David Anderson is principal of David Anderson & Associates, a Philadelphia forensic accounting firm that provides a full range of business valuation and other forensic accounting services in Philadelphia and the Delaware Valley. This is the third of a five-part series in which Anderson reviews the basics of business valuation.
Determining the worth of your business can be quite complicated. Before the actual business valuation can begin, a number of steps must be taken.
“The value of a business often depends on the earnings it generates,” said David Anderson, a business valuation expert in Philadelphia and the Delaware Valley and principal of David Anderson & Associates.
“Small business owners” he said, “have a fair amount of latitude in choosing how they report the financial operations of their business, often selecting alternative accounting practices that lessen their income tax obligation.”
In two earlier posts, Anderson explained the first two steps of the business valuation process — determining the standard of value and deciding on the premise of value. This third in a series of articles examines the steps a business valuation expert sometimes must take to bring a company’s financial statement on an equal footing.
Because of these alternative practices, he explained, a business valuation expert frequently needs to adjust the historical financial statements before implementing selected business valuation approaches and methods. Making these adjustments is often referred to as “normalizing” the financial statements.
“Normalizing the financial statements should provide the valuator with a more economically realistic picture of the value of the assets and the financial operating results of the business,” Anderson explained.
These financial statement adjustments represent estimates and often fall into one of the three categories as noted below:
Comparability adjustments are intended to make the company more comparable to guideline companies or companies within the industry group that were used in comparative ratio analyses. For example, if the company being evaluated used the last in, first out (“LIFO”) inventory method of accounting while the industry group uses the first in, first out (“FIFO”) inventory method, this adjustment would give a valuator a clearer picture of how the company’s financial statement compares to others in its industry.
Non-operating or non-recurring adjustments are removed from the income statement because they are either unrelated to the business operations or unlikely to recur in the future. Non-operating assets or liabilities are elements of the balance sheet that are removed so a more appropriate value of the operating company may be determined.
These assets or liabilities are then added or subtracted to the resulting computed value to arrive at the total equity value of the company. An example of these types of adjustments would be the costs associated with discontinuing a portion of the business.
Discretionary adjustments are those expenses that are usually under the sole discretion of management, or more typically, the owners of the business. Often these expenses are between the company and the owners of the company (i.e., related party transactions). These adjustments are most appropriately made when valuing a controlling interest in the company and they generally represent the difference between the actual recorded book expense and the expense that would be incurred if transacted between the company and an independent third party.
Examples of these types of adjustments include: Officer’s and owner’s compensation, owner’s perquisites, entertainment expenses, automobile expenses (e.g., personal use of company cars), compensation to family members, and other related party transactions.
Once these three types of “normalization” adjustments have been made to the financial statements, the business valuation expert can begin to analyze the value of the business under each of the different valuation approaches and methods, Anderson said.
In upcoming weeks, Anderson will continue to explore the process business valuation experts undergo to determine the worth of a business.
If you require the services of a business valuation expert in Philadelphia or any other forensic accounting services in Philadelphia and the Delaware Valley, please contact the Philadelphia forensic accounting firm of David Anderson & Associates by calling David Anderson at 267-207-3597 or emailing him at firstname.lastname@example.org.
About David Anderson & Associates
David Anderson & Associates is a Philadelphia forensic accounting firm that provides a full range of forensic accounting services in Philadelphia and the Delaware Valley. The experienced professionals at David Anderson & Associates provide forensic accounting, business valuation, fraud investigation, litigation support, economic damage analysis, business consulting and outsourced CFO services. Company principal David Anderson has more than 30 years of experience in financial and operational leadership positions and is a Certified Public Accountant, a Certified Fraud Examiner, a Certified Valuation Analyst and a business valuation expert in Philadelphia.