If you ever valued a private company, financial statements normalization or adjustment requirement should sound familiar. This key step is needed in order to reveal the true earning power of the company, the essential element underlying its economic value.
Put differently, misstating the financial condition of a business is a major error in business appraisal. Underestimate business earnings, and the business value is likely to come way under the true figure. Overestimate it, and your business valuation would look overly optimistic.
Financial statements prepared for public companies tend to be far more consistent as they must be filed with the US Securities and Exchange Commission, or SEC for short.
Consistent financial reporting is needed to help individual investors make informed decisions. The set of rules is known as the Generally Accepted Accounting Principles, or GAAP. While you won’t find a single place to go to review the GAAP rules, the accounting profession has developed a good handle on what GAAP means and how to implement it. Financial Accounting Standards Board (FASB) promulgates the actual rules.
The foundation of GAAP is the historical cost. This is important as only the business assets actually paid for are recorded on the company’s books. Your CPA can then trace any asset to its original purchase invoice. It is an elegant system that works flawlessly for tangible business assets such as property, land, machinery, furniture and fixtures. Taking stock of your business assets is straightforward – just trace their purchase, then chase the asset to its current place of use. If you can find it, you can inspect its current condition and add it to the asset tally.
This system works given two assumptions. First, the company’s assets are physical or tangible objects. Second, the asset values do not change rapidly over time. This works great in many traditional manufacturing and distribution industries. However, things are not as smooth when it comes to modern high tech businesses, especially software development companies.
Not to mention that many business software applications today are distributed or outsourced. How do you go about estimating the market value of software in a typical business?
Original purchase cost? What about the countless all-nighters your IT gurus had to pull in order to customize the software to its current working condition? Is the deployed application worth anything today or due for a major upgrade that costs thousands? An auditor’s worst nightmare, to be sure.
Clearly then, GAAP was conceived in the good old days before the age of the Web, software, and intangible assets such as copyrights and trademarks. Intellectual property assets, especially internally developed trade secrets, technology, and procedures, do not have a historical cost tied to the original purchase.
Today’s interpretation of GAAP demands that companies expense all investments made in developing and maintaining valuable intellectual property. Under GAAP, you can capitalize the cost of developing business software, not its true fair market value.
This real gap in GAAP is one reason business valuation methods such as the asset accumulation technique exist. To determine the business value, you compile the list of all business assets, tangible and intangible, costed, or internally developed, along with all the liabilities. The difference is the business value.