What’s Normal?
How Valuators Adjust Earnings To Reflect Market Value

Your clients may need a business valuation for a variety of reasons — for example, a sale, marital dissolution or buy-sell agreement. So it’s impor-tant to understand how professional appraisers determine value. Although valuators scrutinize their subjects’ balance sheets, they also recognize that those numbers only reflect a business’s “book value” at a point in time. To arrive at the most accurate market value, these professionals must adjust or “normalize” a company’s earnings.

Book vs. fair market

The discrepancy between balance sheet value, or book value, and fair market value (FMV) can usually be attributed to a business’s accounting practices. Many businesses — especially small and midsize ones — record their assets at their historical cost. For example, production machinery purchased for $200,000 is recorded at that amount for the duration of its life, regardless of its current market value. Even accounting for depreciation over time, an asset’s book value probably won’t equal market value because depreciation methods are usually selected based on tax considerations, instead of economic value. Thus, assets are recorded at an amount far below market value. And if they have depreciated fully, they aren’t recorded at all despite remaining in use and having value.Businesses that use cash basis — rather than accrual — accounting also distort their value on balance sheets. Cash basis accounting records income as it’s collected and expenses as they’re paid, as opposed to when they’re earned or incurred. The balance sheet, therefore, doesn’t show accounts receivable (A/R) or payable.

Target areas

For these reasons, a balance sheet typically requires normalization adjustments before a valuator can reach an accurate FMV. Valuators usually make adjustments in several areas, including:

Accounts receivable. A/R is recorded at face value, with a deduction for estimated uncollectible accounts. And unbilled A/R, with adjustments for collectibility, is recorded.

Inventory. Valuators record inventory at current replacement cost value by reducing or writing down obsolete or aging inventory. Inventory that was purchased as assets is recorded, and phantom inventory that doesn’t actually exist is eliminated from financial records.

Property, plant and equipment. Real estate is generally reported at FMV for valuation purposes, although it is sometimes dealt with separately from the overall business value. In that case, the valuator also removes real estate–related income items from other financial statements and records reasonable rent expenses.Furniture and equipment are recorded at used replacement value — current replacement value less a depreciation adjustment for the length of time the asset has already been in service. Leased equipment is recorded as assets (with the remaining balance listed as a liability) if the lease is fairly characterized as a purchase agreement.

Leasehold improvements. If the improvements increase the business’s value, valuators record them as assets even though they remain with the landlord when the lease expires.

Taxes. Overpayments of taxes are recorded as assets.

Prepaid expenses. If a business prepays expenses like insurance, valuators make an adjustment to the extent of the prepayment, thereby erasing future liability and increasing the business’s value.

Unrecorded obligations. The business’s obligations to pay for goods and services it has received but not yet paid for are recorded. These include lease payments, accrued sick and vacation pay, unfunded pension liabilities, unpaid payroll, and payroll taxes.

Contingent liabilities. Valuators estimate contingent liabilities such as potential lawsuits, and record them as debt.

An essential step

In addition to normalizing earnings, valuators may also make corresponding adjustments to a business’s income statement. Your client should understand that these steps are essential to the valuation process and are likely to result in a business value that’s different — anywhere from slightly to dramatically — from the book value they currently know.

Additional Reading:

"Financial Statement Analysis: Don't Value A Business Without It"

"Surviving The Latest IRS Challenge"

"Rocky Economy Alters The Valuation Landscape"

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