Accounting & It's Impact on Valuation

A recent Wall Street Journal article addressed the increased prevalence of “tailored accounting” practices being more prominently highlighted rather than GAAP accounting measures in SEC prospectus filings for companies going public.  Some of you probably just read the word “accounting” and your yawn reflex automatically triggered.  Others are probably asking what this has to do with private equity.

A link to the WSJ article:  http://www.wsj.com/articles/tailored-accounting-at-ipos-raises-flags-1420677431.

While the article’s focus may be on public companies and the presentation of their financial filings, the topic is relevant to privately held companies and how accounting practices impact valuation.  And last time I checked, valuation was a not so yawn-worthy topic and one near and dear to many business owners’ hearts…and wallets.  Here are a few important takeaways:

1.       Important to Have a Common Unit of Measure.  Generally Accepted Accounting Principles, or GAAP, exists so there is a common way to account for and measure the financial results of businesses.  Just ask NASA what happens when a standard or common unit of measure is not used; there can be grave and costly consequences.  The same is true of businesses—cash basis accounting, accrual based accounting, or any other method of accounting can differ significantly depending on the industry, company, and situation.  Investors and business owners need a common starting point for purposes of discussing and evaluating a company’s financial performance.  Failure to do this can result in broken deals / failure to raise capital, a lower valuation than what otherwise might have been possible, re-trade in price or terms at the eleventh hour, or liability / exposure for breach of reps and warranties made as part of a transaction’s legal agreements.

2.       Adjusted Results May Vary Considerably from the Reported Numbers.  The WSJ article cited one company that reported adjusted profit of $13.2 million for the period vs. a GAAP reported loss of $8.4 million.  That is an actual reported LOSS swinging to an adjusted PROFIT—a $21.6 million swing!  Furthermore, the article noted that “40 companies went public in 2014 reporting losses under traditional rules [GAAP] but showing profits under their own tailor-made measures…that is 18% of all U.S. public offerings for the year…”  As demonstrated, adjustments are common and can be quite significant.  However, this brings us to our next point, adjustments must be credible.

3.       Adjustments to Financial Statements Will be Scrutinized and Possibly Debated.  The greater the adjustments the more explanation is warranted to explain why the adjusted figure varies so much from the actual reported results.  In the context of an investment—be it a private equity buyout or someone purchasing shares in an IPO as was the focus of the WSJ article, the investor is making adjustments to actual reported earnings with the sole purpose of trying to identify the best estimate of the current and go-forward profit and cash flow of the business.  Think of this as the true earnings generating capacity of the business.  Thus, there is validity to excluding many one-time and/or non-recurring items to the extent they exist.  However, it is not always clear cut as to what should be adjusted. 

Taken a step further, sometimes the adjustments depend on who is the buyer or operator of the business.  For example, a corporate parent may charge its subsidiary a management fee but not actually provide it any services, so that should be arguably added back for a new owner.  On the flip side, a corporate parent may provide a subsidiary with back office services but not charge or allocate any of these expenses down to the subsidiary, necessitating that most buyers factor in an estimate for these go forward needed expenses.  Adjustments cut both ways.  Taking an even handed approach to adjustments—positive and negative—is more likely to be taken seriously and credible by investors.  Ultimately they will scrutinize and formulate their own perspective on the true level of adjustments and earnings, but tossing in bogus adjustments to show artificially high earnings will kill credibility and turn away some investors from spending any time evaluating the opportunity.

4.       Financial Results and How They are Accounted for Drive Valuation.  Implicitly or explicitly businesses are generally valued as the net present value of the future cash flow streams they generate.  More simply, the amount of profit and cash flow your business generates dictates its value.  Embedded in that statement is the presumption that the cash flow streams are known or reasonably able to be forecasted, which gets to how it is accounted for and our earlier discussion about working off of a universally common measurement.  You cannot separate the accounting from the valuation.  They are intertwined.  So, if a business owner cares about his/her company’s valuation, it might behoove him/her to take an interest in the quality, accuracy, and infrastructure supporting his/her accounting functions.                     

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