Business valuation, GAAP financials, and normalizations – why all the fuss?

Ask any professional business appraiser and you will get an earful about the financial statements, adjustments and the true economic income estimation. Why all the fuss?

In a perfect world, you should be able to figure out business value by just using the company’s financial statements. After all, don’t the income statements and balance sheet capture the company’s financial performance? It turns out, not quite.

If you are not a seasoned accountant, here is a quick rundown on how experts report financial numbers for businesses. In the US, the Securities and Exchange Commission (SEC) requires that all public companies prepare and file financial statements in accordance with the so-called generally acceptable accounting principles, known as GAAP.

Trouble is, there is no one place you can go to in order to understand what GAAP is all about. So accountants have developed a de-facto understanding of GAAP that they all follow. Even though the Financial Accounting Standards Board (FASB) sets the rules, the practicing CPAs interpret GAAP and file the financials with the SEC.

Now, the foundation of GAAP is known as historical cost. But bear in mind one key point for business valuation. Accountants record on the books only the assets the company paid for. CPAs can then trace all such recorded assets to the original purchase invoice. The system functions quite well as long as the assets are in tangible form such as the real property, machinery, office equipment and furniture. If it comes to an audit, you can find the actual physical assets and trace them all the way back to the original purchase invoice.

GAAP misses the value of intangible assets

So far, so good. If the prices of assets change slowly over time, and inflation doesn’t get out of control, the system works well. But what if your company is rich in intangible assets such as intellectual property? The patented software developed by the internal R & D may be the most valuable asset your company owns. Yet, it is not a tangible asset purchased from a vendor. So there is no real book record for it!

What do you think is more valuable from a company investor’s perspective? Office furniture or highly prized software design that generates sales?

In many companies today, the value of such intellectual property far exceeds the value of all the tangible assets combined.

GAAP cost basis misses the market value

Clearly, GAAP financial reporting misses a key point when it comes to business value. The standard was developed in an industrial age when dealing with intangible assets was not an issue. Under GAAP the best you can do is capitalize the cost incurred in developing your patented technology, but not its market value!

Financials are normalized for business appraisal

Correcting this picture in order to determine the company’s true market value is the job for business appraisers. One method that stands out is the asset accumulation technique. You start with the company’s cost basis balance sheet and normalize it by adding the values of assets and liabilities that are missing. The result is an economic balance sheet, one that captures the market values of all assets, whether they have an accounting cost basis or not.

GAAP serves the needs of CPAs who are conservative by nature. As long as the system allows the accountants to do their job well, they are happy. But when it comes to business appraisal, you need to make adjustments that reveal the true value of the company.

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