While the task of valuing a business is challenging enough on its own, it becomes even more difficult when that business deals mainly in cash. But a pair of speakers at the Foundation for Accounting Education’s Business Valuation Conference on May 21 walked their audience through the different ways professionals can adapt.  

Stacy Statkus, senior vice president of business valuation at advisory firm MPI, said that there is a great temptation for all sorts of misbehavior when businesses are dealing with cash that no one is tracking, especially so for businesses that deal with large amounts of it, like laundromats and bars. For example, she said that many such businesses fail to report their full incomes because cash lets them avoid the more typical paper trails. While not every such business is suspicious, Statkus said there are certain signs to look for when determining whether a business is underreporting income. 

The first is whether the reported income is capable of supporting the owner’s lifestyle. For instance, if a business owner’s statement of net worth is $200,000 but the owner consistently reports $20,000 in income on the business’s tax return, this should raise eyebrows. 

“Unless there is something else going on, the lifestyle cannot be supported by the business,” she said.  “So you’ve got to ask: Is the other spouse working? Are they taking on additional debt [or] selling assets? Are they getting money from family or an inheritance or [a] source of income other than the spouse’s business? And if … not, there’s a problem with the information you’ve been given.” 

Another warning sign, she said, is consistent business losses. She pointed out that businesses tend to need money to keep existing. If a business shows loss year after year, it might be worth wondering how exactly it’s still standing despite those losses, especially if the business seems to be supporting a lifestyle beyond its means. A further red flag would arise if, at the same time, the business is somehow accumulating assets or decreasing debts. She also said to look out for sales or gross profit margins too different from industry norms, though said that this factor alone is not necessarily an indication of a problem. 

Still, if the appraiser believes there is a reasonable suspicion that income is going unreported or underreported, that professional should ask the business owner and possibly the spouse about the discrepancy, she said. If they can’t explain it, or if there’s no explanation at all, she said that there are a number of indirect methods to determine the extent of someone’s unreported income, even if they mainly use cash. 

Another speaker, Jean J. Han, a partner with Baker Tilly Krause, spoke about some of these methods, of determining unreported income, which the IRS also uses when auditing cash businesses. She said that the Fully Developed Cash T Account Method is used when dealing with a truly cash-intensive business, the kind where virtually nothing is deposited into a bank account and there’s no balance sheet to check anything against. It involves counting on the left column all the cash received based on things like gross receipts, rents, wages, distributions from pass-through entities and other types of taxable income. This establishes the initial cash on hand. Then, on the right column, it involves subtracting cash expended, which would include all expenses, both business and personal, as well as loan proceeds. The difference is an initial rebuttable presumption of underreported income. 

The Sources and Application of Funds Method, she said, is very similar to the previous one, with the only difference being that the appraiser can also look at the balance sheet. Appraisers should use this method when “there’s a gut feeling, and you know from interviews that the expenses outweigh income,” she said. The procedure is largely the same as before, except now increases and decreases in assets and liabilities come into play. 

In both cases, Han said some subterfuge is necessary, as these methods won’t work if the parties know what you’re trying to do.

“This is why you want to establish beginning cash on hand before you ask for an explanation, because [the business owner] cannot then recant what he said before and try to explain why there is underreported income. … Now he has to find another way of getting out of that hole he created,” she said. 

Han also talked about the Bank Deposit and Cash Expenditure Method, which involves comparing the total deposits plus cash expenses minus nontaxable sources of income to the total receipts shown on the return. For cash-heavy businesses, this will work only if the appraiser reasonably believes that the owner deposits most of the cash received. Basically it involves analyzing net deposits, then adding in the undeposited cash expenditures, “not just cash payments from the bank, but payment in cash of everything that was never recorded, never went through the bank, then add in undeposited cash. Then compare the final result with the reported income and see how they match,” she said. 

“In this method, the important thing is … really spending the time and resources to go through the spending, because you have to have cancelled checks, deposit slips, know [how the business works], and it’s very time consuming. It’s more exact, but still very time consuming. So, depending on how big your estate is, it [may not be] worthwhile,” she said. 

There is also the net worth method. In this method, the professional looks at business net worth and personal net worth, and if there is an increase in net worth, it is presumed to be generated from income. Then the professional subtracts nondeductible expenses like personal expenses, income taxes, or insurance proceeds, and compares that number to reported income. 

Finally, Statkus discussed the Percentage Markup Method, which involves looking at deviations from industry norms, though she reiterated that these deviations are not by themselves signs that there is underreporting of income. It’s more of a way to begin an in-depth probe. She said that this method is most useful when inventories are the main source of income, the business relies on a limited number of suppliers, and industry norms can be determined with reasonable consistency. She brought up gas stations as an example. 

Someone in the audience commented that a lot of these methods sound like full-on financial forensics, rather than just an appraisal, observing that that most appraisers distinguish between valuation and forensic assignments. Han said that valuation experts are not required to do all of the unreported income analysis, but, at the same time it’s not a bad idea to perform at least some due diligence. 

“It becomes sort of routine to do some minimal level of due diligence, kicking the tires, to see if it makes sense. If the smell test doesn’t work, you need to go back and discuss things; especially if you’re the neutral valuator, you need to bring that up and say, ‘This is what I see as a problem: Would you like us to do more work to help settle the matter rather than litigate the matter?’... There are complications that come from not reporting all the income,” she said.