Information presented on a company’s financial statements may not always be meaningful from a valuation perspective – even if it follows Generally Accepted Accounting Principles (GAAP). Whether financial information is obtained from business income tax returns or audited financial records, valuation experts often make adjustments to get a clearer picture of a company’s financial position, market risk, and ability to generate cash flow in the future.
Sometimes, these adjustments may be due to the business owner’s nefarious actions. In other cases, they may be due to elections in accounting methodology or procedures. Although these adjustments vary from case to case, many fall into one or more of the following types when valuing a business interest.
- Nonstandard accounting practices
- Extraordinary or nonrecurring items
- Hidden assets or liabilities, and/or
- Discretionary spending
Nonstandard Accounting Practices
A valuation expert may estimate value by using pricing multiples derived from comparable private and public transactions (the market approach) and discount rates derived from returns on public company stocks (the income approach). Thus, if the subject company deviates from how other companies in its industry typically report transactions, the valuator may need to make adjustments.
Certain financial reporting practices may require adjustments if the subject company’s methods differ from industry norms. Examples include differences in inventory, depreciation, or revenue recognition methods.
For example, if a company reports inventory using the last-in, first-out method (LIFO) but other companies in its industry typically use the first-in, first-out (FIFO) method, an adjustment may be needed to normalize the subject company’s earnings. Companies that use LIFO tend to report lower inventory values and higher cost of sales, assuming an inflationary market and increasing inventory levels, than companies that use FIFO.
Extraordinary or Nonrecurring Items
Sometimes future performance deviates from historic performance. A valuation expert might need to remove nonrecurring or extraordinary items from the financial statements to normalize the economic benefits stream. Examples include start-up fees, remodeling costs, pending litigation, discontinued business lines, and capital gains (or losses) on sales of fixed assets.
Valuators also adjust for nonoperating assets and liabilities, such as marketable securities, real estate, and shareholder loans. These items typically have different risk profiles and may need to be valued separately from the business’s operating assets, possibly using different discount rates.
Hidden Assets & Liabilities
Under GAAP, some assets and liabilities may not be reported on the balance sheet, even though they may affect the value of the business interest. Valuation experts consider the existence of unreported assets and liabilities — and adjust the balance sheet accordingly, especially when using the cost approach to value a business.
Examples of this include internally generated intangible assets (such as goodwill and customer lists) and contingent liabilities (such as pending litigation, tax investigations and warranties).
Some tangible assets also might require adjustments. For example, accounts receivable may require an adjustment to net realizable value, or inventory may need to be reduced from missing or damaged items.
Discretionary Spending
Controlling owners make key decisions about discretionary spending, such as hiring employees, choosing vendors, and paying dividends. When valuing a controlling interest, a valuation professional may need to adjust financial statements for discretionary spending to reflect the economic benefits to a prospective buyer accurately. Adjustments are widespread for small private businesses that engage in related party transactions at above- or below-market rates or pay the owners’ personal expenses with the business checking account.
Discretionary adjustments are typically not made when valuing a business interest that lacks control over day-to-day decisions. When valuators refrain from adjusting the financial statements for discretionary spending, the value based on unadjusted economic benefits contains an implicit discount for lack of control. In other words, this methodology may generate a minority basis of value, eliminating the need to apply a separate discount for lack of control.
Ultimately, financial statements are just the starting point in the valuation process—and in a perfect world, two valuation experts reviewing the same company should make the same financial statement adjustments. In reality, professional judgment plays a role, and slight differences in approach can lead to very different conclusions of value.
To discuss a specific case, contact us by phone at 646-661-3800, or by email msgcpa@msgcpa.com