Abstract: Information presented on a company’s financial statements may not always be meaningful from a valuation perspective. This article provides four types of valuation adjustments experts make to get a clearer picture of the company’s financial position, market risk and ability to generate cash flow in the future — and it explains when such adjustments may be appropriate.
4 types of financial statement adjustments
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.
- 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 valuator may need to make adjustments.
Certain financial reporting practices may require adjustment, 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 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.
- 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 and shareholder loans. These items typically have different risk profiles and, therefore, may need to be valued separately from the business’s operating assets, possibly using higher or lower discount rates.
- 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 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 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 critical, because adjustments can have a substantial effect on value. A credentialed, experienced valuator can help make the right adjustments for your situation.