Why Are Financial Statements Adjustments Important in Business Valuation?
Financial statements are the main documents used in every business valuation. They provide critical information that valuation experts need to perform their duties. However, in many cases the data collected by the analyst are not readily useable for a variety of reasons including accounting type, compensation issues, inventory method used, assets and liabilities issues to name a few.
To correct these issues, the valuation analyst must adjust those data to reflect the true economic financial position and results of operations on a historical and current basis of the company being valued. These adjustments to financial statements affect directly the value of the company therefore; they have to be done with proper care, attention, and professionalism.
Most financial statements adjustments belong to one of six categories as described below.
1- Non-Operating vs. Operating Items
During the valuation of an operating company, non-operating assets on the balance sheet should be separated and treated distinctly from the value of business. When non-operating assets are removed from the balance sheet any income or expense associated with those assets should also be removed from the income statement.
The Fair market value of those non-operating assets should then be added back to the fair market value of the company.
For example some companies have portfolios of marketable securities in their balance sheet. Those should be removed from the balance sheet and any income or expenses removed from the income statement as well. The same goes for non-operating real estate. The fair market value of these marketable securities must be added back to the fair market value of the company.
2- Excess Assets vs. Asset Deficiencies
Excess assets and assets deficiencies should be treated the same way as non-operating assets. This means the value of excess assets should be added back to the value of the company and the value of assets deficiencies should be removed from the company value. In a minority interest situation, a discount for lack of control may be applied due to the fact that the minority owner does not have the power to liquidate the excess assets.
Working capital is another aspect of excess or deficient assets that need to be adjusted if it’s out of industry benchmark range. If working capital is with range no adjustment is necessary.
3- Managing Contingent Assets and Liabilities
Many companies have contingent liabilities and some have contingent assets. Contingent liabilities or contingent losses are potential losses due to a lawsuit in which the company is likely to lose. They arise due to environmental issues, product liability lawsuits, and actual and potential lawsuits. Contingent assets are potential assets associated with a potential gain for example in a lawsuit in which the company may win an estimated dollar amount. The Analyst must adjust them appropriately.
4- Adjusting Cash Basis Statements to Accrual Basis Statements
Many companies, mainly small businesses, and professional practices use cash-basis accounting. This means that revenues and expenses are recorded when they are received or paid instead of when they are incurred. The accrual-basis accounting records revenues and expenses when they are earned, measurable, and collectible, based on the accounting principle of matching costs with related revenues. Most valuations use accrual basis accounting therefore, adjustments have to be made to meet the valuation standard.
5- Normalizing Adjustments
Presenting data in conformance with GAAP and removing nonrecurring items are the main ideas behind normalizing adjustments. The main goals are to be able to compare companies on the same basis and present financial data consistently over time. Some normalizing adjustments include:
Non-recurring gains and losses (fire, flood, strikes, litigation costs, payments or recoveries, Gain or loss on sale of business assets, Discontinued operations)
Inventory accounting methods (First In, First Out (FIFO), Last In, First Out (LIFO) and others)
Depletion methods and schedules
Timing of recognition of revenues and expenses
Policies regarding capitalization or expensing of various costs
6- Controlling Adjustments
Some adjustments can only be made in a controlling owner or potential owner situation. This is because the minority owner generally can not force a change in the management and/or the capital structure of the company. Some of those adjustments include:
Excess or deficient compensation and perquisites
Gains, losses, or cash realization from sale of excess assets
Change in capital structure
Some experts believe that even in minority owner situations, these controlling adjustments should be made, to have comparability across the board between companies regardless of the level of value. Only after that, can the minority interest factors be handled separately as a minority discount.
Achille Ekeu, MBA, CVA
The Washington Valuation Group (WVG)
Achille Ekeu is a Certified Valuation Analyst (CVA) member of the National Association of Certified Valuators and Analysts (NACVA) in the DC-MD Chapter. He provides valuation services for Estate and Gift Tax, Purchase, Sale of business, Debt Financing, Buy-Sell Agreements, and Litigation Support in Divorce/Shareholders disputes cases. He can be contacted by phone at 240-274-9570 or by email at firstname.lastname@example.org.