4 Accounting Primer

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4

Accounting Primer

Although there is no substitute for experience and formal training in accounting, it is clear that a

basic understanding of accounting principles is necessary for effective and accurate business

valuation. Therefore, this primer is intended to provide a basic introduction to the accounting

process as a prelude to detailed guidance on interpreting a company's income statement in

relation to calculating adjusted cash flow (AC!. "iven the central role of AC in business

valuation, such additional coverage is warranted and serves as a supplement to the material

contained in the boo#. $f you read no other section of this primer, ma#e sure that you review the

section titled %&se of the $ncome tatement.% A third accounting topic that reuires additional

discussion is intangible assets. $ntangible assets such as goodwill often are a source of confusion.

Therefore, the final section of this primer addresses this multifaceted issue.

Introduction

inancial statements are the scorecards of the business world, providing guidance for future

allocations of scarce resources. Accounting often is called the language of business. To rely on

financial statements, you must understand them. To understand them, you must have a basic

#nowledge of accounting systems and accounting procedures. $n fact, regardless of your current


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state of #nowledge, you can always learn more about accounting and use these new insights in a

productive way, managing your business to maximi)e profits and company value.

$f you are considering the purchase of a business and have little or no accounting training,

there are several avenues to pursue that will improve your understanding. irst, if time allows,

sign up for a course in financial accounting at your local community college. *any colleges

offer courses specifically devoted to introductory financial statement analysis. $f time is short,

consider attending a two+ to four+day seminar on accounting for business people. These seminars

are periodically offered by local chambers of commerce, mall usiness -evelopment Centers,

community colleges, and even universities. $f this option seems unattractive, you should

purchase a condensed guide to accounting, such as the one published by arron's and available at

most boo#stores. Additionally, purchasing an accounting dictionary and thoroughly reviewing

the terms will increase your #nowledge. A regular text used for a course in financial accounting

would also be helpful. ou must have a sound understanding of accounting to maximi)e the

performance of your business and therefore its value.

$f you own a larger corporation or are an experienced business owner with a fairly strong

command of financial statements and accounting in general, then you should consider purchasing

a text on intermediate or advanced accounting or even a text on federal taxation. /eviewing these

textboo#s probably will generate ideas and insights previously un#nown. Also, if you plan to go

public one day, you will benefit from attaining a level of understanding similar to those who

assist in implementing initial public offerings ($01s! and those interested in acuiring sta#es in

such companies. Tax and accounting issues are important in this arena.

/ecogni)ing the value of a business depends on careful scrutiny of the company's

financial statements. $f you are purchasing a business, you must understand the many nuances of


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generally accepted accounting principles ("AA0s! and the many different accounting concepts,

assumptions, and conventions on which these principles are based. ou must be able to decipher

the economic reality of a company based on the presented statements. This tas# is greatly

complicated by financial statements prepared by small business owners who do not appreciate or

understand "AA0s. These statements normally are compiled rather than audited and must be

scrutini)ed carefully. Compiled statements are prepared either by the owner or by an accountant.

$f an accountant prepares compiled statements, they are based solely on the data presented by the

owner. 2o information is verified or audited. Audited statements, on the other hand, are prepared

by Certified 0ublic Accountants (C0As!, who will verify all account balances and determine

whether "AA0s have been followed. 0ractically spea#ing, you must #now where manipulations

in reported income and expenses can occur in either scenario (compiled or audited!. To

accomplish this, you must have at least a basic understanding of accounting.

$f you are operating or selling a business, the financial statements can be a source of

guidance leading to higher profits and higher business value. ou must understand that almost all

business valuations are conducted via financial statements. $dentifying efforts that will maximi)e

the value of your company is facilitated by review of the financial statements. uccessful exit

strategies call for preparing your business for sale many years before you place it on the mar#et.

The central point here, however, is that calculations of business value revolve around financial

statements. 3earning how to wor# in this environment will help you maximi)e the sales price and

minimi)e tax obligations.

Accounting Process Basics


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The accounting cycle, the accounting system, and "AA0s culminate in the preparation of

financial statements. As mentioned earlier, accounting is the language of business. As it relates to

the purchase and sale of a business, however, the reuired field of #nowledge is fairly precise

and by no means insurmountable. 4e begin now with the basics.

Accounting was created in the sixteenth century and is based on the concept of double+

entry boo##eeping. The essence of double+entry boo##eeping is that for every debit, there is an

eual and corresponding credit. The euality of debits and credits ma#es sense only in the

context of the so+called accounting euation5

Assets 6 3iabilities 7 1wner's euity

A (debit! 6 3 (credit! 7 1.8. (credit!

The accounting euation can be interpreted in many ways. irst, these are the major

categories of the balance sheet. At this point, however, the most useful interpretation tells us that

every company owns assets (A!, which are combined to produce revenues and profits. 8ach of

these assets must be paid for, or financed. They can be financed through debt (3! or euity

(1.8.!. -ifferent companies have different capital structures (more debt than euity or vice

versa!.

$n terms of the accounting system, assets possess a debit balance, whereas liabilities and

euity have a credit balance, to be defined further in a moment. Also note that the following

additional account types relating to the income statement have debit or credit balances5


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Debit Credit

8xpenses /evenues

3osses "ains

-ividends

The accounting system revolves around the principle of double+entry boo##eeping and

the accounting cycle, which has the following major steps5

9. Transactions occur, as evidenced by source documents.

:. Transactions are entered into a journal (general journal! at the end of each cycle.

;. . &nder accrual accounting, adjusting entries are made and posted at the end of each cycle,

typically each month and for the year as a whole.

?. Closing entries are entered into the general journal and posted to the general ledger.

@. inancial statements are prepared (at least the balance sheet and income statement!.

As any student of accounting will tell you, it is possible to become mired in the details.

owever, excellent accounting software pac#ages are available for small business at reasonable

prices, including 0eachtree and Buic#en. These user+friendly pac#ages reuire that you enter

data based on familiar transactions that occur, culminating in the preparation of the financial

statements. or the sa#e of discussion, let's wal# through these steps in a cursory fashion. 4hen


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(cr! Cash ?,DDD

2ote that T+accounts are generated for every type of account, including expenses and

revenues. 8xpenses are increased by a debit entry, whereas revenues are increased by a credit

entry. tated differently, expense accounts have a debit balance and revenue accounts have a

credit balance. 2ote the eternal balance between debits and credits. D,DDD, which is the running total of all individual

sales made throughout the year. imilarly, all rent payments are tallied up in the rent expense

account and used as part of the income statement in determining net income. 1ther sample

entries include the following5

(dr! Cash 9DD,DDD


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(cr! Common stoc# 9DD,DDD

(to record cash received in exchange for ownership interest!

(dr! Cash :D,DDD

(cr! ales revenue :D,DDD

(to record sale from inventory for cash!

(dr! Cost of goods sold 9>,DDD

(cr! $nventory 9>,DDD

(to record inventory expense associated with sale for cash!

The first of these is an entry dealing with the owner's euity, or capital section of the

balance sheet. Crediting owner's euity amounts to increasing the euity balance to reflect the

infusion of cash. The second transaction involves two separate entries (one transaction, two

entries!. As always, total debits eual total credits. Two entries are necessary, one to record the

sale and the other to recogni)e the associated expense with the sale. 2ote that, overall, sales are

credited for :D,DDD and cost of goods sold (C"! is debited for 9>,DDD. At year end (or

whenever financial statements are prepared, perhaps monthly! total sales and total C" expenses

are tallied up and used to prepare the income statement. 2ote that what we are dealing with here

is the company's Fgross profitG (or gross margin!, which is defined as5


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ales revenue

Cost of goods sold

6 "ross profit

/emember that the company's gross profit is an important number for analytical

purposes. A company's gross profit indicates how much profit exists after the inventory is paid

for (whether it is purchased or manufactured! to pay for all overhead expenses (general and

administrative, selling, interest, and tax expenses!. "ross profit of a target company should be

loo#ed at carefully and compared with industry averages. 2ote the following averages and try to

explain why they might be higher or lower for differing types and categories of businesses5

eauty salons HDI

Jideo stores @DI

2urseries >DI

1ffice supply stores ;>I

"rocery stores :DI

A gross profit margin of >D percent, for example, implies the following fictional income

statement5

ales revenue >DD,DDD 9DDI

Cost of goods sold $250,000 50%


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6 "ross profit :>D,DDD >DI

The important consideration in our current discussion is that these numbers (sales

revenues minus C"! are accounting numbers and are subject to manipulation. ales can be

recogni)ed differently, and C" can be calculated using different, legitimate approaches (e.g.,

first+in, first+out K$1L or last+in, first+out K3$1L!. This manipulation can be either legal

(within "AA0s! or illegal (fraudulent!. 4hen purchasing a business, you must be able to

recogni)e these potential problem areas either independently or with the assistance of your C0A.

Jerification of the accuracy of the reported numbers has a direct bearing on the determination of

the company's value. A company's financial statements are compilations of hundreds of

transactions comprising various debits and credits. Appreciating the many steps involved in

preparing these statements is a necessary step toward financial sophistication.

Another important type of journal entry is the so+called adjusting entry. -epending on the

type and si)e of business and the sophistication of the accountant, there may be many such

entries or none at all. asically, adjusting entries are reuired by "AA0s to ensure that the

financial statements are presented in a fair, useful, and consistent format. pecifically, adjusting

entries are necessary to comply with the fundamental principle of Faccrual basisG accounting5 the

so+called matching principle. As described elsewhere in this primer, accrual accounting reuires

that for financial reporting purposes, revenues be recorded when earnedand expenses be

recorded when incurred, regardless of when cash flows in or out. or example, consider the

purchase of a fixed asset such as machinery. 8ven though the entire purchase may have been

paid for in cash all at once, the expense is apportioned over the useful life of the asset in a logical


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fashion, being matched against revenues that are generated by the machinery. 2ote the following

journal entries5

(dr! *achinery 9DD,DDD

(cr! Cash 9DD,DDD

(dr! -epreciation expense 9D,DDD

(cr! Accumulated depreciation, machinery 9D,DDD

The first entry records the purchase of machinery worth 9DD,DDD for cash. -espite the

fact that the machinery is fully paid for, accrual accounting does not allow recognition of this full

amount as an expense in one year. $t must be allocated over the useful life of the machinery,

which entails an estimate by the accountant. This estimate could be five years or ten years,

depending on whom you as# and what type of maintenance is involved. Assuming a useful life of

ten years and use of the straight+line method of depreciation, the 9DD,DDD piece of machinery

will be depreciated by 9D,DDD each year.

The second entry is an example of an adjusting entry, which is necessary to allow proper

presentation of the financial statements. A depreciation expense of 9D,DDD is recogni)ed as a

charge against income. $f the company had chosen an alternative depreciation method that allows

accelerated depreciation, the recogni)ed expense would be larger in the early years and smaller

in later years, affecting dollar for dollar reported net income and AC. Although the total amount

of depreciation expense would be the same (9DD,DDD!, the timing would be different. $n general,

adjusting entries may be classified as either accruals or deferrals. $n both cases, the goal is to


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The debit is to an expense account, which will reduce net income, effectively erasing a

certain percentage of the sales made on account. The credit is to an allowance account (also

called a contra+asset account!, which reduces the carrying value of accounts receivable (AM/! to

what is called net reali)able value. The result of this entry overall is to reduce the asset accounts

receivable and to reduce net income to reflect bad debt expense. or tax purposes, most small

businesses are not allowed to estimate bad debts and ta#e a tax deduction based solely on this

estimate. or tax purposes, only specific accounts that have been written off may normally be

deducted. The logic here should be clear. &ncle am will not allow taxpayers to estimate

expenses that may or may not materiali)e. ou cannot estimate your way to higher expenses,

lower income, and lower taxes. ee your accountant for more tax information.

Another example will further illustrate the differences between boo# and tax accounting.

/ecall that the boo#s may be prepared under cash basis or accrual accounting. $t is possible to

use the accrual basis for one set and the cash basis for another. $n both realms, you must

generally be consistent from one year to the next. owever, for tax purposes, it is possible to use

a hybrid method (cash and accrual! if this approach presents income and expenses clearly. There

are restrictions, however, as follows5

$f inventories are present, you must use the accrual basis for purchases and sales. or all other

areas, you use the cash method.

$f the cash method is used for determining revenues (income!, the cash method must be used for

reporting expenses.

$f you use the accrual method for expenses, ditto for revenues.


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Also be aware that if you change your accounting method for tax purposes, you must

receive $/ approval. They will consider your reason for change in light of the reuirement for

consistency. 2ote that if your business is based primarily on the sale of inventory from stoc#,

you must use the accrual basis and recogni)e revenues when they are earned and expenses when

they are incurred (regardless of when cash changes hands!. usiness tax returns contain a section

that specifically reconciles the difference between tax accounting and boo# accounting (chedule

*+9 on corporate tax returns!. This is a practical place to begin understanding this important

difference.

Financial Statement Analysis

4hen analy)ing financial statements, remember that they are intended to provide a %continued

history, uantified in money terms, of economic resources and obligations of a business

enterprise, and economic activities that change those resources and obligations.% This is the

official description of financial statements according to "AA0s. The general area of interest here

is financial accounting and reporting, which entails the financial statements and supplementary

information that must be published externally under "AA0s. $deally, all businesses will prepare

their statements in accordance with "AA0s, but most small businesses, whose securities are not

publicly traded, are not overly concerned with "AA0s. Their statements normally are not audited

but are occasionally reviewed, which amounts to a watered+down audit. *ost commonly they are

compiled, which simply means that the accountant has ta#en the information provided by the

owner at face value and constructed the statements accordingly. The garbage+in, garbage+out

principle applies very well here. This is why the purchaser of a small business with unaudited


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statements typically must rely on the assistance of an accountant to verify the presented financial

information, at least in a minimal fashion.

$f you are purchasing a business with audited statements, they must be audited in

conformance with generally accepted auditing standards ("AAs!, and they must be presented in

accordance with "AA0s. The role of the C0A as external auditor is to verify that the statements,

as prepared by management, are accurate and in conformance with "AA0s. $f they are not, the

C0A must issue a %ualified% report, indicating that he or she finds that the statements are not

prepared per "AA0s. An %unualified% report is what you hope to find. /emember, though, that

the only implication of the %unualified% finding is that the statements are materially accurate

and are prepared in accordance with "AA0s. The C0A is in no way assessing the current or

future profitability of the company, nor is he or she recommending the company as a sound

investment. The C0A is attesting only to the accuracy and conformity of the statements.

4hat exactly are "AA0sN Chec# out an introductory or intermediate accounting text at

your local library for a complete review. As a business owner, you should understand the

accounting process as best you can. "AA0s are the foundation of the accounting profession and

is one of the reasons why the &nited tates has the most developed capital mar#ets in the world.

"AA0s consist of the financial accounting and reporting assumptions, standards, and practices

that a business entity must use in preparing external financial statements. They are based on

practical as well as theoretical considerations and tend to represent a consensus among

accountants as to what is the appropriate accounting procedure for a given event. "AA0s

provide guidance to preparers and confidence to users. They foster the ability to compare one

company with another and to ma#e important decisions affecting the direction in which resources

flow.


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The truth is, however, that "AA0s have many shortcomings and imperfections, but they

yield the best results. The problems associated with "AA0s are related to the wide latitude given

accountants in terms of estimates, professional judgments, and assumptions. This latitude can

lead to problems based on personal bias, misstatements of facts, errors in estimation, and general

ambiguities. The goal is to have financial statements that are credible to outside users.

4hen purchasing a company that has audited statements, #eep in mind that the auditor

preparing the statements probably has wor#ed for the company for several years and has been

remunerated handsomely for his or her efforts. -espite their fiduciary duty to the public and their

possible liability regarding the accuracy of the statements, bias may still affect the results.

Audited financial statements should include much more information than just the four

primary statements (income statement, balance sheet, statement of retained earnings, and

statement of cash flows!. Consider the following additional data included in comprehensive

annual reports5

Notes to Financial Statements

Accounting policies (depreciation, sales recognition, accounts receivable write+offs!

$nventory methods (e.g., 3$1, $1, specific identification!

Contingencies (e.g., lawsuits, product recalls!

hares outstanding (e.g., sales of stoc# by officers, options, and warrants outstanding!

*ar#et value information (e.g., land, buildings, patents, securities!

Supplementary Information

-isclosures related to changing prices (inancial Accounting tandards oard KAL O;;!


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oreign currency translation (A O>:!

1il and gas reserves (A O?H!

tatement of cash flows (A OH>!

Other

*anagement discussion and analysis in annual report

3etter from chair to shareholders

-iscussion of competition and order bac#logs (8C orm 9D+P!

/eports by industry analysts

8conomic statistics (e.g., gross domestic product, consumer confidence!

2ews articles

The concept of full disclosure plays an important role in the preparation of financial

statements, just as it does in the sale of real estate or the sale of a business in general. $n fact, full

disclosure is at the heart of our efficient and powerful economy. $n terms of financial statements,

full disclosure means that any economic information related to the business entity that is

significant enough to affect the decisions of an informed and prudent user should be incorporated

into the prepared statements. or example, "AA0s allow the use of alternative accounting

procedures, such as depreciation methods, methods of revenue recognition, and inventory

methods. &sers of financial statements, including potential purchasers of the business, must be

aware of these differing policies and procedures.


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$n terms of reviewing the prepared statements for purposes of analy)ing the company's

performance,financial statement analysis refers to the use of various analytical techniues,

including5

Common si)e analysis

Trend analysis

Common si)e analysis on a trend basis

/atio analysis

The term common size analysisrefers to restating each of the #ey accounts on the balance

sheet and income statement on a percentage basis in relation to another #ey account. /estating

each separate expense as a percentage of total revenue (e.g., > percent of sales! is one example.

The goal is to use such information to learn about the subject company and its operations and

effectiveness. Trend analysis calls for analy)ing account balances or other figures over time (e.g.,

gross profit over the past five years!. 8ither absolute figures (gross profit dollars! or relative

percentages (gross profit margin! can be evaluated over time. $deally, such analysis includes both

common si)e and trend analysis at the same time (e.g., comparing advertising as a percentage of

sales over time!.

Another important financial statement analysis tool calls for comparing the subject

company's account balances and common si)e figures with industry averages (as introduced in

the A/* Approach Buestionnaire!. Comparing the subject company's advertising as a

percentage of sales with the industry average can provide insights into the company's mar#eting


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efforts. "ross profit, net income, and other measures can be compared with industry norms as

well.

inally, effective financial statement analysis also calls for the use of ratio analysis. $n

general, ratios can be classified into one of four categories5

3iuidity

olvency

0rofitability

Activity

3iuidity is a company's ability to meet its current debts as they come due. The current

ratio is a common measure in this category and is calculated as5

Current assetsMCurrent liabilities

"enerally spea#ing, a ratio greater than : is considered favorable, but each industry or

type of company is subject to uniue circumstances and tendencies, so care must be exercised in

this regard. The uic# ratio is the same as the current ratio except that inventory is subtracted

from the current assets (thus ma#ing cash and receivables the most relevant assets, which are the

most liuid assets!.

olvency is a measure of the company's longer+term ability to meet debts. The times

interest earned ratio and the fixed charge ratio, respectively, are two of the more common

solvency ratios5


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9. 8arnings before taxes plus interest expenseM$nterest expense

:. 8arnings before taxes plus interest expense plus all mandatory paymentsM$nterest expense plus

all mandatory payments

8xamples of mandatory payments include lease payments, sin#ing fund reuirements,

and any other contractually fixed payments.

0rofitability is self+explanatory and involves measures of the company's ability to

generate profits. 0rofitability ratios include return on assets, return on euity, and less traditional

measures such as profit per employee. /eturn on assets and euity, respectively, are calculated as

follows5

2et incomeMTotal assets

2et incomeMTotal euity

Activity ratios involve measures of operational performance and include ratios such as

day's sales in receivables and inventory turnover. 1ther measures include sales per employee or

sales per dollar of assets. -ay's sales in receivables and inventory turnover, respectively, are

calculated as follows5

2et salesMAverage accounts receivable

Cost of goods soldMAverage inventory


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-ay's sales in receivables indicates the length of time needed to collect the average

account receivable balance, and the inventory turnover illustrates the number of times the typical

inventory holding is liuidated over the course of a year. As always, ratios ta#e on meaning only

in comparison with prior periods or with industry averages. $n a vacuum, ratios are meaningless.

The A/* Approach Buestionnaire contains useful 4eb lin#s for access to more

information about financial statement analysis. *any good boo#s are available, ranging from

accounting texts to practical guides on using and interpreting financial statements. inancial

statement analysis in the form of common si)e, trend, and ratio analysis is one of the most potent

tools available for evaluating companies for purchase.

Use of the Income Statement

As is now obvious, the cash flow calculation is derived primarily from a review of the subject

company's income statement. /ecall from the discussion of the ive+0age Tool in Chapter ; that

the ideal place to begin a business valuation is with the income statement. $ncome statements

serve as scorecards for how a company does over a certain period of time (e.g., over one month

or over one year!. pecifically, the income statement presents inflows and outflows, typically in

the form of revenues and expenses (also gains and losses!. ecause income statements (and

balance sheets! are prepared primarily on the basis of "AA0s, they may not reflect a company's

fair mar#et value (*J! on a going+concern basis.

or example, a company's pretax income may be based entirely on the gain associated

with the sale of an asset or chiefly on the recognition of sales that have not yet been turned into

cash (a sale made on terms that may or may not be collected!. A company's balance sheet is

based primarily on the historical cost principle, which in most cases is at odds with mar#et


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values. As a result, adjustments are necessary to recast the financial statements for purposes of

evaluation and comparison across similar businesses. everal terms are used to refer to the

adjusted statements, including recast earnings, normalized earnings,and economic earnings.$n

regard to the A/* approach, we use the term adjusted cash flow(AC!.

Cost of Goods Sold and Gross Profit

-epending on the type of company (manufacturing, retail, service!, the specific format of the

income statement will differ, reflecting the types of costs incurred by such companies. or

example, only manufacturing and retail companies are associated with a C" and gross profit

component before deducting other expenses in the %"eneral and Administrative% or operating

expenses category.

The gross profit of such companies is an important indication of profitability, calculated

as the difference between net revenues (gross revenues minus returns and allowances! and C".

or example, a retail business that uses a #eystone mar#up will show a gross profit margin of >D

percent (goods purchased are sold for two times cost!. ervice businesses do not have a C"

account because they do not produce or sell goods. The gross profit percentage (gross profit as a

percentage of sales! is an important indicator of how much pricing power a company has. The

higher the gross profit margin, the more power the company has in pricing its goods.

$n economic terms, products that are associated with an inelastic demand have a higher

mar#up percentage. A good is subject to inelastic demand when a given percentage change in

price leads to a smaller percentage change in the uantity purchased (e.g., price is raised 9D

percent but uantity demanded falls only > percent!, thus increasing total revenue. The primary

determinant of elasticity is the uality and uantity of good substitutes available to the consumer.


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&niue products with no close substitutes enjoy the most inelastic demand, which ultimately

means that the company can raise prices substantially without a major loss in customers or

uantity sold.

An alternative interpretation of the gross margin is found when considering extremely

low gross profit margins. The lower the gross profit margin, the ris#ier the business is. 3ow gross

profit margins (low mar#ups! mean that each sale contributes very little to cover all other

expenses ("QA expenses such as advertising, payroll for office staff, office supplies, rent, and

utilities!. mall gross profit margins mean that if the company's sales decrease dramatically, the

ris# of ban#ruptcy or insolvency is greater (compared with a higher gross profit contribution

situation!. Companies that enjoy substantial pricing power via inelastic demand are worth more

than companies with minimal pricing power.

Another way to analy)e gross profit margins calls for comparing the growth in revenues

with the growth in earnings or pretax income. $f revenues are growing faster than pretax income,

the gross profit margins may be declining or under pressure for one reason or another. $f pretax

income is growing faster than revenues, on the other hand, it may be necessary to evaluate the

probability that the current revenue growth is sustainable or that the growth in earnings may have

resulted from one+time or unusual events such as an aggressive strategy to reduce operating

costs. The A/* Approach Buestionnaire will lead you to this specific comparison and others in

ection our.

Accrual Versus Cash Basis Accounting

Another important distinction regarding the income statement is the difference between cash

basis and accrual basis accounting. *any small businesses use cash basis accounting for both


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boo# purposes and tax purposes, whereas more substantial companies are more li#ely to use

accrual basis accounting, which is a major part of the foundation provided by "AA0s. To

complicate matters, certain businesses use a hybrid method containing both cash and accrual

components.

Accrual accounting calls for matching revenues as they are earned with costs as they are

incurred, regardless of when cash actually changes hands. or example, a company that sells

product on terms (e.g., :M9D, nM;D5 if payment is made within ten days, a : percent discount is

offered, and the entire balance is due within thirty days! will record the sale before receiving

cash from the customer. The accrual element here calls for a journal entry that reflects the sale

(credit to sales revenue! and the accounts receivable (debit to accounts receivable!. 4hen money

is ultimately received for payment in full, cash will be debited and the accounts receivable will

be credited to eliminate its balance. All receivables, payables, deferrals, and accruals are a result

of accrual basis accounting.

Sales Recognition

A seemingly simple uestion such as when a sale should be recogni)ed under accrual basis

accounting can lead to confusion. 4hether a sale is recorded sooner or later can affect the bottom

line and thus AC in a material manner. This area of concern is heightened whenever a company

chooses to change its sales recognition procedure because it complicates comparisons from year

to year and can be used to manipulate the numbers. or example, publicly traded companies that

have enjoyed several consecutive years of growing earnings per share may resort to window+

dressing maneuvers such as changing accounting procedures (e.g., accelerating sales recognition!

to ensure continuance of the trend that analysts have come to expect.


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everal different possibilities are available in establishing a sales recognition policy, any

of which could trigger the formal recognition of the sale in the accounting boo#s5

4hen the order is received over the phone or by fax

4hen the order is filled by inventory specialists (placed into a box!

4hen the order is shipped (leaves the doc#!

4hen the customer receives the goods (signs for the delivery!

4hen the customer's chec# is received

4hen the customer's chec# has been deposited

4hen the customer's chec# has cleared and entered company accounts

"AA0s allow discretion as to when the sale should be considered complete (within the

parameters spelled out in various promulgations from the A or other influential accounting

bodies!. y changing its sales recognition policy, a company could either speed up revenue

recognition (higher sales and profits in the current period! or slow it down (lower sales and

profits in the current period but more in the later period!. This type of decision ma#ing permeates

"AA0s and leads to difficulty in comparing one company with the next.

1ther revenue+related concerns from a valuation perspective include companies with

product sales that entail subseuent installation and service attention. uch companies may not

record the complete sale until a later time. ales that are subject to freuent returns and

allowances also warrant special attention. $n addition, increased revenue as a result of substantial

discounting will typically harm future sales results and undermine the uality of current sales. A


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s#illed valuator is always on the hunt for any peculiar, unexpected, out+of+the+ordinary events or

changes because these situations serve as red flags that normally prompt additional investigation.

$t is partly because of this type of situation that you may need to adjust the income

statements when attempting to value a company. Technically spea#ing, the presence of accrual

accounting complicates the calculation of cash flow as used by business bro#ers and other

valuators. As described later in this chapter, even the term cash flowta#es on different meanings

in different applications. ortunately, common practice dictates the process used to calculate the

figure #nown as AC without overcomplicating the process. 2onetheless, a brief discussion of

this type of change and other potential adjustments when evaluating the subject company's

income statement is now warranted.

Potential Adjustments to the Income Statement

The information presented in this section is intended to provide you with as much insight as

possible before you actually evaluate a company under real+world circumstances. As just noted,

the calculation of a company's AC for purposes of implementing the A/* approach often is

straightforward and uncomplicated. $n fact, you might choose to s#ip this section and go directly

to the sections explaining how AC is calculated without affecting your overall valuation

estimate using the A/* approach. *any of the potential adjustments covered in this section will

arise automatically during the valuation process and completion of the A/* Approach

Buestionnaire.

imply adding the various addbac#s to the company's pretax income often is uneventful.

owever, special circumstances can arise that complicate this process. hould you choose to be

extremely thorough in your analysis, paying close attention to the following list of potential


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adjustments will be uite beneficial. The following areas are those most li#ely to reuire

adjustments to calculate a pure AC figure and will be evaluated one by one in this section of the

primer5

ales recognition and uncollected receivables

$nventory valuation and C" implications

ixed asset accounting

ales and warranty or return policies

&nreported sales revenue

$n addition to these fairly common adjustments, other areas may warrant attention as

well. Although the following potential areas of adjustment are less common, they may have a

material impact on the AC and asset values associated with the company under evaluation5

$nvestments in affiliated companies

CompanyMshareholder transactions

&nrecorded or unfunded pension plans

1ne+time expenses or losses and owner's compensation

Sales Recognition and Uncollected Receivales

1ur introduction to accrual accounting addressed the issue of when a sale should be recogni)ed

on the company boo#s. "iven the spectrum of possible answers, differences between one

company and another may be substantial. 1btaining the answer to this uestion is a matter of


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as#ing the company's owner or accountant. 0erhaps the most important consideration regarding

sales recognition is whether the company has been consistent from year to year. $f changes were

made, possible adjustments might be needed to compare apples with apples. ellers will be

tempted to change this recognition policy the year before they put the company on the mar#et for

sale because of the favorable impact on reported revenues and profits.

ales recognition can be even more problematic for companies that use accounting

procedures that are uniue to the industry. or example, construction companies commonly use a

percentage of completion method when accounting for individual construction jobs. This method

is based heavily on estimates related to profit margins per project and the percentage of the job

completed as of the date of financial statement preparation. 4hen evaluating a construction

company, you must give special consideration to this accounting method. Also bear in mind that

for tax purposes, such construction companies use a different method called the completed

contract method. Consult your C0A or consider purchasing a construction accounting primer to

support your analysis.

The use of trend analysis (see the A/* Buestionnaire, ection our! is invaluable for

many #ey accounts and ratios, including those related to accounts receivable. or example, rising

accounts receivable balances may be the result of a strong increase in sales or the result of overly

generous credit or a poor collection effort. 1nce again, loo#ing for material changes in account

balances will help you focus on potentially important value+related events or concerns.

&ncollected receivables are in essence recorded sales that were not ultimately paid for by

the customer. Thus, if uncollectible receivables are not written off, both sales revenue and

accounts receivable will be overstated. A sale that is not paid for is not really a sale at all. 8ven if

the sale is still recogni)ed after writing off the receivable, the company's bad debt expense or


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uncollectible receivables accounts will shed light on the company's collection s#ills or the

strength of the customer base. 4hen attempting to value a company, it is always prudent to as#

for and review the company's AM/ aging report, which lists all receivables by customer in order

of delinuency. Typically, they are presented in thirty+day increments (e.g., receivables that are

thirty days or less, thirty+one to sixty days, sixty+one to ninety days, and more than ninety days

overdue!. 1bviously, the more accounts are overdue, the less value they will have. *ost accounts

more than ninety days old will not be collected unless special circumstances exist that are

documented and credible.

$n regard to bad debt and AC calculations, the main point is that the reported sales

figures might include a material percentage of revenues recogni)ed that will not be collected.

Thus, it may be necessary to reduce the reported AC figure by the related amount (the AM/

balance may be overstated as well!.

Inventory Valuation and CGS Im!lications

This area can be extremely confusing for people without a finance or accounting bac#ground.

owever, the potential adjustments to the related accounts of inventory and C" can be material

to the valuation conclusion. A manufacturing or retail business is associated with a C" account

near the top of the income statement, reflecting the cost of producing goods for sale

(manufacturing! or purchasing goods for resale (retail!. Accounting for C" and inventory is

also a function of accrual accounting, whereby an attempt is made to match the revenues earned

with the expenses incurred (matching sales revenue with the C"!.

/ecall from our earlier analysis that gross profit is the difference between net revenues

and C". A retail business that uses the #eystone mar#up method will show a gross profit


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margin of >D percent (goods purchased are sold for two times cost!. ervice businesses do not

have a C" account because they do not produce or sell goods. Consider the following top+line

measure of profitability5

Amount 0ercentage

"ross revenues 9DD,DDD 9DDI

Returns and allowances $ 2,000 2%

6 2et revenues HE,DDD HEI

3ess C" $ 49,000 49%

6 "ross profit =H,DDD =HI

$nterpreting the top portion of the income statement for either a retail or manufacturing

business would be similar, except for the fact that the calculation of C" for a manufacturing

company is much more complicated because of the inclusion of a labor component and overhead

to the raw materials used in production (the realm of cost accounting or managerial accounting,

if you want to learn more!. $n general terms, the following conclusions can be reached by

reviewing this portion of the income statement5

The gross profit margin is =H percent.

The average mar#up is two times (cost ofXis priced at :X!.

/eturns and allowances are : percent of sales.

1f course, the practical aspect of such a review would include both trend and

comparative analysis. 3isting and comparing these same percentages for the subject company


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over the past three to five years would provide insights, as would comparing these percentages

with industry averages from /obert *orris Associates or similar data providers. At present,

however, we are loo#ing at these figures in regard to calculating the subject company's AC for a

given period of time. The manner in which inventory and C" are accounted for varies across

companies in the same industry, possibly necessitating adjustments for comparison purposes. $n

addition, companies may change their accounting methods from year to year, which leads to

confusing results in need of adjustment.

$n general, C" is calculated as follows5

eginning inventory

7 0urchases

6 "oods available for sale

+ 8nding inventory

6 Cost of goods sold

As this formula illustrates, several accounts affect C" and thus gross profit, pretax

income, and AC. "iven the several "AA0+approved methods for calculating C", the exact

same business underta#ing the exact same transactions could be accounted for in different ways.

irst of all, the valuator must recogni)e the type of inventory accounting used by the company

(e.g., does it use $1, 3$1, or specific identificationN!.

The bottom line is that a choice between $1 or 3$1 leads to higher or lower C",

which in turns leads to a lower or higher pretax income and thus AC and taxable income as well

as a lower or higher ending inventory balance. $f inventory costs are rising, using $1 results in


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greater reported income than 3$1 because the goods purchased before the price increases are

deducted against revenues before expensing the goods purchased most recently at higher costs.

The general implication here is that if 3$1 is used, the ending inventory will be based on the

older, lower+cost units (inventory may be understated on the balance sheet! and the C" will be

based on the more recent, higher+cost units (net income may be understated!. The opposite holds

true as well5 &se of $1 (compared with 3$1! may overstate average inventory value and

overstate net income (through a lower C"!. The important assumption for both of these

conclusions is that inventory costs are rising. 2ote the following summary facts, assuming that

inventory prices are rising over time5

Use of FIFO Use of LIFO

C" &nderstated 1verstated

8nding inventory 1verstated &nderstated

0retax income 1verstated &nderstated

AC 1verstated &nderstated

$n general, $1 leads to a more accurate representation of the condition of the business

because inventory is carried at the more recent costs, and C" reflects the actual pattern of sales

out of inventory. /estating income statements and balance sheets to an $1 basis is one of the

more common adjustments made to compare subject companies with other similar companies.

$n regard to tax issues, note that there are strict $/ guidelines that can tie the use of an

accounting method for inventory to both boo# and tax purposes. $n other words, a business

owner typically is prohibited from using one inventory approach for tax purposes (to minimi)e

net income and income taxes! and another for accounting or boo# purposes (to maximi)e net


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income!. Thus, if a company chooses to use 3$1 for tax purposes (understate income!, then it

must also use 3$1 for boo# purposes. The 3$1 impact on reducing reported income will

continue as long as company sales stay at the same level or increase relative to purchases of

inventory. hould sales fall relative to new inventory purchases, the opposite effect will emerge

as the older, lower+cost inventory items are sold and charged against revenues. 2ote also that the

process of forecasting future cash flows is complicated by the use of 3$1. The act of using

artificial costs for both inventory and C" that do not reflect the actual out+of+poc#et expenses

will necessitate adjustments to the forecasted cash flow results.

An interesting real+world situation involving the 3$1 versus $1 choice concerns

automobile dealerships. The $/ reuires dealers to include an analysis of the impact of 3$1

under inflationary conditions (the so+called 3$1 inflation adjustment!. 0roblems arose when

numerous dealerships chose to omit this analysis (either intentionally or negligently! or

performed improper calculations. 3egally spea#ing, such omissions could allow the $/ to

prevent these dealers from using 3$1 for purposes of saving tax dollars. owever, the

exceptional influence of dealers (through the 2ational Automobile -ealers Association K2A-AL!

led to an agreement that allowed dealers who failed to properly submit the 3$1 adjustment to

ma#e a payment eual to =.@ percent of their 3$1 reserves as of the preceding year end.

$n strict business valuation terms, the evaluation of privately held auto dealerships calls

for an adjustment of mar#et comp data (if using the guideline public company method! to reflect

the fact that almost every publicly traded auto dealership uses $1, not 3$1. &se of $1

tends to maximi)e reported earnings, in line with a legitimate goal of companies that report their

earnings publicly. This adjustment affects both the income statement and the balance sheet. $n

most cases, it is wise to enlist the support of your C0A or tax attorney to ensure proper


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adjustments (for both the 3$1 adjustment for tax purposes and the adjustment to the financial

statements of mar#et comp candidates!.

"iven the importance of inventory accounting in regard to both the income statement and

balance sheet, another example that illustrates the dynamics of this area is worthwhile. 4e will

wal# through the impact of changes in the following accounts that ma#e up the C" calculation5

eginning inventory ($!

0urchases

8nding inventory (8$!

tarting with $, let's see what happens if it is subseuently determined that a large

portion of the $ was obsolete or damaged. Consider the impact5

Before After Difference in CGS and ACF

$ :DD 9>D

7 0urchases ?DD ?DD

"A EDD @>D

+ 8$ :DD :DD

C" ?DD >>D +>D 7>D

A decrease in $ reduces C" and increases AC accordingly. 2ow we loo# at a change

in purchases over the course of a year5


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$ :DD :DD

+ Purchases 600 400

6 "A EDD ?DD

- EI 200 200

6 C" ?DD =DD +:DD 7:DD

This shows the importance of the level of purchases made in the year before a business is

placed on the mar#et. A business owner can manipulate purchases to increase the reported AC

by simply reducing the amount of new purchases to inventory. 1f course, there is a danger of

going too far and having insufficient inventory to meet customer demand, and sales may fall.

owever, carefully engineered reductions in purchases of new inventory can increase AC for

that particular year. 3ower purchases during one year may also lead to a lower $ for the next

year, which in turn would lead to a higher C" and lower AC. $f the company is sold during the

year after the reduced purchases, however, this may not be readily apparent to all buyers.

2ow we loo# at the effect of adjustments to 8$ on C" and AC. Consider the following

scenario5


$ :DD :DD

+ Purchases 600 600

6 "A EDD EDD

- EI 200 300


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6 C" ?DD >DD +9DD 79DD

$n this case, let's assume that the 8$ is improperly valued because of recent significant

increases in the cost and thus mar#et price of such inventory. This is not unrealistic for certain

industries over time (e.g., values of gasoline inventories fluctuate because of major political and

economic changes!. $f the 8$ is valued higher, then C" will be reduced and AC increased by

the amount of the change. This particular situation should help clarify the importance of

inventory accounting (i.e., the differences between $1 and 3$1!. The higher 8$ balance could

be the result of an accounting change as well (e.g., from 3$1 to $1!. This switch would mean

that the older, cheaper units will be expensed, and the newer, costlier units will be held in 8$ (8$

is thus higher and C" is lower than under 3$1!.

1perationally spea#ing, inventory analysis revolves around the inventory turnover ratio,

which is the average number of times the average inventory level is turned over or sold during

the year. The recent popularity of just+in+time inventory has increased this ratio in many

industries. The usefulness of this ratio and many others is found in comparing it over time for the

subject company and with industry averages. The specific bac#ground of a given company in a

given industry must be ta#en into account because rising inventory, for example, may be

interpreted in different ways. $t may signal a decline in sales or a rise in obsolete, difficult+to+sell

goods, which could necessitate a sale or discounted pricing that would reduce the gross profit

margin. Alternatively, it may simply reflect the accommodation of rising sales levels overall,

which obviously is a positive development. $n every case, however, focus on the change from

period to period and compare the subject company's position with the industry norms.


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The main point from this analysis is that accounting for inventory and C" has a

substantial impact on the income statement and ultimately on AC. $t is necessary to as# the

owner or his or her accountant to clarify the company's accounting procedures for inventory and

to confirm whether an actual count is made at year end to verify the reported balances. 1verall,

changes in inventory and inventory accounting procedures can materially affect total assets,

current assets, and financial statement analysis insights regarding liuidity (current or uic#

ratio!, profitability (return on assets!, and activity (inventory turnover! and thus business value.

$n regard to business valuation via the third A/* component (mar#et+based valuation!,

Chapter > covers the related valuation techniues that rely on sale prices paid for similar

companies. 2ote that the $RC1*0 database does not include inventory in its price to cash

flow and price to gross revenue multiples. Their logic is that inventory values vary greatly from

one company to the next, even in the same industry, because of the owner+specific decisions

related to the purchase and storing of inventory before and near the time of selling the subject

company. $n other words, the purchase price may include a certain amount of inventory that

differs dramatically from the optimal holding amount. Thus, inventory amounts tend to distort

the *J figures presumed to arise out of actual business sales. owever, because $RC1*0

normally includes inventory data, these amounts can be added bac# and the multiples adjusted on

a case+by+case basis to compare apples with apples (other mar#et comp databases!.

Fi"ed Asset Accounting

0urchases of furniture, fixtures, and euipment (Q8! or property, plant, and euipment

(00Q8! involve the purchase of fixed assets that must be capitali)ed and then depreciated over


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their useful lives. uch purchases raise many interesting issues in terms of evaluating a company

to estimate its *J. uch issues include5

+ -epreciation for tax versus boo# purposes

+ Adjusting depreciation methods to allow meaningful comparisons of companies when using the

mar#et approach to business valuation

+ 8stimating the *J of these assets for certain valuation methods

-epreciation is the process of allocating the value of a fixed asset with a useful life of

more than one year over the period of time in which the asset is believed to contribute to the

economic production of the company. -epreciation (similar to amorti)ation! is a noncash

expense because it does not reflect an actual current period cash outlay. ixed assets are

capitali)ed at their original cost and then depreciated over their useful lives in one of several

possible fashions. The two most common alternatives are straight+line and accelerated

depreciation, whereby straight+line involves a consistent depreciation expense each year over its

useful life (e.g., the original cost is divided by the estimated number of years of service, and this

result is entered each year on the income statement as an expense that reduces net income!.

3arger companies are li#ely to have different depreciation procedures for tax as opposed

to boo# purposes. or tax purposes, they see# to minimi)e taxable income as much and as soon

as possible because of the time value of money. 8ven though the overall deductions are the same

amount whether straight+line or accelerated methods are used, the accelerated depreciation

techniues can reduce current tax obligations and thereby allow the company to use these tax

savings until the difference is paid in later periods. or boo# purposes, these larger publicly


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traded companies see# to maximi)e reported income and earnings per share. As a result, they are

more li#ely to use a straight+line method for financial reporting purposes.

maller companies are li#ely to use only one method of depreciation. Typically this

means that they will use accelerated depreciation to minimi)e their tax obligations.

&nfortunately, this also reduces their reported boo# income as well as the boo# value of the fixed

assets and the total assets of the company.

As described later, depreciation expense typically is added bac# to pretax income to

arrive at a company's AC because this is a noncash expense and no actual cash outlay was made

in this amount during the current period. avvy entrepreneurs will reali)e that even though

depreciation expense is included in AC, many companies need annual capital expenditures to

maintain or expand their productive capacity. Therefore, they will account for this necessary

expenditure in one manner or another. ecause of a generally accepted custom among valuators

and the manner in which privately held mar#et comp statistics are presented, however, adding

bac# or counting depreciation and amorti)ation expense toward a company's AC figure is

necessary in practice.

1perationally spea#ing, a trend analysis of the subject company's Q8 and annual

depreciation expense levels will help the valuator assess the historical sufficiency of this

important investment (for many companies in manufacturing or other asset+intensive industries

such as dry cleaning or print shops!. A common detractor from business value is the

underinvestment in fixed assets for such companies (i.e., deferred investments in capital assets

lessen business value!. $f future investments are needed to maintain current production levels, the

related debt service reduces future period AC. Clearly, the lower the future cash flow generated

by the business, the less it is worth today.


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or companies that pay a C0A to prepare a statement of cash flows, information about

capital expenditures is readily available. &nfortunately, most small businesses use compiled

statements rather than reviewed or audited statements, which contain this useful financial

statement. 4ithout a statement of cash flows, the valuator must evaluate changes in original cost

of Q8 in light of the current year depreciation expense to ma#e progress in verifying the

actual amount of such expenditures. imply as#ing the owner to list all such expenditures may be

helpful, as is a careful review of the company's federal tax return.

1ne of the more important valuation steps is locating and evaluating similar companies

for purposes of applying the guideline public company valuation method. As explained in

Chapter >, bringing the mar#et comparable companies in line with the subject company entails

several adjustments. 2otably, restating each company's income statement to reflect similar

depreciation accounting is one of the more important adjustments. Although this process can ta#e

time and create certain clerical challenges, it is necessary to compare apples with apples. or

more insights into depreciation and fixed asset accounting, consider purchasing an introductory

or intermediate accounting textboo# or primer such asAccounting for Dummies,written by


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can be a critical due diligence concern for a buyer or a valuator. $f you don't as#, you may not

#now until it is too late.

Unre!orted Sales Revenue

4ithout a doubt, unreported revenue is one of the most challenging aspects of evaluating a

business for purchase. *any businesses (perhaps a majority! fail to report all revenues for a

variety of reasons. Certain types of businesses (typically those with substantial cash sales! are

notorious for s#imming revenues off the top of the income statement. /estaurants and other

food+related businesses, industries with low+price services such as air conditioning service and

repair or landscaping businesses, and any other business that collects cash from customers (as

opposed to chec#s or credit card payments! are li#ely to underreport revenues.

$nterestingly, the response to such underreporting varies greatly from one party to the

next. *ore often than not, the buyer will understand this situation and accept it as part of the way

small businesses are operated. 1ccasionally, however, a buyer will respond with anger and

disappointment because of his or her personal preference for playing by the rules. These buyers

figure that they have paid taxes, so everyone else should pay their fair share. *ore importantly,

underreporting will lead some of these buyers to wonder what other records of the subject

company are false or based on lies and deceit.

/egardless of the rationale behind each person's preference in this area, underreporting of

revenues presents a problem for valuators. The challenge is to determine the following5

4as income earned but not reportedN

$f so, how much, and can it be proven by the ownerN


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*any buyers ta#e the position that the owner has enjoyed the benefit of avoiding tax

obligations, so he or she should not be able to reap benefits on the other side as well (each dollar

of cash flow increases company value by a factor of one to three for small businesses!. 1n the

other hand, if the revenues can be verified, they represent real cash flow generated by the subject

company. Accordingly, the business value should be increased by this extra cash flow. A common

reaction from buyers is to give at least partial credit to the nonreported revenues, which typically

represent bottom+line profit and cash flow. ecause of the sensitive nature of this situation (the

$/ considers nonreporting of income the cardinal sin of taxpayers!, the buyer or valuator may

not learn about this extra income until a strong rapport has been built between the parties.

The primary consideration in terms of business valuation is the determination of how

much verifiable income (cash flow! was not reported and what impact this extra cash flow will

have on business valuation. A complete valuation analysis will incorporate these findings into the

final analysis.

A similar situation arises when business owners intentionally postpone recognition of

revenues into the next year to avoid current period tax liabilities. There is a huge difference

between tax avoidance and tax evasion, so this is very different from hiding income. owever,

the postponement of revenue recognition can be at odds with "AA0s.

The valuator's main concern is the impact of this delayed recognition on business value.

$f there is a pattern wherein the owner postpones similar amounts each year, it will tend to

balance out in the long run. Today's postponed revenue is tomorrow's revenue, so the primary

difference is when and how much tax is paid by the owner. 0ostponing revenue from a good year

into what may be a bad year reduces the overall taxation by shifting revenue to lower brac#et


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rates. The major implication of postponing these revenues is found in the time value of money,

whereby the owner has the money that would have been paid in taxes for one more year. $n other

words, by postponing the tax payment, the owner can invest the related tax cost for one year and

hopefully earn a positive return.

$n conclusion, the valuator must carefully assess the potential underreporting of revenues

and determine its impact on business value. $f the business is being valued for purposes of

acuiring the company, this nonreporting may elevate the overall ris# associated with the

company and its operations. The $/ has been #nown to sei)e assets and shut down businesses

even if the pertinent tax liability was that of the prior owner. $t may be possible to recoup any

such damages from the original owner, but only at great cost in terms of time, emotional capital,

and money for legal counsel.

Investments in Affiliated Com!anies

4e now turn to the second list of potential adjustments with the understanding that these areas

are not encountered as often as the items on the first list. Although they are not encountered as

often, they can have a substantial impact on the company's reported versus actual AC.

andling investments in affiliated companies can be either straightforward or perplexing,

depending on the details. Affiliated companies can be affiliated in the sense that they are directly

related to the subject company (e.g., a manufacturing company may establish a separate

mar#eting company to facilitate tax planning for the owners, or a water utility may establish a

separate construction company to maximi)e the recorded investment costs in fixed assets to

maximi)e their regulated rate of return!. Affiliation in this sense means related in their business

activity.


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$f only one or the other affiliated companies is being valued, situation+specific

adjustments must be made to reflect the economic viability of the subject company. $ts value may

be decreased as a result of this affiliation if the relationship is in jeopardy (e.g., if the subject

company is being purchased by new ownership without the benefits of the affiliated company!. $f

they are being valued jointly, the ideal situation would be consolidated statements (i.e., an

income statement and balance sheet that combines the economic activity of both companies!.

Although this is not always possible for several reasons, it is worth the time involved to reuest

such statements when evaluating the companies.

A second type of affiliation refers to common ownership only. $n other words, the only

lin# between the companies is common ownership. The real challenge occurs when the two

different companies are accounted for on the same financial statements (e.g., a retail business in

which the owner also owns and operates a ranch for recreational purposes and accounts for them

on the same financials!. Carefully segregating the ranch revenues, expenses, assets, and liabilities

is necessary. Complete disclosure is necessary for a meaningful assessment of the core company.

Com!any$Shareholder %ransactions

Also called intracompany transactions, these events alter the income statement and balance sheet

as a result of uniue transactions that benefit the relevant parties. or example, it is not

uncommon to see loans made to and from the company from and to one of the shareholders. $f

the company lends money to the shareholder, the shareholder typically pays the loan bac# with

interest. This is one way to ta#e money out of the business and give it to the shareholders without

paying income taxes. $f the shareholder lends money to the company, the company will pay bac#

the loan plus interest. This is one way for the shareholder to earn an above+average return on his


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or her idle cash or a way for the company to obtain funds at low rates of interest. $n each case,

the rates charged and received often differ from mar#et rates.

/egardless of the direction of funds, adjustments may be necessary to normali)e the

income statement and balance sheet. As described later, all interest paid by the company is added

into AC, so in a sense the amount is irrelevant. $f the company earns interest income from loans

made to shareholders, this income should be bac#ed out of AC for the same general reason that

interest expense is added into AC. All financial implications related to the company's capital

structure (primarily interest expense! should be factored out because of the wide variation in debt

levels from one owner to the next. $nterest expense is added into AC to arrive at a figure from

which the new owner can service his or her own debt levels, which may be higher or lower than

those of the current owner. Thus, all interest expense and interest income, regardless of their

source, should be incorporated into the AC results by adding bac# the expense and deducting

out the revenue.

4hether dealing with affiliated company transactions or company+shareholder

transactions, a #ey premise is to adjust these events to what is considered to be an arm's+length

transaction. Another good example concerns the handling of real estate. $t is common for

business owners to be advised by their C0As to establish a separate holding company to hold the

real estate on which the business is located for tax purposes. $n these situations, the business

typically pays rent to the affiliated company at a level that minimi)es taxable income for the

holding company (as opposed to mar#et+level rents!. Thus, the rent expense may be understated

or overstated relative to mar#et rates. The business AC figure should be adjusted accordingly to

reflect mar#et levels of rent for similar properties.


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Another type of intracompany or intercompany transaction is the payment of

management or consulting fees. uch management fees are more li#ely to be intercompany

transactions that are designed to minimi)e income for one entity to reduce the overall tax burden.

This is based on the fact that a given amount of profit split between two entities will result in a

lower effective tax rate than if all profits were contained in one entity. This important fact is a

result of brac#et creep, or a progressive income tax system wherein higher profit levels are taxed

at higher rates.

Unrecorded or Unfunded Pension Plans

This situation typically is an issue only for larger companies, e.g., 8nron Corporation. 1f course,

the larger the employee base and payroll, the greater the potential danger of improperly funding

the related pension obligations. $n general, two potential misfunding situations may arise,

necessitating current+ or next+period cash outlays to bring the funds into compliance with

regulations5

Amount owed to employees as a result of prior years of service

Amount owed to employees as a result of probable future service

As of 9HH;, the A has reuired full funding of all past and future service+related

pension obligations. 3arger companies hire out pension management services and ma#e an

annual payment into the pension fund based on statistical and actuarial estimates based on the

number of employees, hours wor#ed, wage and salary amounts, and so on. The manager of the

fund (called the trustee! invests these funds. The difference between the present value of all


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future pension obligations and the value of the fund determines the amount of the annual

payment.

The following problems may be encountered when evaluating a company's pension

situation5

+ $nsufficient payments into the fund in prior years out of neglect

+ $ncorrect actuarial estimates regarding future (now historical! rates of return or future employee

or salary levels leading to improper fund levels

+ 1verpayments resulting from incorrect estimates or managerial incompetence

1bviously, overpayments might add value to a company, but underpayments will

certainly detract from value. $n regard to AC figures, prior year figures may need to be reduced

to reflect the proper contributions, or future period cash flows will be reduced to ma#e up for

prior year deficiencies.

As noted earlier, it is typically only in larger companies with do)ens to hundreds or

thousands of employees that this situation becomes extremely problematic. owever, even

smaller companies can have problems related to their pension plans. or example, whether the

small business uses a implified 8mployee 0ension (80! or =D9(#! plan, these too can be

underfunded. $t is important to verify that such plans are properly funded when attempting to

value (or purchase! companies that offer pension benefits. 8ach company must meet its legal

funding reuirements or ris# future financial and legal difficulties. $f such plans are underfunded,

then once again the prior year AC figures or future period estimates of AC or cash flow must

be adjusted to reflect the economic reality associated with these retirement plans.


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&ne$%ime '"!enses or (osses and &)ner*s Com!ensation

4ith this category of adjustments, we move closer to the more traditional type of analysis that is

done when estimating the cash flow+generating capacity of small businesses. $t may be that all or

none of the prior issues (e.g., underfunded pensions, intercompany transactions, unreported

income! warrant attention. $n all cases, however, certain mandatory, routine calculations must be

made and added together to arrive at the customary figure of cash flow #nown as AC. As

described later, AC is the sum of pretax income, owner's salary and benefits, depreciation and

amorti)ation expense, interest expense, and any one+time, unusual, nonrecurring expenses or

revenues.

4hether or not you delve into the numerous prior issues that can affect a company's AC,

calculating AC based on the formula just listed is your gateway to understanding how small

businesses are commonly valued by business bro#ers and valuation professionals ali#e. Any one+

time or nonrecurring expenses, losses, revenues, or gains should be accounted for (added bac# or

deleted from AC! when calculating a company's cash flow generation to obtain a measure that

reflects the amount a new owner can expect to earn. Clearly, a one+time event such as a favorable

settlement of a lawsuit that included receipt of treble damages is not expected to occur each year

and should not be included in the company's AC results. 0ayment of a one+time severance

pac#age for a #ey employee probably is a nonrecurring event and should not be deducted from

AC.

8arlier, we discussed in some detail the top line of an income statement5 gross profit. 4e

noted that net revenues minus C" euals gross profit, which we deemed an important indicator

of financial success to the extent that the greater the gross profit margin is, the more room for


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error there will be in terms of other expenses further down the income statement. 4e interpreted

this gross profit figure as being the contribution toward covering other costs and generating

profits made from the sale of product after accounting for the direct cost of the product.

After gross profit is presented on the income statement, the next section of costs concerns

general and administrative or operating expenses. These expenses are deducted to arrive at either

net income before taxes and interest (earnings before interest and taxes K8$TL! or net income

before taxes (pretax income, or earnings before taxes K8TL!. inally, income tax expense is

deducted to arrive at after+tax earnings or net income.

-epending on the type and si)e of company, 8$T or earnings before interest, taxes,

depreciation, and amorti)ation expense (8$T-A! may serve as the foundation for applying

multiples to arrive at an estimate of company value. *iddle+mar#et and larger small businesses

may be best valued using 8$T or 8$T-A. pecific industries may also be #nown for use of

these multiples. or example, one of the largest national real estate bro#erage franchises uses

8$T-A as its preferred measure of income for estimating value in regard to acuisitions (on

average it pays approximately three times 8$T-A, whereby an adjustment is made if the

owner's salary is above or below mar#et!.

Intangile Assets

The final section of the primer is intended to supplement the information presented in the %Asset

or Cost Approach to usiness Jaluation% section of this C-+/1*. All businesses can be viewed

as a collection of assets being combined in ways that see# to maximi)e profit. Assets come in

many forms, as a uic# glance to any company's balance sheet shows. Current assets and fixed

assets, liuid assets and hard assets, clean assets and encumbered assets are all different


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categories of assets. 1ne more relevant distinction exists5 tangible and intangible assets. $t is

important to reali)e that every company possesses at least a minimal amount of both types. The

most common association with the term assetsis to tangible assets such as cash, accounts

receivable, inventory, and euipment. 3ess common but in many ways more important are

intangible assets, which also ta#e many different forms, including goodwill, trade names, patents,

and covenants not to compete.

/eali)e that not every balance sheet includes intangible assets. $tems such as goodwill

and a covenant not to compete, for example, are formally recogni)ed (per "AA0! only after one

company or buyer has acuired another company and its assets. $n other words, the fact that a

business enjoys the goodwill of its customers does not merit recording of goodwill on the

company's balance sheet. 1n the other hand, recall that if a business is purchased for :DD,DDD

and there are only 9DD,DDD in tangible assets, the balance must be allocated to a variety of

intangible assets, often in an arbitrary manner. There should be a logical, coherent, and justifiable

allocation, but it will inevitably be subjective.

or example, goodwill is an intangible asset that typically represents the fact that a

business is worth more than the sum of its tangible assets. The entire 9DD,DDD from our example

could be allocated to goodwill. *ore commonly, particularly for the purchase of smaller

businesses (non+ortune >DD companies!, the 9DD,DDD would be allocated to different types of

intangibles such as trade name, customer list, and covenant not to compete. ow much is

allocated to each category is at the discretion of the buyer and seller. The entire 9DD,DDD, no

matter how it is allocated, will be amorti)ed over future periods. The only significance for boo#

accounting (as opposed to tax accounting! is the chosen period of amorti)ation, which should


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reflect the useful life of the asset. The shorter the useful life, the greater and sooner the

deductions against revenues will be in the determination of net income.

The choice of amorti)ation period for tax purposes can have much greater importance

because a deduction today is worth more than a deduction in the future (time value of money!.

As the tax laws currently stand, however, all intangibles are to be amorti)ed over a fifteen+year

period. 0revious laws allowed uic#er write+offs for covenants not to compete but left the

deductibility of goodwill as a uestionable practice. The recent law was a tradeoff. All

intangibles can be amorti)ed (tax deductions!, but only over a fifteen+year period. 1nce again, it

is possible to use different deductions (amorti)ation! for accounting purposes and tax purposes.

Tax purposes reuire a straight+line, fifteen+year amorti)ation and boo# purposes are more or less

discretionary.

Another minor application of the concept of intangibility relates to due diligence

proceedings. ervice businesses are almost exclusively based on intangible ualities such as

customer service, availability, and pricing advantages. The proper way to view intangibility in

this regard is that a customer is purchasing a bundle of promises, including general customer

satisfaction. $n terms of evaluating a service business acuisition, the ualitative review hinges

on assessment of these intangible ualities.

Valuation Issues

*any of the valuation formulas for businesses call for analysis of intangible assets. $ntangible

assets are one of two asset categories that are long term in natureS the other is fixed assets.

$ntangible asset valuation can be approached either generally as a loose collection of

miscellaneous, nonphysical assets in the context of valuing a going concern or in terms of a


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single, specific asset such as a patent. $n almost all cases, valuation of intangibles is necessary as

part of some larger event, ranging from the sale of an entire business to calculating damages

resulting from a patent infringement. 1ther reasons for valuation include5

acilitation of ban#ruptcy proceedings (liuidation or reorgani)ation!

Calculation of value as collateral for a loan

Tax planning (gifts, estates, intercompany transactions!

*iscellaneous dispute resolutions

As always, there is great latitude in selecting and applying the various concepts and

approaches used by appraisers and bro#ers in their attempts to value these interesting assets.

efore loo#ing into the valuation concepts, consider the following accounting definition

of intangible assets5

2oncurrent, nonmonetary, nonphysical assets of a business. Although they generally lac#

physical characteristics, they have values because of the advantages or exclusive

privileges and rights they provide a business. They generally arise from two sources5

exclusive privileges granted by governmental authority or by legal contract and by

superior entrepreneurial capacity or management techniues.

rom a valuation point of view, intangible assets normally incorporate the following

characteristics5

$dentifiable as to creator, existence, and ownership


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Associated with past, present, or future economic benefit (increase in revenues or decrease in

costs!

$n legalese, intangible assets comprise a legal %bubble of rights,% which vary dramatically

from one type of intangible asset to another. The two broad characteristics just described refer to

the legal existence and economic value that ma#e up the foundation of valuation for intangible

assets. 4ithout both of these components existing simultaneously, there is little need for

discussion or analysis. or example, a legal patent for a worthless product is as unattractive as a

cutting+edge technology without patent ownership (patent owned by another party!.

0rofessional business appraisers will tell you that the selection of valuation approaches

Documents

4 Accounting Primer