Information presented on a company’s financial statements may not always be meaningful from a valuation perspective — even if it follows U.S. Generally Accepted Accounting Principles (GAAP). Often, valuation experts make adjustments to get a clearer picture of a company’s financial position, market risk and ability to generate cash flow in the future.
Here are four types of adjustments that may be appropriate when valuing a business interest, depending on the facts and circumstances of the assignment.
1. Nonstandard accounting practices
A valuation expert may estimate value by using pricing multiples derived from comparable private and public transactions (under the market approach) and discount rates derived from returns on public company stocks (under the income approach). Thus, if the subject company deviates from how other companies in its industry typically report transactions, the
Certain financial reporting practices may require
For example, if a company uses the last-in, first-out method (LIFO) to report inventory but other companies in its industry typically use the first-in, first-out (FIFO) inventory method, an adjustment may be needed to normalize the subject company’s earnings. That’s because 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.
2. Extraordinary or nonrecurring items
Sometimes future performance deviates from historic performance. A valuation expert might need to strip 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, capital losses and gains (or losses) on sales of fixed assets.
Valuators also adjust for nonoperating assets and liabilities, such as marketable securities, real estate
3. Hidden assets and 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 they may adjust the balance sheet accordingly, especially when using the cost approach to value a business.
Examples include internally generated intangible assets (such as goodwill and customer lists) and contingent liabilities (such as pending litigation, tax investigations
4. Discretionary spending
Controlling owners make key decisions about discretionary spending items, 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 more accurately reflect the economic benefits to a prospective buyer. Adjustments are especially common 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 typically are not taken when valuing a business interest that lacks control over day-to-day decisions, however. 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 explicit discount for lack of control.
Small adjustments, big effects
Valuation experts consider various adjustments during the appraisal process. But they’re not all appropriate for every business interest. Deciding what’s appropriate is