can provide a comprehensive list of documents to request. In addition, it’s often helpful for minority shareholders and spouses that don’t control the business to obtain a court order, allowing their experts to tour the facilities and interview management. If an expert is hired late in the case, he or she may be denied physical access to these resources.

Understand the Warning Signs

Controlling shareholders aren’t always dishonest. But experienced valuation experts know the warning signs that something’s awry. During site visit and management interviews, experts consider a variety of factors. This includes asking certain key questions:

    • Do company personnel seem uncooperative or reluctant to answer questions?
    • Does the interviewee seem agitated or nervous — for example, sweating profusely or avoiding eye contact?
    • Do members of the management team provide conflicting answers?
    • Does an answer to a question contradict the interviewee’s previous responses or what’s reported on the financial statements?
    • Was the valuation expert denied access to certain parts of the facilities?

In addition to these qualitative factors, valuation experts evaluate quantitative signals of impropriety. Benchmarking performance over time and against competitors, which is a standard part of the valuation process, can also help identify hidden items. To illustrate, if profit margins have deteriorated since a lawsuit was filed or are below industry norms, the change could suggest that revenues are understated or expenses are overstated.

Experts also look for new line items that appear on the financial statements after the lawsuit is filed. Examples include loans, contingent liabilities, management fees, rent or lease expense paid to related parties, phantom employees on the payroll, and excessive professional fees, which may include the controlling shareholder’s personal legal fees.

Expand the Assignment

Valuation experts employ professional skepticism, but they’re not responsible for unearthing fraud unless a client specifically hires them to conduct a forensic investigation. In cases where the controlling shareholder has a financial incentive to hide assets or downplay cash flow, consider expanding the scope of the engagement from the get-go to include additional forensic procedures.

 Sidebar: Consider Unreported Assets and Liabilities

A company’s balance sheet tells only part of the story about a company’s financial condition. There may be other assets and liabilities that aren’t reported, such as pending litigation or regulatory inquiries, warranties, bad debts and built-in capital gains tax obligations.

These items may not necessarily be hidden because management is intentionally misrepresenting the truth. In some instances, they’re not required to be reported under U.S. Generally Accepted Accounting Principles (GAAP) — or a private company’s financial statements may not conform to GAAP.

Although unreported, these items can impact future cash flows and, therefore, the value of a business interest. If investors would consider a hidden item, it should generally be factored into a valuation expert’s analysis.

Financial statement footnotes and management interviews can help reveal these hidden items. Additionally, valuation experts who specialize in a niche tend to be familiar with what other industry participants report on their balance sheets, helping them to identify possible omissions.