I have been valuing closely held companies since 1985. I have earned two of the highest and most challenging designations in the business valuation field including the CBA and ASA. I am a Certified Public Accountant, have a Master’s in Business Valuation and holds the ASA, CBA, ABV, ICVS, CVA, MAFF, CFD, CVGA, ICVS-A credentials.
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This week, I am discussing the misuse of normalized or adjusted financial data to historical financial data.
Because you as the attorney need to detect the deficiencies in business valuation reports.
And the better informed you are, the better the outcome of your cases for you and your clients!
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Have a great week.
Normalizing vs Generally Accepted Accounting Principles (“GAAP”) Financial Statements
The normalizing of financial information is the process of adjusting for nonrecurring, noneconomic, or other unusual items to eliminate anomalies and/or facilitate comparisons. These items are not expected to continue into the future and they have no impact on value.
The intent of the normalized financial statements is to quantify the ongoing, recurring cash flows of a company.
GAAP aims to improve the clarity, consistency, and comparability of the communication of financial information. GAAP helps govern the world of accounting according to general rules and guidelines. It attempts to standardize and regulate the definitions, assumptions, and methods used in accounting across all industries.
Benchmarking Using Generally Accepted Accounting Principles (“GAAP”)
In the discipline of business valuations, benchmarking is the process of measuring key business metrics or key performance indicators and comparing them—within business areas or against a competitor, industry peers, or other companies around the world—to understand how and where the organization needs to change in order to improve performance.
Benchmarking compares a company’s historical GAAP financial data. The application of benchmarking should compare the same basis of comparison with the company specific financial data compared to the industry data. The industry data as used by Risk Management Associates (“RMA”) is gathered from bank loan information. The bank loans are prepared using historical financial information on a Generally Accepted Accounting Principles (“GAAP“) basis. If the company specific GAAP financials are compared to the industry or competitors GAAP financial statements, information can be drawn on how the specific company has performed, compared to the industry. This information can be used to determine how the specific company has performed and make a risk assessment on the company’s performance based on the industry performance. One of the objectives is to make an assessment of the various ratios’ risk performance to determine a company specific risk for a business valuation.
Benchmarking Using Normalized Financial Statements
Benchmarking compares company specific historical, GAAP financial data to historical GAAP industry data. This is an apples to apples comparison. However, what is the result when a business valuation expert uses the normalized or adjusted financial statements for benchmarking. The result is a nonsensical comparison with non-accurate results or conclusions drawn between the data. The normalized financial statements have been adjusted away from GAAP and therefore the data is no longer comparable to the benchmark data. Any conclusions drawn from the GAAP key performance indicators have no relationship to the company specific data. Therefore there is no relationship between the two sets of data; any conclusions reached between the data is false. This could render the company specific risk unreliable and any conclusion relying on the benchmarking unsupportable. In the table below you will also note that there is no annual industry data recorded for the industry as recorded by RMA indicating the trending of data to determine how the company has compared to the industry over time. (See highlighted area)
The table below is a sanitized version of using normalized financial data compared to benchmarking data.
If the normalized data is used to determine the risk using the GAAP key performance indicators, the entire conclusion of the business valuation will be incorrect.