Law of Unintended Consequences

The Ninth Circuit Court of Appeals recently upheld the District Court in Howard v. United States.  In 1980, Howard incorporated his solo dental practice.  At the time, Howard also executed a covenant not to compete ('CNTC")with his own corporation.  I don't know what risk Dr. Howard was attempting to mitigate; and in retrospect it may have been in his best interest, considering his circumstances.  However, as it turns out, this did not play out very well as an income tax avoidance strategy.

Thirty years later, Dr. Howard sold his practice and allocated nearly $550,000 to his personal goodwill and treated it as capital gains on his federal tax return.  Arguing that the CNTC transferred Howard's personal goodwill to the corporation, the IRS re-characterized the $550,000 as a dividend, subject to tax as ordinary income.  From an income tax standpoint, the implication is clear.

However, the precedent is a good deal murkier with respect to marital dissolution.  The majority of states currently hold that personal (a/k/a professional) goodwill is not subject to inclusion in marital property.  The McReath divorce case in Wisconsin introduced transferable goodwill as the amount included in marital property.  CNTC's may become instrumental in characterizing personal goodwill as transferable; and, thus includable in the marital estate.  Of course, if this becomes the norm, the pendulum will swing to assessing reasonable compensation and avoidance of double-dipping on alimony.

It's About the Goodwill Stupid

As I have addressed several times, inclusion of goodwill in marital assets vary from state to state.  The majority of states include entity or practice goodwill  and exclude personal or professional goodwill from divisible marital assets.  A minority of states include or exclude all goodwill, while a smaller number currently has no precedent.

As I discussed recently, within the last year the Wisconsin Appellate and Supreme Courts returned a ground-breaking decision in McReath v. McReath.  This case involves the valuation of a dental practice.  The Court coined a new definition - saleable goodwill.  Saleable goodwill is the amount of professional and / or practice goodwill that can be transferred to a buyer.  Generally, saleable professional goodwill is substantiated by the presence of a reasonable and enforceable covenant not to compete.  This seems reasonable enough because no intelligent person is going to pay for anything beyond tangible net assets absent a covenant not to compete.

However, the Court did not stop there.  The Court went on to rule that it was not "double-dipping" to award periodic payments supported by excess income generated by goodwill and to include that goodwill in marital assets.  The court reasoned that an income-producing asset has intrinsic value beyond the cash flow it generates to its owner.  What?!  You cannot be serious!! This is wholly illogical Mr. Spock!

An asset is defined as something that has the capability of providing income, cash flow, or benefit in the future.  Regardless of what we are valuing, an asset is only worth the present value of its future cash flows. Period.  End of discussion.  As my grandmother used to tell me, "You cannot have your cake and eat it, too."  If you strip away all the future cash flow, what ever income-producing asset you hold is, well, worthless.  The Court whiffed badly here.  Actually, probably worse than that.  I think this went OB and they are hitting 3 on the tee.

Brave New World of FRCP Rule 26

It has been about six months since Federal Rules of Civil Procedure No. 26 was revised to protect communications between an attorney and any witness required to file a report.  The exceptions to this protection are :

1. Compensation of the expert.
2. Facts and assumptions that the engaging attorney provided to expert which were considered in rendering his/her opinions.

Many states have adopted provisions similar to revised Rule 26.  However, as an expert, you should discuss with the engaging attorney beforehand whether these provisions will apply to the case at hand. 

Before rushing into the brave new world of Rule 26, consider the following:

1. There will probably be increased scrutiny at deposition or expanded disclosure requests by the opposition to ensure that the authorship of the report is solely the experts.
2. Take care to segregate protected communications from discoverable documents.  This should be vetted by the engaging attorney to ensure that there are no omissions.
3. The engaging attorney should review the expert's produced work file to make sure nothing in it could damage the expert's credibility or endanger the basis of his/her opinions.

In other words, be careful out there.

At What Point In Time Should Future Lost Profits Be Estimated

Coincident with the current recession, court cases have been coming out that challenge the timing of the estimation of future lost profits.  Primarily, the cases deal with commercial real estate; but they may get extended to other industries as the recession continues.

Obviously, plaintiffs want to forecast future lost profits based on the economic conditions at the date of the breach of contract or other "but for" event.  On the other hand, defendants want to use the economic conditions prevailing at the date of trial. 

In November 2010, the Court found in favor of the defendant in Capitol Justice LLC v. Wachovia Bank N.A.  This decision reduced the plaintiffs claimed losses from $33 million to $6.7 million.  In March 2010, the Court ruled that the forecasted losses should be estimated based on the anticipated conditions at the date of breach (Epicenter Partners LLC v. Northeast Phoenix Partners). 

Traditionally, experts have relied on the economic conditions and outlook that existed at the date of loss, while disregarding subsequent events and conditions.  Although we attempt to focus on what was known or knowable at the date of loss, we must consider whether a particular subsequent event could have been reasonably expected to occur in the future.  Case in point - Consider Hurricane Katrina and its devestating effect on New Orleans.  While it may be reasonable to consider that hurricanes will periodically occur along the Gulf Coast, is it reasonable to include a storm of that magnitude in your assumptions when forecasting future losses?

Off topic bonus heads up - The IRS is not subject to the recent changes to Rule 26(2) of the Federal Rules of Civil Procedure.  Furthermore, U.S. Tax Court has not adopted FRCP 26.  So be careful with report drafts related to income tax issues.

The Ongoing Rage Over Tax Affecting Pass Through Entities

As many of you know, for years there has been an ongoing dialogue over whether pass-through entities should be tax-affected for valuation purposes.  At a recent ASA (American Society of Appraisers)-IRS Symposium, Miles Friedman , Associate Area Counsel in the IRS Office of Chief Counsel, stated definitively that courts and the IRS say no to tax-affecting.  This statement was certain to launch at least a thousand rebuttals.

Intelligent and well-qualified valuation experts hold positions on both sides of this argument.  Personally, I generally tax-affect pass-throughs for valuation purposes.  Many proponents of not tax-affecting point to Gross v. Commissioner as justification.  Like any precedent, care should be taken in applying it.  In Gross, the Court did not reject tax-affecting, it merely said that given a choice between 40% and 0%, 0% was a better choice under the circumstances at hand.  It remains incumbent on the valuation analyst to support his/her position and persuade the Court to accept that tax affecting is justified.

Good data, appropriate analysis, well-reasoned application, and effective communication will generally carry the day.

A Decade After SOX and SAS No. 99, Are We Any Better?

Modern awareness of occupational fraud has its inception with the formation of the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in 1985.  Occupational fraud can be defined as the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organizations resources or assets.  This definition includes asset misappropriation schemes, corruption, and financial statement frauds.  In response to a spate of high-profile financial statement frauds including Enron, WorldCom, and Tyco, the Sarbanes-Oxley Act of 2002 (“SOX”), alternatively known as the Public Company Accounting Reform and Investor Protection Act, was signed into law.  Although not in response to these frauds, the Auditing Standards Board issued Statement on Auditing Standards No. 99 (“SAS 99”), Consideration of Fraud in a Financial Statement Audit, in 2002.  While one would like to believe that the heightened awareness of occupational fraud, the enactment of SOX, and the implementation of SAS 99 would deter financial statement frauds, the evidence indicates that it just is not so.

In 1992, COSO released its initial report, Internal Control –An Integrated Framework. This project assimilated various concepts regarding internal control into one document.  It remains a starting point for designing and assessing effective systems of internal control.  SOX and SAS 99 build on the concepts contained in the COSO report to focus attention on the prevention and detection of fraud.  SOX puts the burden of accountability for financial statement fraud on the boards of directors and management of publicly-traded companies.  SAS 99 expanded the scope of procedures and emphasized the assessment of fraud risk as part of a financial statement audit.  Specifically, SAS 99 highlighted the risk of management overriding internal controls while perpetrating frauds.

Several studies have been performed over the last fifteen years relating to occupational fraud in general and financial statement fraud in specific.  These studies shed light on whether progress is being made to curtail financial statement fraud.  COSO issued two studies, Fraudulent Financial Reporting 1987-1997 and Fraudulent Financial Reporting 1998-2007. These studies examine publicly-held companies.  Since 1996, The Association of Certified Fraud Examiners (“ACFE”) has presented a biennial Report to the Nations on Occupational Fraud and Abuse.  These reports include frauds at publicly-held companies, privately-held companies, non-profit organizations, and governmental entities.  Finally, COSO issued two reports in 2010 on enterprise risk management (“ERM”), Board Risk Oversight – A Progress Report and COSO’s 2010 Report on ERM.  ERM includes all business risks, not just occupational fraud.  These ERM studies include publicly-held companies

Salient observations from COSO’s Fraudulent Financial Reporting 1998-2007, include the following:

·         There were 347 alleged cases of fraudulent financial reporting, versus 294 from COSO’s previous study.

·         The median loss increased from $4.1 million in the first study to $12.1 million more recently.

·         The Securities Exchange Commission named the chief executive officer and/or the chief financial officer for involvement in 89% of the frauds (as compared to 83% in the earlier study).

·         There was little difference in the composition and character of the boards of directors for victim companies versus non-victim companies.

·         Companies with fraudulent financial statements were twice as likely as companies with reliable financial statements to change external auditors before or during the fraud.

Significant findings on financial statement fraud from ACFE’s 2010 Report to the Nations are as follows:

·         Median loss for companies in the United States is $1.7 million.

·         The median duration for the frauds is 27 months.

According to the 2010 Report to the Nations, fewer than 5% of all frauds are initially detected by external audit.  Furthermore, survey respondents estimated that the typical business enterprise loses 5% of its annual revenue to fraud.  Applied to Gross World Product, fraud potentially causes losses in excess of $2.9 trillion.

Key findings from COSO’s Board Risk Oversight – A Progress Report are as follow:

·         47% of the directors noted that improvement is necessary in their ERM.

·         87% of the directors believe that improvement is necessary specifically in the monitoring of the risk management process.

·         86% of directors indicated that their ERM is inadequately resourced.

Observations from COSO’s 2010 Report on ERM include the following:

·         72% of executives responded that improvement in ERM was needed.

·         Over half of the organizations have not established a board subcommittee to oversee ERM.

·         60% of the organizations performed ERM on an informal or ad hoc basis in specific areas with no ERM applied company-wide.

Considered in the aggregate, the results of these surveys should be alarming.   Financial statement fraud is up in the last decade versus the preceding decade.  Top executives are involved in almost 90% of financial statement frauds. The typical financial statement fraud occurs for over two years before detection.  Fewer than 5% of occupational frauds are discovered by external auditors. Less than half of publicly-traded companies have board subcommittees assigned to risk management.  A majority of executives believe that improvement is required in ERM and that inadequate resources have been designated for the process.  SAS 99’s emphasis on management override has not resulted in effective detection of financial statement frauds perpetrated by high-level executives.  SOX’s mandate to make executives and directors responsible for the prevention of financial statement fraud has not succeeded.  Senior executives are the primary perpetrators and directors have not developed reliable risk management systems. 

The results of these surveys point up the expectation gap that auditors face.  Owners and third party users of financial statements generally expect the auditor to detect all fraud.  Auditors need to bring healthy doses of professional skepticism to their work.  In addition, they need to focus on fraud risks and specifically investigate those areas that benefit executives (e.g., incentive compensation plans and debt covenants).  Rigorous analytic review procedures that tie income statement and balance sheet accounts together should be designed.  Finally, if earnings don’t translate into cash flow to equity, further investigation is warranted.  Almost a decade after SOX and SAS 99, we expected to see improvement in fraud detection and prevention.  For now, we appear to be no better than we were before Enron and WorldCom.

Company Specific Risk Double Dipping in Cost of Capital?

Business valuation analysts use the cost of capital as the denominator in an equation (where annual cash flow or income available to equity is the numerator) to estimate entity value.  Cost of capital is sometimes loosely referred to as reasonable or fair return.  In the models that we use to develop cost of capital, we include risk premia for company size (based on equity or revenue) and company-specific factors.  The follow list of considerations for company-specific risk is not exhaustive but covers most of the primary factors:

• Small company
• Insufficient management depth
• Insufficient access to capital
• Customer concentration
• Customer pricing leverage
• Lack of product / service diversification
• Volatility of earnings and / or cash flow
• Technology life cycle
• New competitors
• Life cycle of current products or services
• Availability of labor

It can be argued that many of these company-specific risks are commonly found in smaller enterprises.  That being the case, the size premium most likely includes a component of risk that reflects most or all of these risks.   As such, due consideration must be given to the development of a company specific risk premium (CSRP) which will not double count some of the size premium.

There is not a quantitative formula to establish the CSRP.  As such, estimating a reliable CSRP is a highly subjective process.  Valuators will perform extensive qualitative analysis to develop the CSRP; but converting the qualitative analysis into a quantitative expression requires significant judgment.  Absent factors which are truly unique to the company or its industry (if industry specific risk has not been separately included in the cost of capital), I believe that the CSRP should rarely exceed 1%. 

I frequently perform valuations of medical practices or ancillary services (eg. ambulatory surgery centers, imaging centers, dialysis centers).  This industry is highly regulated and the regulations evolve over time.  The extent of regulation affects the revenue stream and allowable legal structures / ownership.  Furthermore, much of the technology is constantly evolving and obsolescence can be a concern.  In light of these factors, I will often use a high CSRP in valuing such operations.

Although there are valid exceptions, valuators need to use due professional care in developing the CSRP to ensure that the same risk is not accounted for twice.

Discounted Cash Flow Method and Forecast Assumptions

This just in - financial statement forecasts / projections are key to a reliable valuation using the discounted cash flows method (DCF).  My first reaction is, "Wow that is mind-blowing."  It must be true because the highly-regarded Delaware Chancery Court ruled on it in S. Muoio & Co v. Hallmark Entertainment Investments.

In the case at hand, the expert puffed up or, as I like to say O'Learyed (see O'Leary, George, Notre Dame head football coach for one week), the management forecast in order to derive a higher value.

In all seriousness, forecasted earnings and the assumptions on which they are prepared are the cornerstones for reliable estimates of value when using DCF.  From my viewpoint, DCF is appropriate only when future earnings or cash flow will significantly exceed the long-term sustainable growth rate, which is generally measured based on inflation rates.  As such, start-ups and emerging technology enterprises are likely candidates for DCF.  However, some very well-regarded valuation analysts live and die by DCF.  Theoretically, DCF can be used in all valuation engagements.

DCF is driven by assumptions.  Bad assumptions will give unreliable estimates of value.  This makes some courts wary of the method.  If management wants a higher value, they will use aggressively optimistic assumptions in their forecasts.  So the caveat is: pound on the assumptions.  Perform due diligence.  How accurate has management been in their previous forecasts or budgets?  Is it really reasonable that the future will be better than the immediate past has been?  Beware of the industry operating cycle and know where the subject company is with regard to the cycle.  If the cycle is 3 years up followed by 3 flat years, make sure the plateau is incorporated into the forecast.

Valuation analysts are paid for their analysis and observations.  More importantly, they are paid to give appropriate wait to their observations as they affect value.  Be careful out there; and, when using DCF, trust but verify.

Be Safe Out There

This weeks edition contains a couple of warnings to help you stay safe.  Earlier this week, I spoke at Mississippi State University's Insurance Day on the topic of ethics.  Ethics is a broad topic, so I spoke on one of my favorite topics, fraud.  Most people do not fail ethically because they cannot determine the difference between right and wrong, they fail because they want the benefit to be gained by doing wrong.  (As I freely admit, I would have no problem with sin if it did not look like fun).

A couple of attendees approached me after the session with their stories.  Their losses were caused by misplaced faith.  As Ronald Reagan said, "Trust but verify!" The simplest and most effective fraud deterrent is for the small business owner to receive the bank statements unopened and review canceled checks. Review for reasonableness of payee, amount, and timing. Occasionally follow up with your personnel to let them know that you are looking.

My second caveat relates to the valuation of start-up or high-growth companies.  In most cases involving such companies, the business valuator relies on the discounted future cash-flow method.  Under these circumstances, the valuator must challenge the assumptions which underly the forecast, which are generally provided by the owner of the company, if said owner does not prepare the forecast.  As you may expect, we often encounter the following circumstances:

• Unrealistic revenue growth, both in terms of rate and duration.
• Growth in expenses at the CPI rate of inflation.
• Over-valuing of a patent or patent application.
• Overstated benefit of synergies.

Generally, crunching the numbers in such a valuation is straight-forward.  An analyst needs to earn his/her keep by determining whether the key assumptions are reasonable and by assessing the effect of small deviations in the forecast.

One final caution on patents.  Patents are relatively cheap to obtain.  Enforcing them is very costly - consider a ballpark figure of $7 million per case.  Statistics indicate that half of all patents have NO strategic value.  Only 2-5% of patents generate any royalties.

Keep your eyes open.  As Yogi Berra says, "You can observe a lot just by watching."

Tax Discounts in Business Valuations for Divorce

Historically, courts have not allowed a discount for built-in capital gains tax when valuing a business for divorce purposes.  A couple of recent cases point up some inconsistency in this area.  In Balicki v. Balicki, the Pennsylvania Superior Court ruled that family law courts need to consider the tax consequences of selling a marital asset (including a business enterprise).  Such a discount for taxes is required even if a sale is not planned or imminent.

On the other hand, the Nebraska Court of Appeals recently ruled in Shuck v. Shuck.  The Court reversed the application of a discount for built-in capital gains tax liability by a court-appointed expert.  The Court reasoned that such a discount is relevant under only the following two circumstances:

• The sale of the marital business is reasonably certain to occur in the near future.
• The sale of the marital business is necessary in order to satisfy a spouse's obligations upon divorce.

I tend to agree with the findings in Shuck. 

There is one area where I believe a tax discount for divorce valuations is appropriate.  For cash basis taxpayers, I think it is reasonable to apply a discount for income taxes against the collectible value of trade accounts receivable.  I justify this position because the earnings process is complete, the cash will be collected in the near future, the prevailing tax rates can be estimated reliably, and the taxes will be due in the foreseeable future.  Let me know if you agree or disagree and why.  Thanks.

Spring Break Friday Musings

This week's installment has a little of something for everyone.  I will lead off with several tidbits related to medical clinic operations.

Medicare Payments to Physicians

The Centers for Medicare and Medicaid Services (CMS) recently sent a letter to the Medicare Payment Advisory Commission (MedPAC).  CMS estimates that payments to physicians in 2012 will be cut by 29.5% in the aggregate.  As has become customary, Congress will probably intervene and reduce this adjustment.  In the meantime, as required by Congress, MedPAC filed its 2012 recommendations on Medicare payments to Congress earlier this month.  As one of its recommendations, MedPAC endorsed a 1% increase in Medicare payments to physicians for 2012.  The disparity in these recommendations points up the ongoing fight over the relevance of using the Sustainable Growth Rate ("SGR") in setting Medicare payment levels.  The SGR uses a convoluted formula to derive the change in payment levels.  The SGR has been in place for a number of years.  However, in the last five years, it has been overridden by acts of Congress.  Hence, the adjustment indicated by the SGR has accumulated to the point where it is almost 30% for 2012.  Apparently, MedPAC saw the hand writing on the wall when it made its 2012 recommendation to Congress.

I believe physicians will not see their payments reduced by 29.5%.  Congress will either adopt MedPAC's suggested 1% increase or will freeze the payments at current levels.  However, in an earlier post, I discussed the ramifications of the Patient Protection and Affordable Care Act ("PPACA") on provider payments.  PPACA will create the independent payment advisory board ("IPAB").  IPAB will be tasked with reducing the per capita cost of Medicare.  PPACA restricts the actions available to IPAB in carrying out this mission.  Basically, IPAB is precluded from doing anything other than reducing payments to providers.  Physicians will continue to work harder and get paid less.


Red Flag Rules Update

The Red Flag Rules were created as part of the Fair and Accurate Credit Transactions Act.  The Red Flag Rules require that creditors take steps to protect the identity of customers.  The Federal Trade Commission ("FTC") applied a broad definition to creditor.  Under the FTC's definition, accountants, attorneys, physicians, and others were included as creditors.  Several ongoing lawsuits challenged the FTC's definition and Congress has intervened to clarify its definition of creditor.  Based on this clarification, physicians are no longer considered creditors and will not have to implement the Red Flag Rules.


Is Overhead Too High for Your Medical Practice

I regularly consult with medical practices of varying size and specialty.  Many of my client-physicians want to know how they can keep more money by reducing overhead.   I believe that most practices are being run efficiently.  Cutting overhead can save some nickels and dimes; but it may end up being penny-wise and pound-foolish.  The biggest component of overhead in a medical practice is personnel.  Reducing personnel, may increase overtime, which cuts into the savings.  However, the impact on morale could be devestating.

Currently, I believe that a better approach is to explore ways to grow top line collected revenue.  Some options for doing this include:

1. Add ancillaries that you currently refer out.  Pathology, lab, ambulatory surgery centeres, and imaging are popular choices.  Employing a physician in a role that complements your patient base can be an alternative.
2. Add a new location.
3. Pursue joint ventures.  Often, rural hospitals are short on capital and will lease equipment such as CT Scanners from physicians.
4. Make your employees stakeholders by rewarding them for recommendations that enhance profitability.

Wall Street Recovery Not Making It to Main Street

Lately, there has been much discussion of the record profits of American corporations juxtaposed against the continued elevated unemployment level.  As it turns out, American companies are creating lots of jobs.  These jobs just happen to be outside the United States.  The jobs are closer to the international consumer, saving shipping costs.  The international labor tends to be cheaper.  It is no longer just toys and clothing, high tech jobs are being created overseas.  With China becoming the second largest economy, this shift makes sense.  Consumer demand in the U.S. remains subdued due to high unemployment and the sluggish housing market.  Until demand increases or labor becomes affordable, the recovery of the U.S. economy will continue to be slow and uneven.


Tax Effecting in S Corporation Valuations

The argument over to tax-effect or not tax-effect has raged for years.  Is there a value to an S Corporation that can be captured and transferred?  Should the avoidance of double-taxation be considered?  Practitioners far smarter than I hold both positions.  Personally, I tax-effect when I value pass-through entities.  The components of our cost of capital build-ups are after-tax.  To apply these to pre-tax benefit streams seems intuitively illogical to me.  Regardless of which side you take, you need to be able to defend your position.

Don't Fall for This Identity Theft Scam

This just in - you can't trust everything you see on the web.  This is not a new scam but it is not as familiar as phishing scams.  Typically, you are browsing the web and probably not looking for anything in particular.  Suddenly, you receive a warning that your computer has been infected by a dangerous virus.  Of course the warning provides you with a link to download a trial version or a complete version to remove the virus.  DON'T DO IT!

This is known as scareware fraud.  The fraudster wants your credit card information only so that he/she can steal your identity (by the way, as you may have guessed, the download will not cure the virus and may introduce numerous viruses onto your computer). A partner of mine was hit by this scam last weekend.

Here's what you do.  Hit control-alt-delete (the three finger salute) and use your task manager to shut down your browser.  Then run your own virus detection software.  Hopefully, nothing will turn up and you will have avoided this scam.

Remember - Whenever you get a fraud warning, do not reply directly.  If it is a credit card, call the number on the back of the card and follow the fraud reporting / investigation directions.  Never, I mean never ever, share any personal information on a contact that you did not initiate. 

Be careful out there.

Identity Theft - Securing Your Personal Information

In no particular order, here are some steps that you should take to secure your personal information from identity thieves:

1. Order and review your credit reports from all three credit reporting agencies annually.
2. Use passwords on bank accounts, debit cards, and credit cards.
3. Minimize the number of credit cards, debit cards, and identification cards that you carry.
4. Absolutely do not carry your social security card or birth certificate.
5. Do not include your social security number on your checks.
6. Change your driver's license number to something other than your social security number.
7. Shred all documents with personal information on them when discarding.
8. If using a debit/credit card at a restaurant, pay at the counter.
9. Review bank and credit card statements when received.
10. Follow up delayed statements or new accounts requests that you did not make.
11. Never leave receipts at ATMS, cash registers, or gasoline pumps.
12. Investigate any credit cards that expire without a new card issued.
13. If a financial institution contacts you regarding unusual activity, do not give any information and call back at the phone number on the back of the card in question.
14. Get insurance against identity theft.
15. Don't leave purses, wallets, debit cards, or credit cards unattended, even in your car (even if hidden).
16. Don't let others see or hear you enter passwords.
17. Mail payments and documents with personal information from a post office mailbox.  Never use your home mailbox.
18. Have mail and newspapers held if you are going out of town.
19. Do not write your social security number or account numbers on checks or envelopes.
20. Stop pre-approved credit card offers (1.888.5OPTOUT).

Using passwords effectively is an essential component of securing your identity.  Here are some guidelines for your passwords:

1. Avoid easily deciphered passwords - birthdays, anniversaries, names of children, spouses, or pets, last 4 digits of your social security number.
2. More characters is better.
3. Use alpha-numeric.
4. Use upper and lower case letters.
5. Use symbols if possible.
6. Change passwords periodically.
7. Do not tape login information or passwords to your desk or computer.
8. Do not carry passwords in your purse or wallet.
9. Do not allow Windows to memorize your password on internet sites.
10. Do not use the same password and/or login information for multiple accounts.
11. Maintain your login information and passwords on a password protected excel file.

Be careful out there.

Mississippi Court of Appeals - Cox v. Cox

On January 25, 2011, The Court of Appeals of the State of Mississippi affirmed the ruling of the chancellor in Cox v. Cox (No. 2009-CA-01233-COA).  Several points of the appeal were related to business valuations rendered by a court-appointed expert. 

For the primary business being valued, the chancellor accepted a 50% discount for lack of marketability ("DLOM").  DLOMs are component of the standard (i.e., definition) of  fair market value.  As such, businesses valued at fair market value will consider the DLOM.  50% is an extraordinarily high DLOM, especially when the business was valued using the asset approach, which excluded goodwill and other intangible assets.  However, the expert pointed out that the business had not been profitable in the years leading up to the valuation.  Furthermore, the company, a steel contractor, was having difficulty getting bonded and its primary financial institution was reluctant to continue extending credit.  Finally, the groundwater at the company's site was contaminated and the most recent real estate appraisal did not reflect the contamination in its value.  The preliminary estimate of the cost to cure the contamination exceeded $1 million. 

This case is hardly a mandate to begin using DLOMs around 50%.  However, it does show that the Court will consider higher DLOMs when the circumstances warrant.  Proper analysis supporting a reasonable DLOM should be upheld.

Secondly, the Court upheld the inclusion in the valuation of a contingent asset.  Generally accepted accounting principles preclude the recording of contingent assets because to do so would violate the conservatism principle.  The contingent asset was a lawsuit that settled subsequent to the valuation date.  The chancellor included this settlement in the value of the business.  In general, valuation experts are precluded from considering events that occur subsequent to the date of valuation.  This position raises opportunities or exposures depending on your point of view.

Finally, the Court addressed the issue of valuing patents.  One of the companies valued in this case owned patents related to computer programs used in steel fabrication.  Patents are intangible assets in that their value has limited or no correlation to their cost.  Similar to goodwill, which is an intangible asset, the value of a patent is very subjective and requires professional judgment to estimate. The court-appointed  expert excluded the patents from the value of the company.  The expert reasoned that the Court's definition of goodwill in Singley included all intangible assets.  The chancellor assigned no value to the patents and the Court affirmed this on appeal.  However, it is important to note that no one presented the chancellor with a value for the patents.  Had a value been rendered, it is uncertain whether the chancellor would have assigned value to the patents.

Avoiding Pitfalls on Fidelity Insurance Claims

Those of you who keep up with this blog have heard the statistics before.  The Association of Certified Fraud Examiners ("ACFE") estimates that the average business enterprise, including non-profit organizations, loses 5% of its annual revenue to employee fraud.  ACFE further estimates that only 25% of all fraud cases result in civil actions.  My experience supports both of these premises.  Fraud is very widespread and the victims are reluctant to take action beyond terminating the perpetrator.

Against this backdrop, one of the most recommended safeguards against fraud is fidelity insurance coverage for dishonest acts by employees.  If your clients do not carry fidelity coverage, they need it and it borders on malpractice if you do not inform them of this need.  That said, fidelity policies have very strict requirements for filing and collecting on claims (as an aside, remember that claims adjustors are hired to not pay claims).

The deadline for providing notice of a loss and submitting claims is immovable.  Make sure notice is provided immediately, before you conduct the investigation.  A lot of information is required with the claim.  Any missing pieces will delay or preclude payment of a claim. 

A certified fraud examiner ("CFE") can help organize and prepare the claim to ensure maximum recovery.  The kicker is that most fidelity insurance policies will pay for the services of a fraud expert.  Hence, it is a no-brainer to hire one to direct the investigation.  You will need to assign some employees to assist with the investigation; but the CFE will perform most of the work in preparing the claim and supporting documentation.  The CFE can also review and rebut any reports from the insurer's experts.

In summary, fidelity insurance is necessary.  Get a CFE involved early in the process so that the insurance covers the entire loss.

Fraud Alive and Well and Danger of Preliminary Valuation Reports

As the recession / recovery continues to stagnate, we are reminded that fraud is alive and well.  This makes sense intuitively because one of the primary factors present in fraud is pressure or incentive.  In economically uncertain times, pressures become increasingly prevalent as the uncertainty is prolonged.  A survey performed by the Association of Certified Fraud Examiners revealed, unsurprisingly, that certified fraud examiners ("CFEs") anticipated increased fraudulent activity during periods of economic recession. 

As a CFE who consults with smaller business enterprises, I have seen instances of fraud that begin with the perpetrator  encountering a financial need that he or she cannot meet.  It can be a car repair, medical bills, or other ongoing expenses.  As the pressure to make ends meet mounts, the perpetrator may rationalize the fraud by pretending that it is a loan that will be paid back, which, by the way, rarely occurs.  More often than not, if the initial fraud is not detected, the perpetrator becomes emboldened to commit additional frauds.  So what can a business owner do to protect himself or herself?

First of all, use common sense.  Ronald Reagan popularized the phrase, "Trust but verify."  No employee is above temptation.  As a business owner or manager, one needs to monitor employees and verify that they are functioning in an ethical manner.

Secondly, protect your checks.  Checks are one step away from being cash.  Restrict access to blank check stock.  Do not use a signature stamp or check-signing machine.  Sign all checks without exception.

Thirdly, and most importantly, receive (unopened) and review all bank statements.  Examine the checks that have been scanned for appropriateness of payee, amount, and timing.  If there are any suspicious items, review the back of the check online or request a copy of it from the bank.

Fourth, know your employees and beware of tell-tale signs of fraudsters.  Is someone living well beyond his /her means?  Is there someone who never takes vacation and works a lot of overtime?  Make vacations mandatory; and, more importantly, have another employee perform the vacationer's duties in his / her absence.

Finally, if you're uncomfortable with the effectiveness of your checks and balances (what auditors call internal controls), hire a qualified CPA / CFE to perform a fraud risk assessment for your business.

Here is an anecdote from my personal experience.  I had a client who just wanted a check up on his business to make sure that no one was stealing (by the way, if you think you are not making as much income as you should, you're probably right).  I arrived at his office at about 10:30 am and got introduced to his staff.  I interviewed him over lunch.  Upon our return, we discovered that his office manager, whom I had only met that morning, had left a note of resignation, never to return. In response to his question, I said, "Do you want to know how much and are you willing to press charges?"

As some of you are aware, there are two primary levels of service that a business valuation professional can render.  The first is a valuation engagement in which a valuator provides an opinion or a conclusion of value.  This is the higher level of service and it requires significant study and analysis, which translates into higher cost.  The lower level of service is known as a calculation of value or preliminary valuation.  A calculation does not involve the same analysis and study, which makes it less costly.  However, it carries very little weight with triers of fact.  In a calculation, the valuator and the client agree on what calculations to perform and the valuator exercises limited, if any, judgment.

For negotiation purposes, I often suggest a calculation of value because it is much less costly and it gives my client a starting point in determining the value of his / her business.  Furthermore, if the need arises, a calculation of value can be upgraded to a valuation engagement.  As a caveat, I would not prepare a calculation of value if I reasonably believed that the matter would ultimately be heard by a trier of fact.

Two cases support my opinion.  In Hagar, the Court rejected a calculation of value because it lacked sufficient professional judgment.  More recently, in the Marriage of Cantarella, the chancellor rejected a preliminary valuation that disputed a value previously stipulated to by both parties. As we say in Chicago, "Don't bring a knife to a gunfight."

New Case Law on Goodwill in Divorce

Last week, the Supreme Court of Mississippi released its ruling in the case of Lewis v. Lewis.  The Lewises owned a real estate development enterprise that, upon distributtion of assets, was awarded to Mr. Lewis.  No formal business valuation was performed on Legacy.  Upon appeal, the appellate court ruled that Legacy must be re-valued at fair market value including goodwill.  The Supreme Court upheld the requirement to have Legacy valued at fair market value; but, consistent with the Singley, Watson, and Yelverton cases, fair market value is to exclude goodwill. 

Based on the Lewis ruling and consistent with my rendering of the Singley ruling,  I believe that the Court's definition of goodwill extends to what accounts call intangible assets.  Intangible assets include, but are not limited to, workforce in place, customer base, patient charts, patents, and trademarks. 

In divorce proceedings, a caveat remains in situations where alimony is awarded.  In cases where alimony is involved, due consideration needs to be given to the level of compensation and /or income that is being used as the basis for the amount and duration of the alimony.  If the alimony is based on compensation that exceeds fair market value, goodwill has constructively been divided.

Potential Impact of Healthcare Reform on the Private Practice of Medicine

As the fight to repeal Obamacare rages, let's take a look at the potential effect of various provisions on the delivery of medical services.  By the way, anyone who thinks that Obamacare will bring rationed medical care can take comfort.  Well sort of.  Rationed care exists throughout rural communities across the country.  Rural Mississippi is critically underserved with regard to medical doctors and waits to see a doctor for Medicare and Medicaid patients can be weeks.  The upshot is that Obamacare could exacerbate this problem.

Americans pay more per capita for healthcare than any other people on earth.  Period.  What do we get out of this enormous cost? We rank 30th in life expectancy among developed, high-income nations. Regardless of your political disposition, this is a problem of gigantic proportion that needs to be addressed.  Your philosophical bent will affect the way you view correcting these statistics.

There are two inputs into the equation.  First, and obviously, there is the hopelessly interlocked systems of the provision and financing of healthcare.  Are these systems to blame for the cost and failure of improving / maintaining our health?  Many would say so.  However, people often overlook the second component of the equation.  It is often assumed, and incorrectly, that we are as healthy as any other group of people on the earth.  When you get down to it, the average American is as healthy as, for sake of discussion, the average Japanese.  Hmm.  Not so fast my friends.  America ranks first in this statistic - Obesity! The second component in this conundrum is the patient.  And we, as patients, are unbelievably unhealthy and it isn't even close.  On average, we are 10 times as obese as Japan and South Korea.  You read that right.  10 times.  Almost one in three Americans is obese.

Unfortunately, it is politically unsavory or incorrect to attack obesity, despite its miriad of side effects and diseases it causes or intensifies.

With no further ado, these factors will adversely affect private practitioners.

1. Continued decline in reimbursement for services rendered.  For the last decade or longer, physicians have been getting paid less for doing the same amount of work.  Almost a quarter of primary care physicians are uncertain if they can keep their doors open now.  The factors which follow will likely redue reimbursements further.

2.  Physician Quality Reporting Initiative - Physicians will be measured using various metrics, some of which are arbitrary and of questionable value.  This will require more intensive IT and track much more data, expanding the operating cost of medical practices.  Non-participation and poor scores will result in reduced reimbursements beginning in 2015.

3. Accountable Care Organizations - Groups various suppliers and providers in a geographic region in order to manage and coordinate care, meet specific quality performance guides, promote certain initiatives.  Good results and lower costs will have a positive effect on reimbursements.

4.  Independent Payment Advisory Board - Appointees of the President who are commissioned to reduce Medicare's per capita spending.  However, they are constrained from redcucing benefits, rationing care, increasing premiums, and raising taxes.  Hmm, who is left holding the bag?  Healthcare providers.  By the way, their proposals must be implemented unless Congress intervenes.

As a final note, prior attempts to manage physicians and enhance their efficiency have failed.  Most recently, refer to the now defunct physician practice management company (PPMC) movement.  Implicitly, the PPMC wave made sense, consolidate medical practices, reduce physician management time and maximize time to practice medicine.  Economies of scale and efficient management to boot.  Sadly, it did not work out.  Physicians do not always make good employees.