Business valuation experts can’t always accept the subject company’s financial statements at face value. Sometimes experts need to adjust the financial statements before using them to value the business. Here are descriptions of three common types of adjustments and explanations of when each one might be relevant.
Normalizing adjustments align the subject company’s financial statements with U.S. Generally Accepted Accounting Principles (GAAP) or industry standards. For example, a company that uses the cash (rather than the accrual) method to report income and expenses would require several adjustments. On the balance sheet, receivables, prepaid expenses, payables, deferrals and accrued expenses would be estimated.
On the income statement, revenues would be increased for items invoiced but still outstanding. Expenses would be matched to the current period’s revenues.
A subject company also may deviate from industry accounting practices. Normalizing adjustments can help make more meaningful comparables between the subject company and data drawn from others in its industry. These comparisons come into play when benchmarking performance, identifying guideline companies and gauging risk.
For instance, suppose the subject company reports inventory using the last in, first out (LIFO) method, but most other industry participants use the first in, first out (FIFO) method. LIFO companies tend to report higher cost of sales and lower inventory balances, assuming an inflationary economy and rising (or stable) inventory levels. Therefore, a subject company that uses LIFO will likely be undervalued because its accounting methods make it appear less profitable than FIFO companies — unless normalizing adjustments are made.
Hypothetical investors buy shares based on how a company is expected to perform in the future. Historical financial results are relevant only as far as they provide insight into what’s likely to occur later.
Discontinued operations and one-time events are typically eliminated unless management expects them to recur. Examples of nonrecurring items include settlement costs or proceeds related to a lawsuit, gains and losses from asset sales, and environmental cleanup costs. These items usually don’t represent any value to a potential buyer and require an adjustment to reflect that they’re unusual and nonrecurring.
In addition, when valuing an operating business, it’s important to differentiate between operating assets (such as machinery and office equipment) and nonoperating assets (such as real estate and investments). Why? Because distinct capitalization rates and pricing multiples apply to each.
Nonoperating assets should be valued separately because they aren’t integral to normal operations and may have more or less risk than a private business interest. In addition to separating these assets on the balance sheets, business valuation experts also adjust for any income generated and expenses incurred by the nonoperating assets.
This is the most subjective category of valuation adjustments and may not be appropriate in every case. For example, when experts value an interest on a minority, nonmarketable basis, they generally refrain from adjusting for items outside the minority shareholder’s realm of control.
Owners’ compensation is a common example of a discretionary adjustment. If the company’s owners receive above- or below-market compensation, a business valuation expert would consider adjusting pretax income for the difference between actual compensation and the owners’ replacement compensation.
Management’s future plans also affect whether discretionary adjustments are made. Continuing with the compensation example above, if an overcompensated owner plans to retire soon and will be replaced by an unrelated party, an adjustment might be warranted, regardless of whether valuing a minority or a controlling interest. But if the owner has no plans to retire or alter his or her compensation, an adjustment is unlikely when valuing a minority interest.
Adjustments impact value
Valuation adjustments can affect how an expert applies the cost, market and income approaches — and disagreements about which adjustments are appropriate can lead to major discrepancies between expert opinions. So, it’s important to understand how adjustments affect the valuation process and support them with objective market data.
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