November 13, 2012
Corporate equity and shareholder issues are staples in the study of accounting, starting in Accounting 101 and continuing in-depth in most core classes throughout the accountant’s five-year course of study.
The issue is studied again for the uniform CPA exam, and it is frequently encountered during the CPA’s annual 40-hour mandatory continuing education studies.
In litigation, the issue often is a pragmatic one involving an analysis of transactions to determine their true effect on each shareholder’s piece of the company’s wealth.
Here are some issues CPAs review in their litigation support work that may be of assistance to your law practice.
Shareholder agreements and stock certificates provide good starting points. CPAs will look at whether the financial information presented – and the allegations made by opposing counsel – makes sense in the context of any shareholder agreements or stock transfer restrictions.
CPAs also analyze whether the client’s share might have been diluted through improper stock transfers.
Income Tax Returns
Most income tax returns include a section regarding shareholder equity and its changes for each year. Even if the return doesn’t show that, reviewing the income and expense information can be helpful, and it sometimes can identify situations where the returns don’t seem to match other information about income and shareholders’ equity.
It’s important to get complete income tax returns. Usually, a request for tax returns yields a set of incomplete returns.
Opposing counsel may provide only the primary forms but omit some or all of the required attachments. This is an innocent oversight most of the time, but sometimes it’s a deliberate omission, done hoping that counsel will not be familiar with tax returns and will not spot the omission.
For example, in the case of a construction company, a CPA insisted on being provided with depreciation schedules. Those schedules revealed that the company was using corporate assets to support a personal NASCAR hobby. The company might have had a profit for the year except for the cost of the NASCAR automobile and related expenses.
Most business organizations maintain regular financial statements at least annually. More often, they maintain such statements quarterly or monthly. It is important to review the statements to determine whether they agree with the income tax returns. Any discrepancies can be explored in discovery or negotiations.
As with the income tax returns, the financial statements should be presented in complete form. Financial statements must include a section about shareholders’ equity and the changes thereto. These sections, and any notes or explanations, can give some insight into whether shareholder equity has been calculated properly.
Depending on the particular business being analyzed, the CPA might want to do a ratio analysis, Dun & Bradstreet comparisons and other tests to determine whether the information presented by opposing counsel makes sense for that particular company.
The CPA also will want to look at the general ledger and some underlying transactions to evaluate whether any anomalous information is significant to the litigation. The CPA will be alert to any information provided outside of the context of formal financial statements and tax returns because that information might not carry any assurance of trustworthiness.
Assurances of Trustworthiness
Tax returns carry some assurance of trustworthiness because often they are prepared by CPAs or others who are at risk of losing their professional licenses for producing false or inaccurate returns, and because filing fraudulent tax returns could lead to prison time for the company owners. Financial statements prepared by CPAs, or by honest accountants within the organization, bear some indication of trustworthiness for the same reason.
The same cannot be said of spreadsheets and narrative explanations provided by management without supporting documentation.
One case, in which two families sold a golf course, resulted in litigation over shareholder distributions. Opposing counsel presented spreadsheets showing the allocation of assets and shareholders’ equity.
At the CPA’s suggestion, counsel insisted that he be provided with “complete” income tax returns for specified years. With that information, it was determined that opposing counsel’s spreadsheet double-counted items such that tens of thousands of dollars were shifted away from the client into the opposing party’s pockets.
At trial, counsel was able to demonstrate to the jury how the double-counting had cheated his client out of a significant share of its equity in the sold company.
Many jurors, as well as other parties to the litigation, will likely have limited or no experience with corporations and might have a hard time understanding the concept of shareholder’s equity.
It’s critical at all stages of the case – discovery, negotiation, and trial – to be able to reduce the shareholder’s equity transactions into simple, easily understood concepts that make sense to a jury.
This article was originally posted on November 13, 2012 and the information may no longer be current. For questions, please contact GRF CPAs & Advisors at firstname.lastname@example.org.