RECASTING FINANCIAL STATEMENTS FOR
There continues to be significant discussion in the financial community, especially among accounts, concerning the changes made to the financial statements of closely-held businesses for valuation purposes. The valuation community insists on making sometimes weighty changes to a company’s balance sheet and income statement in order to, as they say, “normalize” the figures. Many of these changes are non-GAAP in nature. The accounting community, on the other hand, insists on holding to the promulgations of GAAP (Generally Accepted Accounting Principles).
Should non-GAAP changes to financial statements be made by valuation professionals? What are the nature of these changes and why are they made?
As a beginning point, it is important to define the essentially non-GAAP changes made by valuation consultants and then to provide a few graphic examples.
Even though this concept is critical to the valuation process, it is also true that the quality of the underlying assets plays a role in the overall determination of value. Marketable majority interest in an asset held by a partnership is more valuable than an unmarketable minority interest. The quality of the underlying assets is, therefore, an important and appropriate issues to study, although it’s the partnership interest which is actually being valued
The changes referred to above are generally non-GAAP in nature, although not necessarily in every case. These changes, which in effect recast the financial statements, are made in order to “normalize” the financial statements. The term “normalize” means to remove all unusual, non-recurring, one time type events from the financial statements so that they will present a picture of the company’s normal operation. Examples of these normalizing adjustments are as follows:
Unusual gains or losses appearing on the income statement are removed in order to show a more accurate picture of earnings.
The effects of discontinued operations are removed from the income statement in that such entries tend to significantly skew earnings and operating results. A prospective buyer of the company would want to view the company without the effects of a no longer existing operation contaminating operating results.
The effects of related party transactions are often removed from operating results so that the company’s true earning power can be determined. Examples of related party transactions are excessive executive compensation and perks, loans make to related parties or family members, discretionary expenses or other transactions not reflecting arms-length bargaining between parties, and which may not have a business purpose.
Adjustments to restate data on a different basis of accounting: An often used adjustment in this category is the LIFO adjustment to inventory. Reversing the LIFO adjustment can often increase income significantly. Another example would be the reversal of the deferred tax entry. This can have a significant effect on the balance sheet and the income statement.
Unusual one time events such as uninsured flood damage, or insurance proceeds from the death of a key person, or a one time repair bill, due to vandalism, on a major piece of equipment should be removed from operating results in order to normalize operations. Leaving these anomalous events in place is tantamount to purposefully distorting the company’s earning capabilities.
Non-operating assets should be carefully scrutinized for their business purpose within the organization. For example, consider a company-owned airplane, where the company involved has no remote operations, no need for travel and, therefore, absolutely no need for an airplane. The costs of that asset should be quantified and removed from consideration in the earnings stream so that the true earning capabilities of the enterprise can be determined.
Another example of a non-operating asset is the case where a company owns an office building, which is not used in its operations and is not inhabited by the company being valued. This is obviously a non-operating asset, which has no redeeming business purpose vis-à-vis the stated mission of the company. In such cases, the asset should be removed in order to normalize operations.
Conclusion: The examples can go on and on. The types of normalizing adjustments referred to above are essential to the valuation process. This is where the experience and judgment of the valuation professional is critical. Judgments concerning normalizing adjustment must be made if corporate valuations are to reflect Fair Market Value.