Financial Statement Adjustments Are Essential in Business Valuation
The value of a business under the income and market approaches depends on how much earnings it will generate in the future. Historical results are a helpful starting point, but they usually need to be adjusted to reflect objective, unbiased data — and when projecting future performance.
The first category of adjustments accounts for any unusual or nonrecurring items, such as revenue from a one-time custom project or legal expenses associated with a pending lawsuit. These items aren’t expected to continue in the future and thus have no value to a potential buyer. As a result, they need to be eliminated from the company’s earnings.
The novel coronavirus (COVID-19) pandemic is an example of an unprecedented event that has had a major impact on business earnings. Going forward, valuation experts will use financial statements from fiscal year 2020 to estimate business value. And they’ll need to consider how the pandemic affected earnings, cash flow, and asset values. Fiscal year 2020 financial statements will need to be adjusted for effects of COVID-19 — both positive and negative — that aren’t expected to happen again. These could be temporary changes in demand, one-time insurance gains, bad debt write-offs, and supply chain disruptions.
However, projections of future earnings also must reflect effects of the pandemic that are expected to continue over the long run. For example, some workers may continue to work from home after shelter-in-place mandates expire. Some businesses may decide to increase their insurance coverage and safety stock levels to hedge against future business disruptions. Business models, supply chains, and cost structures may be permanently altered by this epic event. So, when making financial projections, valuators must go beyond multiplying historical results by a long-term growth factor. They’ll also need to address measures the business has taken to mitigate this risk factor going forward.
Discretionary Spending and Accounting Norms
Fair market value is typically based on the future cash flow that a hypothetical prospective buyer could generate from the business’s operations. Certain adjustments are designed to bring a company’s expenses in line with industry norms. Discretionary costs that commonly require adjustment include owners’ compensation and related-party transactions. These adjustments are especially important when valuing a controlling interest in a business.
Valuators also evaluate the company’s accounting methods. Adjustments may be needed to align the business’s financial reporting practices with comparable companies that are used to benchmark performance, gauge risk and return, and calculate pricing multiples.
Examples of accounting method differences include reporting for inventory, pension reserves, depreciation, income taxes, and cost capitalization vs. expensing policies. Small businesses also may use cash- or tax-basis reporting, rather than conforming to U.S. Generally Accepted Accounting Principles (GAAP).
After a valuator makes a preliminary estimate of a company’s value, he or she considers additional fine-tuning. Common last-minute adjustments include:
- Changes to working capital (compared with the company’s normal operating needs),
- Contingent or unrecorded assets and liabilities, and
- Nonoperating assets.
In some situations, it also may be appropriate to take discounts for lack of control and marketability associated with a business interest.
No Universal Formula
Adjustments vary depending on the nature of the business and the terms of the engagement. Discuss these issues with your valuation expert. He or she can determine what’s appropriate for your situation.