Business valuation: the impact of undisclosed cash and personal expenditure

How are transactions accounted for?

Undisclosed cash

Cash is less prevalent in a post-pandemic world but disputes can be years in the making so it is still something we come across. In cash based industries such as hospitality, retail or many traditional trades, goods sold or services provided for cash may simply not be reported in the accounts. In this case its existence cannot be proven absolutely.

Personal expenditure

Personal expenditure is less straightforward. There are two ways in which this is typically dealt with for accounting purposes (assuming it does not fall into the ‘cash’ category above).

• DLA – expenditure is recorded as a director’s loan owed back to the company (DLA = director’s loan account). The expenditure is not reported in the profit and loss account and is balance sheet neutral (reduction in cash asset matched by DLA asset of equal value).
• P&L – expenditure is recorded as an expense in the profit and loss account, reducing reported profits.

It is important to be aware that an expert witness is rarely in a position to identify personal expenditure, although it can be quantified based on instructions. This is because individual transactions are not identifiable from the accounts and, even if bank statements are provided, the expert may have no way of knowing whether payments are for business or personal reasons or how they have been accounted for. All businesses have different expenditure profiles so a business incurring significant ‘consultancy costs’ could either be masking amounts in fact paid in school fees/to close business associates or reporting amounts paid to third party consultants to review its management structure.

Travel and entertaining costs are probably the most difficult to distinguish – the only way of knowing whether that flight to New York was for business or personal reasons may be by asking the person taking the flight (and they may have their own agenda).

Impact on valuation

Financial perspective

Transactions that are not reported in the accounts at all are very difficult to quantify. Sometimes it is possible to estimate the quantum of undisclosed cash, for example by comparing diary entries or number of appointments made multiplied by an average price per appointment against turnover reported in the accounts. Assumptions can then be made about profit margins and overhead costs. However, as an expert witness the quantum of undisclosed transactions often falls down to instructions given.

Personal expenditure which has been quantified is more likely to have a clear impact on valuation. This may be as a result of:

• reduced cash balances as a result of personal spending; and/or
• reduced profits (whether EBITDA or net profit).

Which measure of value?

Once the financial impact of transactions has been assessed the specific instructions given to the business valuer are likely to be fundamental to valuation. 

If the expert is instructed to opine on the market value of the company, being broadly the value on the basis of an arm’s length transaction between a willing buyer/willing seller, it is difficult to see a purchaser being willing to pay more for a business on the basis of the promise of extra, undisclosed profits. Indeed, purchasers may well be less likely to buy a business like this as there may be tax liabilities in relation to underpaid corporation tax, interest and penalties in addition to concerns about the way in which the business has been run. The valuation is therefore likely to be lower rather than higher.

If, however, the expert is instructed to assess the equitable value of the company, the position may be different. Equitable value is similar to market value but crucially differs because it reflects the respective interests of those parties. If, for example, a business is owned equally by two individuals and the shares owned by one shareholder are likely to be transferred to the other, it may be appropriate to consider the equitable value – a company generating significant profits through undisclosed cash receipts where shares are going to be bought out by one shareholder from another is likely to have a higher equitable value than market value.

Thinking ahead

Identifying a clear approach to issues of undisclosed cash and/or personal spending at the outset of a dispute is crucial to obtaining the desired outcome of any valuation exercise. Your expert will be able to advise on the possible shortcomings of any review and the information required to undertake a more in depth exercise. Early consultation will also help to contain costs and focus the expert’s work in the right area.