Accounting and appraisal are interrelated disciplines. After all, financial statements are the foundation for valuing a business. So it’s imperative that valuators understand accounting terminology and how to adjust for material differences in accounting methods.
Acceptable accounting methods
Private businesses use different methods of accounting depending on what works best for their financial circumstances. Take inventory as an example. A manufacturer might use the last-in, first-out (LIFO), first-in, first-out (FIFO), average cost, or specific identification method to report its inventory.
All are acceptable methods under Generally Accepted Accounting Principles (GAAP). Some privately held companies, however, don’t follow GAAP and may simplify accounting with cash or tax-basis reporting.
Importance of adjustments
Balance sheet and income statement items differ depending on the accounting methods used. Therefore, valuators need to adjust a subject company’s financial statements – as well as market data obtained from public and private comparables – for differences in accounting methods.
Valuation professionals most frequently make adjustments in areas such as:
- Fixed-asset depreciation,
- Revenue and expense recognition timing,
- Bad debt write-offs,
- Treatment of intangibles,
- Differences in inventory reporting methods, and
- Contingent or unrecorded liabilities.
Valuators unfamiliar with accounting may not realize the importance of these adjustments. For example, a fictional novice valuator might use a pricing multiple of 1 times the prior year’s revenues to value an accounting firm. The valuator obtains this multiple from sales of comparable private firms that had used the accrual method to report revenues.
But the subject company reports revenues using the cash-basis method, meaning it reports revenues only when it collects cash, not when services are rendered. Thus, the novice appraiser’s use of the prior year’s cash-basis revenues likely understates the company’s current value if the firm is growing. If those revenues are adjusted to accrual basis, a growing company’s appraised value probably will be higher. Thus, the valuator needs to determine industry accounting norms and then adjust the subject company’s financial statements to match the methods the comparables used.
Apples to oranges comparisons
As the previous example shows, failure to adjust financial statements for differences in accounting methods results in apples to oranges comparisons — and potentially erroneous value conclusions. That’s why it’s critical for companies to engage professional valuators with a thorough understanding of accounting methodology.