Generating Economic Financial Statements

Generating Economic/Normalized Financial Statements

• Performing a thorough analysis of historical financial statements is a prerequisite to a meaningful valuation.
• Basic financial statements include balance sheets, income statements, and statements of cash flow.
• A complete financial analysis helps to identify strengths/weaknesses, identify trends, compare to similar businesses, and identify areas for normalizing adjustments.
• Financial analysis should be initially performed before economic adjustments to pinpoint adjustment areas and after adjustments.

Necessary Information

• Analysts need financial data, factual history, competitor info, and management's expectations.
• Revenue Ruling 59-60 suggests considering five+ years of data to approximate a business cycle
• The period to analyze can vary based on the analyst's judgment and the firm's economic environment.
• A checklist aids in requesting and obtaining information, which can be used for organization.
• Audited statements may appear reliable, but GAAP doesn't always equate to economic value, so adjustments may still be needed.
• There is no single method for analyzing statements, it requires careful evaluation of all data.

Economic/Normalized Financial Statements

• Relying solely on recent balance sheets or income statements isn't sufficient for valuing closely held businesses.
• Financial statements prepared with GAAP or Tax Basis Accounting (TBA) may not reflect economic reality.
• Analysts prepare normalized statements to compare a company's performance with its peers and accurately measure economic factors.
• Objective: Recasting statements adjusts tax returns towards a firm’s true economic position.
• Balance sheet adjustments reflect current market values, while income statement adjustments show the true economic results.
• Normalizing adjustments are hypothetical and differ from AICPA guidelines for historical results/future forecasts.

Purpose, Categories, and Examples of Economic/Normalized Financial Statements

• Serve to make comparisons to industry averages and for making meaningful projections and forecasts.
• Serve to provide representative benefit levels and to represent net asset market values.
• Normalizing adjustments can be classified by accounting method, non-recurring events, operating status, and GAAP compliance.
• Common examples of adjustments include reconciling GAAP/TBA accounting to economic reality.
• Closely held firms expense aggressively to reduce taxes and use historical or cost basis valuation.
• Economic statements can be costly due to lack of supportable data, it requires analyst interviews with management and industry research.
• Must account for excessive compensation, perks, unusual rent, and effects of company ownership.

Controlling vs. Non-controlling Interest Adjustments

• Some analysts don't adjust elements beyond the non-controlling interest's control, others debate adjusting owner's compensation.
• Analysts must understand state laws defining "control" in the context of minority interest adjustments.
• Control typically refers to >50% interest, while minority shareholders lack power to distribute earnings, alter the company, etc.
• Valuations of majority interests often adjust compensation/benefits, spending, inefficiencies, and financial structure.

GAAP vs. Economic Accounting

• GAAP allows latitude in financial statement preparation.
• GAAP principles include:
  • Historical Cost
  • Revenue Recognition
  • Matching
  • Consistency
  • Objectivity
  • Full Disclosure
  • Modifying (or Exception, which includes Materiality, Conservatism, Industry Peculiarities/Practices, and Cost-Benefit).

Common Economic/Normalizing Adjustments

• In introductory valuation, only main normalizing adjustments are covered, as US GAAP and IASB GAAP converge.
• The type of historical financial statements used significantly impacts the number of economic adjustments needed.
• Tax basis and internally prepared financial statements are more cash accounting focused.
• Adjustments may vary based on the facts of the case
• The valuation analyst's economic adjustments usually represent a departure from GAAP.
• Balance sheet adjustments reflect market value, bringing depreciated-historical cost to market.
• Adjustments bring the “normalized” market value which can be offset against retained earnings.
• Income statement adjustments may not require balance sheet offsets.
• Removing one-time expenses doesn't change the economic balance sheet but can be increases/decreases to retained earnings.
• Valuation software tracks both sides of normalized adjustments to help understand after tax or pre-tax effects.

Adjustments for Doubtful Accounts and Notes Receivable

• The goal is to adjust for doubtful accounts to reflect the market value of receivables.
• Allowance for doubtful accounts is analyzed and adjusted as necessary, by challenging trade and notes receivables.
• This is done by comparing historical write-offs to current estimates, or aging accounts to the allowance account.
• For notes receivable, the analyst must scrutinize loan receivables and payables, judging based on the valuation purpose.
• Many issues relate to related-party receivables.
• Notes are valued at face value unless analysis shows otherwise, key considerations are:
  • Indebtedness evidence?
  • Security?
  • Security type?
  • Factors set up for estate and gift tax rules?
  • Interest Rate.
  • Date of maturity.
  • Inability to collect (full/partial) due to the insolvency, collateral, comparable sales, or whether it is negotiable.
  • Consideration for the discounts noted for the loss of use of money.
  • Changes in the interest rate of duration of notes.
  • Documents evidence arms-length bargaining?
  • Intention to repay?

Inventory Valuation Adjustment

• Goal: Make adjustments to reflect the inventory market value as of the valuation date).
• Involves valuation, especially Last In First Out (LIFO).
• A balance sheet using First In First Out (FIFO) shows current inventory value.
• During periods of inflation, LIFO charges more costs against income, and lowers tax liability.
• For a LIFO to FIFO adjustment, change the amount in the LIFO reserve.
• Corresponding adjustments to income are the yearly change in the LIFO reserve, some valuators would not adjust.
• Company write-down, write-off and costing policies are analyzed to find potential adjustments, and consider obsolete inventory.
• Adjustments are made if costing policies vary from the industry standard.

Depreciation and Leases Adjustments

• Goal: To restate depreciation allowances to reflect the true economic depreciation.
• Restate for comparative purposes to commonly found depreciation in a subject industry.
• Company methods are evaluated, keeping in mind it may be tax motivated.
• Common methods and asset lives in the industry must be determined.
• The most common methods are:
  • Straight Line
  • Declining Balance
  • Sum of the Year's Digits
  • Units of Production
  • Tax Methods (ex: ACRS/MARCS)
• Goal: to locate assets held and liabilities and get them into adjusted net assets).
• Analysts evaluate leases for proper classification (capital vs. operating) based on FAS 13.
• The analyst can adjust fixed asset values to reflect appreciation or impairment.

Capitalizing and Expensing Adjustments

• Is adjusted to industry standards as needed
• Capitalizing and expensing policies are analyzed for reasonableness, with adjustments made if limits are exceeded.
• Includes analyzing policies regarding:
  • Fixed Assets
  • Inventory
  • Research and Development Costs
  • Timing of Income and Expense Recognition
• Goal: Restate earnings to match pattern within the subject's industry.
• It is important to note that knowledge of industry-specific practices is very important to properly adjust financial statements.
• Analyst assesses if income recognition timing is reasonable.
• Timing/recognition issues common in long-term contracts and installment sales.
  • It is important to consider long-term and installment contracts.
  • Completed vs Percentage -Other

Accounting, Extraordinary Items, and Compensation Adjustments

• Goal: To recognize a potential deferred tax liability.
• Deferred liability recognizes and books a deferred tax liability when a firm uses different book and record methods. This will need to be removed if the deferred liability won't actually result in any liability.
  • Flow Through
  • Deferral
• Net operating loss carryovers must be taken into account
• Goal: eliminate one-time income and historical earnings
• Accounting Principles Board Opinion No 30 defines extraordinary items as follows:
  • Unusual in nature; the underlying event or transaction should have a high degree of abnormality and unrelated qualities that reflect typical operation activities.
  • Infrequent in occurrence; should not reasonably be expected in the foreseeable future for current organization environments
• Businesses have extraordinary or non-recurring items or expenses from litigation, asset sales, or insurance claims.
• Amounts considered extraordinary/non-recurring must be eliminated to accurately reflect the financial results.
• Is used to adjust officer or compensation, goal is to reflect reasonable reimbursement of a replacement officer.
• Numerous "reasonable compensation" databases exist, but are frequently adjusted to the economic/normalized financials
• It is important to consider officer compensations with the industry average. Information adjustments can be obtained from:
  • Industry Associations
  • Employment or search agencies
  • Integra, Risk Management Associates Annual Statement Studies
  • NIBM Executive Compensation, Panel Publishing
  • Economic Research Institute

Contingent Liabilities

• Are commonly omitted from income stream adjustments.
• Goal: consider including contingent liabilities to the adjusted net assets.
• To attempt to find any unrecorded and contingent liabilities.
• Should be adjusted to reflect any effects of the items, FAS 5 determines that contingent liabilities are probable and should be expressed in the financial statements.
• Analysts should understand recent case laws in capital gains and the purpose for the required valuation.

Operating/Non-Operating Items and Intangibles Adjustments

• Goal: remove non-operating assets and any relating liabilities.
• Non operating items must be valued separate in order to exclude any incoming or expense generated by non-operating assets.
• Related revenue should be valued separately from the income base.
• Goal: Identify and value tangible assets, the value must be estimated based impacts on benefit stream

Constructing Normalized Balance Sheets

• Requires converting and adjusting the exiting balance sheet, OCBOA on a line by line basis, and the market value of all assets/liabilities should be established.

Balance Sheet Adjustment Procedures

• Key accounts and potential adjustment procedures include:
  • Cash can be adjusted for excess that can be considered non-operation assets
  • Trade Notes and Contracts: Typically adjusted towards a collectible amount and the owner's accounts removed -Marketable securities adjusted towards market value
  • Inventories: Adjusted for replacement cost and can wrote down unusable inventory, raw materials, adjust costing procedure, pricing policies, adjust to replacement cost and analyze write-downs.
  • Prepaid Items are to be analyze amortization percentage
  • Fixed Assets: can be adjusted to market value, analyze capitalization or depreciation policies
  • Leased Equipment: Adjustment for FAS 13 criteria and for capital vs operating tax
  • Real Estate: May influence operating and cause distortion, which may distort ratios and capitalization/assets.
  • May be considered as non-operating and reduce stream benefits
  • Intangible Assets: Adjust estimated value using prescription methodology
  • Deferred Credits/Debits: Analyze for proper inclusion of tax liability
  • Non-Operating or Personal Assets: Remove from statement, with debt.
  • Liabilities: Adjust to current market value

Constructing Normalized Income Satements

• Can be established for three reasons, assisting in projecting futures, providing info fo comparison and basis for determining value
• Should be noted that an important measurement of income is Net Pre-Tax operating profit.

Income Statement Illustration

• Includes income, cost of sales, officers' compensation, other salaries, travel, and entertainment. -Income: eliminate operating income, compare company rules -COS: Review costing procedure adjust accordingly -Officers Comp, must be in a comparable market range -Other Salaris: Remove any none related party -Determine if travel and entertainment, find if company owners are the direct contributor to the operating, eliminate reflect on earnings

Rent, Fees, and Other Income Considerations

• Company Rent: Analyst should determine companies expenses
• Fees: analyst must determine what is need it and make proper adjustment
• Employee: must be adjusted to reflect real employee levels
• Others Auto Expense: can be used in this section analyst should ensure that its not business activity
• Depreciation should be considered as income
• Analyst should search for other outside expenses that affect company economic status

Income Tax effects on Economic/Normalizing Adjustments

• Many analysts ground analysis base on pre tax gains, in the support premises that the company avoid the time for payments of time taxes as a form adjustment An Important point to deal with income taxes may be investments being valuated should be aware the base is revived in tax benefit Under stock value buyer won't expect step in base assets in addition the buyer would be assuming a addition to that is based from valuation