Clients are often mystified by the adjustments business valuation analysts make to financial statements when we start to value a business. Let’s explore the most common adjustments and why they are made.
You can't rely on financial statements to show the true value of a business because they simply don't reflect economic reality. They are based on accounting principles or income tax regulations that are designed for purposes other than portraying economic reality. They may also include some transactions that aren't arms-length or market driven in nature.
A standard valuation procedure adjusts a company's financial statements to better reflect economic reality. This process is called normalization and it achieves several goals. Normalized financial statements provide a better comparison to industry statistics and other similar companies. More importantly, they provide a more accurate picture of the company's true earning capacity, which is the primary driver of business value.
Here are some of the most common types of adjustments that business valuators make in the normalization process.
Related party transactions
Transactions between a closely held company and its owners or officers are not made at arms-length. The amounts are compared to the appropriate market data for reasonableness. Officers' compensation is compared to industry statistics or job market data. Property rented from a business owner is compared to existing commercial or industrial real estate rental rates. The amounts of these transactions are adjusted to reflect market rates.
Discretionary or unnecessary expenses
Expenses incurred at the discretion of management that are not necessary for normal business operations are eliminated or reduced to levels common in that industry. Travel and entertainment, charitable contributions, and automobile expenses are common areas of adjustment. Any expenses that were incurred primarily for the benefit of an owner of the company are also eliminated.
Income Tax Regulations
Many small businesses do not bother to prepare financial statements. Income tax returns are the next best source of financial data, but they are also not based on economic reality. Tax returns are obviously prepared with the company striving to minimize taxable income. For example, using income tax laws:
-Companies may elect to expense the purchase of capital assets that would normally be depreciated over time.
-Depreciation methods and periods are set by regulation, not by actual experience.
-Components of goodwill are amortized over 15 years regardless of their expected economic lives.
These are just a few examples. There are several other areas where income tax regulations impose standardized treatments that may not reflect economic reality.
Accounting principles are designed to provide a framework for a company to accurately report its financial results. These results may contain expenses that are legitimate but discretionary or unnecessary. They may contain related party transactions that are not based on arms-length negotiations. These amounts must be eliminated or adjusted as described above.
Accounting principles allow the use of estimates in some situations. These estimates are based on assumptions, not actual results. A company may deduct an allowance for bad debts from its trade receivables even though all of those accounts are subsequently collected. A company may deduct income taxes in an amount different from the actual taxes due for that year because of a deferred tax calculation. Accounting estimates are reviewed and adjusted to economic reality.
Accounting principles allow using different methods in areas like accounting basis, revenue recognition, and inventory costing. The methods being used must be evaluated and adjusted to economic reality. A simple example is a business that uses the cash basis of accounting. If that business has significant uncollected revenue and/or unpaid expenses, its financial statements must be converted to the accrual method of accounting to reflect economic reality.
Normalized financial statements provide a better picture of economic reality and are the bedrock of a competent business valuation. They provide a more accurate indication of a company's earning capacity and a better basis to compare with other companies.