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As discussed earlier, financial statements of private firms sometimes do not show the true profitability.
Victoria tells Bob that adjustments to the financial statements are sometimes needed for a valuation
analysis.
These adjustments fall into two areas. The first type removes unusual or nonrecurring items. These
sorts of adjustments remove the effect of past events that are not expected to occur again, such as
operations that have been closed, legal costs to defend an extraordinary lawsuit, or a nonrecurring
capital gain from the sale of an asset. A buyer of a firm would not expect these items to occur in the
future and, therefore, they are not relevant to the analysis.
The second type of adjustment is economic. These include adjustments to costs on the financial
statements that are not shown at their market values, such as officers‟ wages being paid at an abovemarket
amount, the firm‟s rent expense being paid to a related party at an amount different from
market rent, or a shareholder‟s extra perquisites being expensed by the business for tax purposes. In
addition, some private firms fail to report all of their revenues in order to improperly lower their taxes,
and any unreported sales would be an adjustment. Furthermore, expenses related to non-operating
assets (e.g., a ski condominium owned by the firm but used only for nonbusiness reasons) would also
be eliminated. Many adjustments of the second type arise from activities between the firm and related
parties.
Once these adjustments are made to the historical income statements, they represent what the firm
would have earned if revenues, related-party transactions, and so forth were properly recorded and if
unusual or nonrecurring events had not occurred. Those adjusted earnings are a historical benchmark
for estimating the firm‟s future earnings and cash flows.
For Acme, Victoria determines that the amount of officers‟ wages paid to Bob and his family were
more than the wages the firm would have paid to nonfamily employees in the same job positions.
Thus, officers‟ wage expense on the historical income statements are reduced to the amount of market
wages, and therefore the firm‟s earnings increase. In addition, Bob personally owns the property
where the factories are located, leases the properties to the firm, and collects rents. Victoria finds that
Acme is paying rents to Bob that exceed market rents, so she reduces the firm‟s rent expense. As
reflected in Exhibit 16.2, Acme has elected to be treated as an S corporation for U.S. income tax
purposes. Thus, Acme does not pay income taxes since the income is reported on Bob‟s personal
income tax return. As a result, Bob—rather than Acme—pays the income taxes on the firm‟s profits,
and Acme‟s income statements do not show an expense for income taxes. Victoria believes the most
likely buyer of Acme would be a large corporation that would not be able to maintain Acme‟s S
corporation tax status. The buyer would be a corporation that pays income taxes. Therefore, Victoria
makes an economic adjustment to Acme‟s income statements to include an expense for income taxes.
This adjustment is made because the after-tax income is what a typical buyer of Acme expects to earn.
That buyer would use Acme‟s after-tax income—what it would receive as its return on investment—in
estimating a price it would pay to buy the firm.
Once Victoria determines Acme‟s true historical profitability, she now applies the valuation
methodologies.