Sources of balance sheets that may be used in a valuing a marital estate in a divorce
There are five sources of balance sheets that divorce lawyers commonly rely on in valuing a marital estate in a divorce:
- Marital estate disclosures. The standards of value represented in disclosures for the purpose of marital dissolution will be varied.
- Loan applications. The standard of value represented in loan applications is generally “fair market value.” Lending institutions usually require use of this standard.
- Personal financial statements. The standard of value represented in personal financial statements is normally “fair market value.”
- Business financial statements. The standard of value represented in business financial statements is normally “book value.” However, in the interest of full disclosure (or to assist an owner in getting a loan) CPAs may reference the fair market values of assets in the notes to the financial statements. They may also prepare supplemental financial statements on a fair market value basis.
- Business tax returns. The standard of value used in the balance sheets of tax returns is normally “book value.”
Each of these sources is discussed in more detail below. For more information on the various standards of value, read “How are assets valued?”
Marital estate disclosures
Balance sheet analysis for the purpose of finding hidden assets or valuing a marital estate starts with the marital estate disclosure. This document is required by most jurisdictions. It is a list of assets and liabilities of the couple seeking a divorce. The disclosure can be divided into preliminary disclosures or final disclosures with associated amendments. Some jurisdictions put the disclosures into more or less balance sheet format. That is, the assets are listed in columns, then the liabilities. The difference between the assets and liabilities is then determined to illustrate the net worth the couple has to divide. Other jurisdictions simply require the assets and liabilities to be listed in paragraphs or some other written format.
The first step in the analysis of the marital estate disclosure is to compare it with other information that is available. For example, the first comparison that is often performed is the comparison of one spouse’s disclosure to the other spouse’s. Simply put, if the disclosures of assets and liabilities don’t match, this may indicate a missing asset or an error. After the disparities in assets and liabilities are addressed, the analysis turns to valuation issues. As indicated, it is not unusual to find several different standards of value applied in martial estate disclosures. The job of the divorce lawyers (and/or their investigators) is to restate each value in terms of fair market value. To do this for real estate and businesses usually requires the participation of expert appraisers. Significant collections of jewelry, guns, antiques, coins, stamps, art and other items may also require the participation of appraisers. Automobiles and other vehicles may be valued by referencing one or more of the online resource sites available. An appraiser may be needed to resolve significant differences in vehicle values or to value custom vehicles. Household goods normally do not retain significant value and, therefore, the cost of an appraisal may not be warranted.
The adjustment to fair market value is necessary to limit the risk of assets being hidden in plain sight. For example, a husband may list the value of his business at $200,000, which is the book value of the operation. However, an expert business appraiser may determine that the fair market value of the business is $550,000 because of the amount of money the business earns. The existence of the business has been properly disclosed. The book value has been disclosed, but the standard of value that the court may apply is fair market value.
In many marital estates, as well as businesses, leveraging or borrowing is a significant component of operations. In order to grant loans, banks usually require a balance sheet and income statement. The bank may request personal financial statements (see below) or have its own balance sheet and income statement forms that it requires to be completed. In requesting a balance sheet, the bank is seeking assets to secure the loan or at least an overall financial picture that will be favorable to getting the loan paid back. The income statement is requested to insure that there is a cash flow adequate to service the loan repayment. These statements can provide essential information in valuing a marital estate because loan applicants are highly motivated to secure the loan requested. This means that they are likely to disclose all of their assets to paint the most favorable financial picture possible. They also will not be shy in assigning values to assets. In our business example above, it is highly likely that the business owner would enter the value of the business at $550,000 rather than the $200,000 on loan application documents. These statements, therefore, are an effective counterpoint to the asset disclosures made during the course of a divorce. The assets in the disclosures may be understated or undervalued, but since the motivation in the statements presented to the bank is the opposite of the motivation in statements presented in a divorce, all assets will normally be presented and their values may actually be overstated.
Personal financial statements
Occasionally, individuals will prepare, or have prepared for them, personal financial statements. These statements are normally prepared in conjunction with attempts to obtain loans (see above), but there may be other reasons as well. For example, partners in a joint venture may require that personal financial statements be exchanged in order to assess relative risk and ensure that enough capital is available for the venture. Personal financial statements are analyzed in the same manner as Loan Applications.
Business financial statements
Business financial statements are prepared on the “book value” basis. That is, the assets are listed at their purchase price and depreciation is deducted from their value. The difference is referred to as the “book value” of the asset. The book value of an asset may or may not reflect its fair market value. For example, assume that “land” on the business balance sheet is valued at $10,000. This is the price that was paid for the property twenty years ago, when the business started. Today, the fair market value of the land is $250,000. Which value should be used for purposes of a divorce? This may be statutorily determined or it may be a point of law to be determined by the court. Whatever the case, the difference between the two standards of value — fair market value and book value — should be recognized and addressed by the parties.
Business financial statements can be generated by the business itself or by a CPA who is contracted for their completion. In general, the credibility of these financial statements depends on who creates them and on what terms. The least credible business financial statements are those prepared by the business because the skill of the preparer may be questionable or because the preparer may be highly motivated to skew the statements in a particular direction. Next in line are statements compiled by a CPA. A “compilation” consists of information that is put together in financial statement form by a CPA. The CPA is under no responsibility to evaluate the information presented, but will usually question anything that appears to be out of line. The next most credible statements are reviewed statements (“reviews”), in which the CPA reviews the financial statements for reasonableness and continuity. Finally, there are audited financial statements (“audits”). These statements are not only reviewed by the CPA, but the underlying transactions that make up the statements are tested. However, unless otherwise clearly stated, all of these financial statements are presented on the book value basis. As noted, this standard of value may not be appropriate for marital dissolutions.
Business tax returns
The balance sheets presented on tax returns are condensed versions of the financial statements that the business prepares or has prepared for it. They are prepared on a book value basis. Because of their condensed nature, their usefulness is limited. That is, these balance sheets may only reveal changes in major asset and liability categories. However, the presence of major changes in the total assets or liabilities of a business provides the basis for obtaining the detail associated with those changes.