Could Missing Non-GAAP Adjustments Adversely Affect Your Concluded Value?
Why it Matters
This article examines the major nonconformance issues the average valuator may face, where to find the information necessary to investigate, and how to make the adjustments to conform with GAAP. The adjustments discussed are not exhaustive but do cover the more common adjustments valuators should consider. While a valuation is not an audit, the valuation analyst must recognize material deviations from GAAP and understand how to make the necessary adjustments.
Valuation principles require the financial statements used be prepared based on generally accepted accounting principles (GAAP) unless there is a different agreement by the parties to the valuation. Otherwise, adjustments must be made to non-GAAP compliant financials prior to doing any in-depth financial analysis. While these adjustments are not specifically detailed in the NACVA standards, they are implied in the due professional care requirement and in the expectation that a valuator will follow generally accepted valuation practices.
So why is this so important? First and foremost, non-GAAP compliant statements may misrepresent a companyâ€™s true financial condition, which in turn, can skew financial ratios, obscure its true earnings potential, and possibly cause the valuator to incorrectly conclude the subject company should be treated as a going-concern. Second, any industry financials used for comparison with the subject company are most likely presented using GAAP.
There are many valuators who are not CPAs, making it more difficult for those practitioners to detect and correct GAAP errors. In addition, many of the statements are initially prepared by non-CPAs so nonconformance with GAAP may be present in many of the financial statements with which valuators must work. While most valuation engagement letters contain language stating the provider guarantees the accuracy of the financial statements given to the valuator, valuators still have a responsibility to make adjustments for obvious GAAP errors in order to bring financial statements into compliance with GAAP to the extent necessary for the valuation conclusion to be materially accurate.
Valuators should not be expected to be financial auditors and should specifically state that in the engagement letter and in the valuation report. However, valuators should ask questions necessary to ensure there are no GAAP departures that could significantly affect the valuation conclusion. If there are many GAAP compliance issues, it should be brought to the attention of the client (and attorney, if litigation is involved). One of three options are then available: 1) ask the companyâ€™s CPA or other financial professionals to fix the non-compliance issues; 2) if you are a CPA and comfortable fixing the issues, get a separate engagement letter and charge for the additional services (which expands your liability for the engagement); or 3) partner with a CPA to whom you can refer the client. If none of these options are available, consider withdrawing from the engagement.
This article examines the major nonconformance issues the average valuator may face, where to find the information necessary to investigate, and how to make the adjustments. This is not an exhaustive list but does cover the more common issues. Again, a valuation is not an audit; however, an analysis of any obvious and material deviations from GAAP should be considered. Here are some of the more common sources of nonconformance with GAAP:
Book-to-tax depreciation differencesâ€”When tax returns or tax-basis financial statements are used, the valuation must take into consideration tax versus GAAP differences in the financial statements. Most companies take advantage of tax rules that allow them to depreciate their assets much faster than the depreciation corresponding to an assetâ€™s actual useful life and pattern of use. For GAAP purposes, many assets are depreciated using the straight-line method over the assetâ€™s actual useful life. The depreciable base is the assetâ€™s original purchase amount less the estimated salvage value. By contrast, when utilizing the modified accelerated cost recovery system (MACRS), which is a tax depreciation method, the full purchase amount is used as the depreciable base with no allowance made for salvage value. It also assigns the â€śuseful lifeâ€ť based on the asset category to which the asset belong, as specified by the Internal Revenue Service.
By far though, the biggest adjustments have to be made because of Section 179 deductions that allow asset purchases to be expensed in the year they are purchased, up to a ceiling amount. In 2020, the Section 179 total is capped at $1,040,000, although there are specific circumstances that can increase or decrease that amount.
Where to find: You will need a depreciation schedule and the tax returns. The tax returns will have a form detailing the depreciation deduction (IRS Form 4592 and any accompanying schedules) that shows the Section 179 deduction, current MACRS deduction, and other depreciation deductions.
The adjustment: Use an Excel spreadsheet to calculate the annual difference between straight-line deductions for each asset (or whatever GAAP method best represents the actual use of the asset) and the Section 179 and accelerated deductions.
Cash-basis booksâ€”GAAP requires accrual-basis accounting to more accurately match income with the expenses incurred in generating that income. If the balance sheet does not show accounts receivable or accounts payable, you may be looking at cash-basis books.
Cash-basis books record revenue when received and expenses when paid. GAAP requires revenue to be recorded when earned and expenses when incurred. To adjust, you will need to know the annual changes in the balances of accounts such as accounts receivable, accounts payable, inventory, prepaid items, and accrued expenses. (You may also have an issue with totally unbooked revenue in some primarily cash businesses.)
Where to find: With some luck, there may be a cash flow statement that will show the adjustments needed to convert to an accrual basis. If not, then looking at any records showing the change in the balances of accounts receivable, inventory, prepaids, accounts payable, and accruals will be necessary.
The adjustment: Keep in mind, cash flow statements convert from an accrual basis to a cash basis, so the adjustments are reversed to convert from a cash basis to an accrual basis.
|Increase net operating income for:||Decrease net operating income for:|
|Increase in accts receivableIncrease in inventoryIncrease in prepaidsDecrease in accts payableDecrease in accruals||Decrease in accts receivableDecrease in inventoryDecrease in prepaidsIncrease in accts payableIncrease in accrualsDepreciation and amortization|
Then adjust the balance sheets to reflect the income statement adjustments.
Deferred revenue booked as revenueâ€”Advance payments should be recorded as liabilities until they are earned but are sometimes incorrectly booked as earned revenue.
Where to find: This may be more difficult to find but usually, there is some separate record of advance payments because the customer is owed either merchandise or services. During the management interview, ask about how advance payments are recorded and tracked.
The adjustment: Reduce revenue on the income statement. Reduce either retained earnings (or the current yearâ€™s income line if there is one) and add a liability for the deferred revenue, which is a liability account because the customer has a claim to an asset (cash) if the merchandise or service is never rendered.
Non-existent or unreasonable allowance accountsâ€”GAAP requires that reasonable estimates be made for things like the collectability of receivables and expected warranty claims.
Where to find: Look at prior trends and ratios for things like bad debt and warranty claims to help determine if the estimates are reasonable. If the direct write-off method has been used, which is a non-GAAP method, make sure those write-offs fit the established criteria for reasonableness.
The adjustment: Establish or add to a bad debt expense line and/or warranty expense line as needed on the income statement. Reduce either retained earnings (or the current yearâ€™s income line if there is one) and add or adjust the allowance for bad debt on the income statement (or in the case of the warranty claims, add or adjust the warranty expense account.) Â
Obsolete or damaged inventoryâ€”GAAP requires that inventory be adjusted to reflect its true value.
Where to find: During the management interview, ask about outdated or slow-moving inventory, particularly if the subject company has a lot of high-tech inventory. If the last-in, first-out (LIFO) inventory method is used, it may be necessary to adjust the inventory to current value since LIFO represents the cost of the oldest inventory purchased.
The adjustment: Establish or add to an inventory adjustment expense line. If this is a normal occurrence for this type of business, include it in the operating income. If not, it belongs in the other income/other expense section of the income statement. On the balance sheet, reduce the inventory down to its realizable value and reduce either retained earnings (or the current yearâ€™s income line if there is one) by the amount of the reduction in inventory.
Impaired assets or assets not used in the business (including intangible assets)â€”GAAP requires impaired assets be written down to reflect any diminishment in value. Asset impairment is a complex area of accounting, and an adjustment should only be made if there is an obvious impairment of an operating asset. Assets not used in the active conduct of a business should be considered as non-operating assets and evaluated separately.
Where to find: During the management interview, ask about potentially impaired assets (things like contaminated land) and obsolete equipment, particularly if the subject company has a lot of high-tech equipment. Also ask if there are any assets that are not used in operations. These can include assets held for sale or recreational assets like lake houses and boats, which most likely represent non-operating assets.
The adjustment: (For impaired assets) Establish or add to an asset impairment expense line. If this is a normal occurrence for this type of business, include it in the operating income. If not, it belongs in the other income/other expense section of the income statement. On the balance sheet, reduce the asset down to its corrected value and reduce either retained earnings (or the current yearâ€™s income line if there is one) by the amount of the reduction. (We strongly recommend using a CPA to ascertain the correct amount of impairment.)
(For non-operating assets) Exclude these assets from ratios utilizing asset amounts and value the business without these assets, then add the market value of these assets to the value established for the business. Excess cash can also be an adjustment; if the cash balance is far in excess of what is needed for working capital and/or greatly exceeds industry standards, it is possible the company has excess cash. However, it is also possible the cash is reserved for expansion or other long-term goals, so it is best to clarify this during the management interview.
Income and expenses associated with non-operating assets or liabilities included in operating incomeâ€”In addition to separately considering non-operating assets and liabilities, any income and expenses associated with the non-operating assets and liabilities should be excluded from operating income, and should be considered separately for the purposes of ratio analysis and industry comparisons, especially important when comparing the subject company to its industry peers. An example of a common expense would be depreciation and a common income item would be interest income.
Where to find: Once any non-operating assets or liabilities have been identified, think through what income or expenses would typically be associated with them. Go over that list with management to test your assumptions, uncover any additional associated income or expenses, and to quantify the amounts involved.
The adjustment: Move any income or expenses included in operating income that are associated with non-operating items to the other income/other expense section of the income statement.
Non-conforming capitalization policiesâ€”Capitalization problems can go either way. Routine expenses may have been capitalized, or capital leases may have been expensed. When purchases are improperly capitalized, income will be overstated since the amount is not fully expensed but spread over several periods.
Where to find: During the management interview, ask about the subject companyâ€™s capitalization policy. The current IRS guidelines allow expensing of assets up to $2,500. If the amount of the purchase exceeds $2,500 and will provide benefit for more than one year or the operating cycle (whichever is longer), then it should be capitalized. Keep in mind, capitalization limits less than $2,500 may be more appropriate for smaller companies. Also ask about the companyâ€™s leases to ensure any significant leases have been booked correctly. In February 2016, FASB began changing the lease standards and has continued to issue new pronouncements through 2021. If you are not familiar with them, review the ASC topic 842 (Leases), that details the changes.
|Expense items incorrectly capitalized||Capital items incorrectly expensed|
|Remove the asset from the balance sheetRemove any related liabilityAdd the expense amountDecrease the equity section||Add the asset to the balance sheetAdd any related liabilityDecrease the expense amountIncrease the equity section|
Â Not accruing significant expense liabilities like payroll, payroll taxes, and paid time off (PTO)â€”Wages expense and payroll taxes should be expensed in the period in which the employees worked, which does not always correspond to the period in which they are paid. The absence of any accrued payroll or payroll taxes can be a red flag. It is very rare but occasionally a company will time the end of its payroll so that there will not be accrued payroll. Usually only salaried positions are treated in such a manner. The other possibility is that the accounting is on a cash basis (see previous paragraph regarding cash-basis accounting).
Where to find: During the management interview, ask about the absence of accrued expenses. If they should have been accrued, find out the amounts and the reason behind the non-accruals.
The adjustment: If the non-accruals are the result of cash-basis accounting, then follow the previous guidance for converting cash-basis books to accrual-basis. If not, then adjust the balance sheet to show these liabilities and decrease the equity section by the same amount for calculating ratios. If this is a long-standing practice, adjusting the current income statement as well will invalidate any trend analysis.
Not recognizing the current portion of long-term debtâ€”GAAP requires the current yearâ€™s principal repayment amount associated with long-term debt to be included as a short-term liability. Failure to do so will overstate working capital.
Where to find: Look for the current portion of long-term debt in the current liabilities section of the balance sheet. If it is not there, then ask for the amortization schedules associated with any long-term debt to see what principal amount will be due in the next year (or operating cycle if the operating cycle is longer).
The adjustment: Reclassify the current portion of long-term debt amount from the long-term liabilities section of the balance sheet to the current liabilities section prior to any ratio analysis.
Changes in accounting principlesâ€”In order for financial statements to be comparable and do trend analysis properly, all years used in the valuation analysis must be presented using the current accounting methods.
Where to find: Ask whoever prepares the financial statements if there have been any changes in the accounting principles used during the time period for which you have been provided financials. If you are lucky enough to have been provided financials with accompanying notes, you can check the notes as well.
The adjustment: In this case, an adjustment is not appropriate. Ask for any financials that were run prior to the change in accounting principles to be re-stated so that all the financials provided have been prepared on the same basis.
Change in reporting entityâ€”Likewise, all years used in the valuation analysis should reflect the same reporting entity structure. This often requires restating prior periods to reflect what they would have looked like as a combined entity if subsidiaries are involved. We recently had a case where past year financials did not include a subsidiary but the current one did, so the valuator should not assume all the financial statements provided reflect the same reporting entity.
Where to find: Ask whoever prepares the financial statements if there have been any changes in the reporting entity of which you should be aware. Any acquisitions? Any divestitures? Any discontinued operations included in the operating section? If there are subsidiaries, are those included in the financials for all the years provided?
The adjustment: Again, an adjustment is not appropriate. Ask for the financials to be re-run so that all the financials provided have been prepared on the same basis.
Prior period adjustments/corrections of errorsâ€”Again, for the purposes of trend analysis, the prior period adjustment or error corrections must be moved to the proper year. Prior period adjustments indicate there were errors made in the financial statements in previous years. To avoid confusion and to maintain the integrity and continuity of the accounting records, the previous financials are not changed. Instead, a prior period adjustment is made to correct the beginning balance of retained earnings in the current year.
Where to find: Prior period adjustments should be shown in the retained earnings section of the balance sheet as an adjustment to the beginning balance of retained earnings in the current year or occasionally, shown in a separate statement of retained earnings. Ask for the details of the prior period adjustment to determine what adjustments should be made and in what years.
The adjustment: Prior periods should be adjusted as if the correct accounting methods were used and any errors in the financial statements should be eliminated. Any adjustments made should move the correction of the errors into the year or years the errors occurred. What adjustments need to be made will depend on the source of the errors.
Unusual, extraordinary, or nonrecurring items included in operating incomeâ€”These are items that are unusual in nature and/or infrequent in occurrence and should not be included as part of on-going operations. Any item that fits this description should not be included in the income from operations.
Where to find: During the initial financial analysis, the valuator should look for any non-recurring (one-time) income or expenses as well as any unusual or extraordinary income or expenses. Examples of non-recurring items would be expenses associated with moving an office, or in 2020 or 2021, expenses related to COVID-19. (We certainly hope the latter does not become a routine expense!) Gains and losses on the sale of equipment may be recurring but should not be included in operating income unless the subject companyâ€™s business involves selling equipment. A gain or loss associated with an insurance settlement should also not be included in the operating income.
When evaluating potentially unusual or extraordinary income or expenses, consider the subject companyâ€™s industry and location. What is unusual for one region may be a routine occurrence in another region. For instance, hurricane damage along the coast of Florida is to be expected but hurricane damage in Oklahoma would be extraordinary.
The adjustment: Move any of these non-recurring, unusual, or extraordinary items included in operating income to the other income/other expense section of the income statement.
Integrity issuesâ€”In order to check the integrity of the financials received, valuators can do what is referred to as a rollforward of the equity section of the balance sheet. A rollforward is nothing more than ensuring the balance that has â€śrolled forwardâ€ť is the correct balance. In the case of equity, it typically involves taking the previous equity balance and adding to it the current year income less any distributions. Occasionally, new equity will have been issued (adds to balance) or shares redeemed by the company (reduces balance). The result should match the new ending balance for equity.
More often than we would like, we receive balance sheets that do not balance. When this happens, it is usually due to one of two things: 1) the software may need to have an integrity check run to clear up any internal errors, or 2) an account has been added that is outside the range of known account groupings and the ranges must be adjusted. The latter problem also frequently plagues income statements, which is why the rollforward is important because it will alert you to this possibility. If that occurs, a trial balance can be used to build the corrected financials.
It is important to explicitly state in your engagement letter that you are not taking any responsibility for errors and misstatements contained in the financial statements. When relying on audited financial statements, the chances of errors and misstatements are reduced. However, when reviewed or compiled financial statements or tax returns are used, the chances of GAAP errors increase. As stated earlier, valuators are not required to perform an audit in a valuation engagement but need to be aware of any obvious GAAP errors that could materially affect the valuation conclusion.
While checking for all these adjustments can be time-consuming, it ensures a more accurate valuation conclusion and keeps the valuator out of the hot seat on cross-examinationâ€”something all of us would like to avoid.
Cathy Roper, CPA, ABV, CVA, CFE, CGMA, is an adjunct professor of accounting/forensic accounting at Webster University, a long-time financial professional, and has the rare distinction of being an Elijah Watt Sells medalist when she sat for the CPA exam. Her firm, Roper Consulting Group, is based in St. Louis and specializes in business valuations, lost profits, economic damages, and other types of forensic accounting services. She also partners with ARA Fraud and Forensics in the prevention and detection of business fraud and the quantification of resulting damages.
Ms. Roper can be contacted at (314) 835-7876 or by e-mail to firstname.lastname@example.org.
Troy V. Luh, PhD, CPA, ABV, CFF, CGMA, MSvs, is a professor of accounting/forensic accounting at Webster University and has a specialized masterâ€™s degree in valuation. He performs consulting work in business valuation and litigation support. He has valued over 500 businesses in a wide range of industries and has served as an expert witness in many cases. His expertise includes the areas of business valuation, litigation support, fraud auditing, commercial damages, lost profits, and other areas of forensic accounting.
Dr. Luh can be contacted at (314) 807-2009 or by e-mail to email@example.com.