The value of a business is not directly determined by its historic performance. Instead, investors are more interested in the economic benefits the business will generate in the future. Past performance is only relevant to the extent that it demonstrates trends and is expected to continue going forward. This forward-looking approach applies whether an appraiser uses the cost, market or income approaches.
When using past results to predict future performance, historic financial statements may need to be adjusted for nonrecurring, noneconomic or other unusual items to normalize cash flows. These normalizing adjustments eliminate anomalies and facilitate comparisons with benchmarks and guideline companies.
In addition, some financial statement adjustments — also known as control or discretionary adjustments — are made to estimate future economic benefits on a control basis.
Why We Adjust the Financials?
Financial statement adjustments are an important part of the valuation process. Some reasons valuators make these adjustments include:
•To present historic financial information on a normalized basis, that is, under normal operating conditions, to predict future cash flows;
•To adjust for accounting practices that depart from industry standards or Generally Accepted Accounting Principles (GAAP);
•To facilitate comparisons of the subject company to itself and to other companies within the same industry; and
•To compare owners’ compensation and other related party transactions with industry norms.
These adjustments are hypothetical in nature. They aren’t intended to restate results or forecast future performance in accordance with GAAP or guidelines of the American Institute of Certified Public Accountants. Instead, valuators base these adjustments on their professional judgment to get a clearer picture of the subject company’s future anticipated economic benefits.
How Do Adjustments Affect Value?
Failure to develop the appropriate normalizing adjustments may result in a significant overstatement or understatement of value.
To illustrate, suppose an appraiser estimates a value of $1 million by capitalizing next year’s expected cash flows of $200,000 using a cap rate of 20 percent ($200,000 divided by 20 percent equals $1 million).
In this case, each dollar of normalizing adjustments equates to a $5 change in value. If an appraiser increases expected cash flows by $50,000 to account for a nonrecurring loss, the hypothetical company’s value would increase by 25 percent to $1.25 million. So, seemingly small normalizing adjustments can have a big impact on value.
Breakdown of Adjustments
Appraisers make many different kinds of financial statement adjustments when valuing a business. Which ones are necessary depend on the unique characteristics of the subject company, the appropriate standard of value, and the purpose of the appraisal.
The primary categories of normalizing adjustments include:
•Differences in accounting methods for such items as unconventional inventory or depreciation methods, revenue recognition practices, bad debt write-offs or allowances for pension liabilities;
•Nonrecurring and unusual expenses, such as casualty losses, litigation, and gains or losses on asset dispositions or discontinued operations;
•Non-operating assets and liabilities, such as artwork, marketable securities, and real estate, which also require adjustments for related income and expenses;
•Excess (or deficit) operating assets, such as working capital and deferred taxes; and
•Differences in tax rates or capital structures.
Investors without control cannot force the same changes as controlling owners. So, appraisers make an important distinction between financial statement adjustments available to a controlling owner and those changes that a minority owner can expect.
Control adjustments, such as modifying dividend policy, capital structure or related party transactions, are only appropriate when valuing a controlling interest — or if management is expected to make these changes in the normal course of business.
How Are Adjustments Supported?
Not all adjustments are obvious from a cursory review of the subject company’s financial statements. So, the process of developing adjustments requires diligence on the part of the appraiser. Documents requested and procedures undertaken to quantify these adjustments include:
Documents:
•Historic financial statements, tax returns and other records (such as board minutes, budgets, business plans and marketing forecasts);
•Audit and tax workpapers;
•Footnotes to financial statements; and
•Asset appraisals.
Procedures:
•Management interviews;
•Site visits;
•Third party verification;
•Industry research and benchmarking; and
•Consultation with experts in other fields of specialization.
How Adjustments Affect Other Valuation Elements?
Normalized adjustments do more than help valuators predict future economic benefits. They also provide valuable insight that appraisers use to form a more complete picture of the subject company and its potential risks.
Enhanced insight helps valuators select discount, capitalization and growth rates, as well as identify non-operating assets (and liabilities) to add to (or subtract from) a preliminary value conclusion. This exercise is also helpful when deciding on the appropriate capital structure or valuation discounts that apply to the business interest.
Valuing a private business interest is a complex process that includes many interrelated steps. The process of determining normalizing adjustments creates a foundation that valuators draw on throughout the appraisal process. If you have any questions please contact us at 617.738.5200 or contact us below.
