4

AccountingPrimer

Although there is no substitute for experience and formal training in accounting, it is clear that a
basic understanding of accounting principles is necessary for effective and accurate business
valuation. Therefore, this primer is intended to provide a basic introduction to the accounting
process as a prelude to detailed guidance on interpreting a company's income statement in
relation to calculating adjusted cash flow (ACF). Given the central role of ACF in business
valuation, such additional coverage is warranted and serves as a supplement to the material
contained in the book. If you read no other section of this primer, make sure that you review the
section titled "Use of the Income Statement." A third accounting topic that requires additional
discussion is intangible assets. Intangible assets such as goodwill often are a source of confusion.
Therefore, the final section of this primer addresses this multifaceted issue.

Introduction
Financial statements are the scorecards of the business world, providing guidance for future
allocations of scarce resources. Accounting often is called the language of business. To rely on
financial statements, you must understand them. To understand them, you must have a basic
knowledge of accounting systems and accounting procedures. In fact, regardless of your current

state of knowledge, you can always learn more about accounting and use these new insights in a
productive way, managing your business to maximize profits and company value.
If you are considering the purchase of a business and have little or no accounting training,
there are several avenues to pursue that will improve your understanding. First, if time allows,
sign up for a course in financial accounting at your local community college. Many colleges
offer courses specifically devoted to introductory financial statement analysis. If time is short,
consider attending a two- to four-day seminar on accounting for business people. These seminars
are periodically offered by local chambers of commerce, Small Business Development Centers,
community colleges, and even universities. If this option seems unattractive, you should
purchase a condensed guide to accounting, such as the one published by Barron's and available at
most bookstores. Additionally, purchasing an accounting dictionary and thoroughly reviewing
the terms will increase your knowledge. A regular text used for a course in financial accounting
would also be helpful. You must have a sound understanding of accounting to maximize the
performance of your business and therefore its value.
If you own a larger corporation or are an experienced business owner with a fairly strong
command of financial statements and accounting in general, then you should consider purchasing
a text on intermediate or advanced accounting or even a text on federal taxation. Reviewing these
textbooks probably will generate ideas and insights previously unknown. Also, if you plan to go
public one day, you will benefit from attaining a level of understanding similar to those who
assist in implementing initial public offerings (IPOs) and those interested in acquiring stakes in
such companies. Tax and accounting issues are important in this arena.
Recognizing the value of a business depends on careful scrutiny of the company's
financial statements. If you are purchasing a business, you must understand the many nuances of

generally accepted accounting principles (GAAPs) and the many different accounting concepts,
assumptions, and conventions on which these principles are based. You must be able to decipher
the economic reality of a company based on the presented statements. This task is greatly
complicated by financial statements prepared by small business owners who do not appreciate or
understand GAAPs. These statements normally are compiled rather than audited and must be
scrutinized carefully. Compiled statements are prepared either by the owner or by an accountant.
If an accountant prepares compiled statements, they are based solely on the data presented by the
owner. No information is verified or audited. Audited statements, on the other hand, are prepared
by Certified Public Accountants (CPAs), who will verify all account balances and determine
whether GAAPs have been followed. Practically speaking, you must know where manipulations
in reported income and expenses can occur in either scenario (compiled or audited). To
accomplish this, you must have at least a basic understanding of accounting.
If you are operating or selling a business, the financial statements can be a source of
guidance leading to higher profits and higher business value. You must understand that almost all
business valuations are conducted via financial statements. Identifying efforts that will maximize
the value of your company is facilitated by review of the financial statements. Successful exit
strategies call for preparing your business for sale many years before you place it on the market.
The central point here, however, is that calculations of business value revolve around financial
statements. Learning how to work in this environment will help you maximize the sales price and
minimize tax obligations.

Accounting Process Basics

The accounting cycle, the accounting system, and GAAPs culminate in the preparation of
financial statements. As mentioned earlier, accounting is the language of business. As it relates to
the purchase and sale of a business, however, the required field of knowledge is fairly precise
and by no means insurmountable. We begin now with the basics.
Accounting was created in the sixteenth century and is based on the concept of doubleentry bookkeeping. The essence of double-entry bookkeeping is that for every debit, there is an
equal and corresponding credit. The equality of debits and credits makes sense only in the
context of the so-called accounting equation:

Assets = Liabilities + Owner's equity

A (debit) = L (credit) + O.E. (credit)

The accounting equation can be interpreted in many ways. First, these are the major
categories of the balance sheet. At this point, however, the most useful interpretation tells us that
every company owns assets (A), which are combined to produce revenues and profits. Each of
these assets must be paid for, or financed. They can be financed through debt (L) or equity
(O.E.). Different companies have different capital structures (more debt than equity or vice
versa).
In terms of the accounting system, assets possess a debit balance, whereas liabilities and
equity have a credit balance, to be defined further in a moment. Also note that the following
additional account types relating to the income statement have debit or credit balances:

Debit Credit
Expenses

Revenues

Losses

Gains

Dividends

The accounting system revolves around the principle of double-entry bookkeeping and
the accounting cycle, which has the following major steps:

1.

Transactions occur, as evidenced by source documents.

2.

Transactions are entered into a journal (general journal) at the end of each cycle.

3.

Journal entries are posted to the ledger (general ledger), or chart of accounts.

4.

Trial balance is prepared, listing all accounts and their balances and checking for equality

of debits and credits.

5.

Under accrual accounting, adjusting entries are made and posted at the end of each cycle,

typically each month and for the year as a whole.

6.

Closing entries are entered into the general journal and posted to the general ledger.

7.

Financial statements are prepared (at least the balance sheet and income statement).

As any student of accounting will tell you, it is possible to become mired in the details.
However, excellent accounting software packages are available for small business at reasonable
prices, including Peachtree and Quicken. These user-friendly packages require that you enter
data based on familiar transactions that occur, culminating in the preparation of the financial
statements. For the sake of discussion, let's walk through these steps in a cursory fashion. When

a transaction occurs, two or more of the accounts in the business are affected, with each
transaction generating a debit (dr) and credit (cr) component. For example, inventory might be
purchased for cash. The basic journal entry is:

(dr) Inventory

$5,000

(cr) Cash

$5,000

Inventory, which is an asset account, is debited. Debiting an asset account is the same
thing as increasing the account. If an asset is credited, as is the case here for cash, the account is
reduced. The use of so-called T-accounts facilitates understanding of the accounting cycle by
visualizing various debits and credits that occur to an account over an accounting period. In
terms of liabilities (credit balance), a debit entry reduces the account balance, whereas a credit
entry increases the account balance.
Using T-accounts, a debit balance implies that increases in the account will occur on the
left-hand side, whereas decreases will occur on the right-hand side. Consider two more
transactions. First, the performance of a service on credit:

(dr) Accounts receivable

(cr) Service revenue

$10,000
$10,000

Second, the payment of wages to employees:

(dr) Wage expense

$6,000

(cr) Cash

$6,000

Note that T-accounts are generated for every type of account, including expenses and
revenues. Expenses are increased by a debit entry, whereas revenues are increased by a credit
entry. Stated differently, expense accounts have a debit balance and revenue accounts have a
credit balance. Note the eternal balance between debits and credits. Journal entries may be
compound entries, but total debits always equal total credits. Consider the following transaction,
in which a sale is made on credit with a partial down payment:

(dr) Cash

$2,000

Accounts receivable $6,000

(cr) Sales revenue

$8,000

All entries are recorded into a general journal in their order of occurrence (also called the
book of original entry) and then posted into the general ledger, which is a compilation of all
accounts and their balances. Account balances in the general ledger at the end of the accounting
cycle, after all adjusting entries have been made, are the source of financial statements. For
example, total sales revenue may equal $750,000, which is the running total of all individual
sales made throughout the year. Similarly, all rent payments are tallied up in the rent expense
account and used as part of the income statement in determining net income. Other sample
entries include the following:

(dr) Cash

$100,000

(cr) Common stock

$100,000

(to record cash received in exchange for ownership interest)

(dr) Cash

$20,000

(cr) Sales revenue

$20,000

(to record sale from inventory for cash)

(dr) Cost of goods sold

(cr) Inventory

$15,000
$15,000

(to record inventory expense associated with sale for cash)

The first of these is an entry dealing with the owner's equity, or capital section of the
balance sheet. Crediting owner's equity amounts to increasing the equity balance to reflect the
infusion of cash. The second transaction involves two separate entries (one transaction, two
entries). As always, total debits equal total credits. Two entries are necessary, one to record the
sale and the other to recognize the associated expense with the sale. Note that, overall, sales are
credited for $20,000 and cost of goods sold (CGS) is debited for $15,000. At year end (or
whenever financial statements are prepared, perhaps monthly) total sales and total CGS expenses
are tallied up and used to prepare the income statement. Note that what we are dealing with here
is the company's gross profit (or gross margin), which is defined as:

Sales revenue
Cost of goods sold
= Gross profit

Remember that the company's gross profit is an important number for analytical
purposes. A company's gross profit indicates how much profit exists after the inventory is paid
for (whether it is purchased or manufactured) to pay for all overhead expenses (general and
administrative, selling, interest, and tax expenses). Gross profit of a target company should be
looked at carefully and compared with industry averages. Note the following averages and try to
explain why they might be higher or lower for differing types and categories of businesses:

Beauty salons

90%

Video stores

70%

Nurseries

50%

Office supply stores

35%

Grocery stores

20%

A gross profit margin of 50 percent, for example, implies the following fictional income
statement:

Sales revenue

$500,000

100%

Costofgoodssold

$250,000

50%

= Gross profit

$250,000

50%

The important consideration in our current discussion is that these numbers (sales
revenues minus CGS) are accounting numbers and are subject to manipulation. Sales can be
recognized differently, and CGS can be calculated using different, legitimate approaches (e.g.,
first-in, first-out [FIFO] or last-in, first-out [LIFO]). This manipulation can be either legal
(within GAAPs) or illegal (fraudulent). When purchasing a business, you must be able to
recognize these potential problem areas either independently or with the assistance of your CPA.
Verification of the accuracy of the reported numbers has a direct bearing on the determination of
the company's value. A company's financial statements are compilations of hundreds of
transactions comprising various debits and credits. Appreciating the many steps involved in
preparing these statements is a necessary step toward financial sophistication.
Another important type of journal entry is the so-called adjusting entry. Depending on the
type and size of business and the sophistication of the accountant, there may be many such
entries or none at all. Basically, adjusting entries are required by GAAPs to ensure that the
financial statements are presented in a fair, useful, and consistent format. Specifically, adjusting
entries are necessary to comply with the fundamental principle of accrual basis accounting: the
so-called matching principle. As described elsewhere in this primer, accrual accounting requires
that for financial reporting purposes, revenues be recorded when earned and expenses be
recorded when incurred, regardless of when cash flows in or out. For example, consider the
purchase of a fixed asset such as machinery. Even though the entire purchase may have been
paid for in cash all at once, the expense is apportioned over the useful life of the asset in a logical

fashion, being matched against revenues that are generated by the machinery. Note the following
journal entries:

(dr) Machinery

$100,000

(cr) Cash

(dr) Depreciation expense

$100,000

$10,000

(cr) Accumulated depreciation, machinery

$10,000

The first entry records the purchase of machinery worth $100,000 for cash. Despite the
fact that the machinery is fully paid for, accrual accounting does not allow recognition of this full
amount as an expense in one year. It must be allocated over the useful life of the machinery,
which entails an estimate by the accountant. This estimate could be five years or ten years,
depending on whom you ask and what type of maintenance is involved. Assuming a useful life of
ten years and use of the straight-line method of depreciation, the $100,000 piece of machinery
will be depreciated by $10,000 each year.
The second entry is an example of an adjusting entry, which is necessary to allow proper
presentation of the financial statements. A depreciation expense of $10,000 is recognized as a
charge against income. If the company had chosen an alternative depreciation method that allows
accelerated depreciation, the recognized expense would be larger in the early years and smaller
in later years, affecting dollar for dollar reported net income and ACF. Although the total amount
of depreciation expense would be the same ($100,000), the timing would be different. In general,
adjusting entries may be classified as either accruals or deferrals. In both cases, the goal is to

match revenues as they are earned with expenses as they are incurred (regardless of when cash
actually changes hands). Examples include accrued payroll, which is a liability account that
represents payroll expense that has been incurred but not yet paid and would be associated with
an equal expense entry on the income statement. Thus, the accrued liability is equal to the
recognized expense (which has been incurred but not yet paid). An example of a deferral is
deferred income taxes.
This brings us to another critical point, which is also reiterated throughout the book.
There is almost always a difference between the financial statements prepared for book purposes
(GAAPs) and those prepared for tax purposes (the Internal Revenue Service [IRS]). As a rule,
GAAPs offer more flexibility in accounting than the IRS tax code. Under GAAPs, the accountant
must decide how long the useful life of an asset will be. For tax purposes, the IRS code is
specific and inflexible. The only flexibility involved with the IRS tax code is a result of changing
political winds and rewriting of tax laws. Don't be surprised when you see that a company's tax
returns differ from its financial statements. What you need to do is carefully explain the
differences. One example will help illustrate these differences. Under GAAPs, a company is
required to estimate uncollectible debts and generate an adjusting entry at year end to reflect the
fact that not all sales made on credit will be collected. The basic entry will look something like
this:

(dr) Uncollectible debt expense

$29,693

(cr) Allowance for uncollectible accounts

$29,693

The debit is to an expense account, which will reduce net income, effectively erasing a
certain percentage of the sales made on account. The credit is to an allowance account (also
called a contra-asset account), which reduces the carrying value of accounts receivable (A/R) to
what is called net realizable value. The result of this entry overall is to reduce the asset accounts
receivable and to reduce net income to reflect bad debt expense. For tax purposes, most small
businesses are not allowed to estimate bad debts and take a tax deduction based solely on this
estimate. For tax purposes, only specific accounts that have been written off may normally be
deducted. The logic here should be clear. Uncle Sam will not allow taxpayers to estimate
expenses that may or may not materialize. You cannot estimate your way to higher expenses,
lower income, and lower taxes. See your accountant for more tax information.
Another example will further illustrate the differences between book and tax accounting.
Recall that the books may be prepared under cash basis or accrual accounting. It is possible to
use the accrual basis for one set and the cash basis for another. In both realms, you must
generally be consistent from one year to the next. However, for tax purposes, it is possible to use
a hybrid method (cash and accrual) if this approach presents income and expenses clearly. There
are restrictions, however, as follows:

If inventories are present, you must use the accrual basis for purchases and sales. For all other
areas, you use the cash method.
If the cash method is used for determining revenues (income), the cash method must be used for
reporting expenses.
If you use the accrual method for expenses, ditto for revenues.

Also be aware that if you change your accounting method for tax purposes, you must
receive IRS approval. They will consider your reason for change in light of the requirement for
consistency. Note that if your business is based primarily on the sale of inventory from stock,
you must use the accrual basis and recognize revenues when they are earned and expenses when
they are incurred (regardless of when cash changes hands). Business tax returns contain a section
that specifically reconciles the difference between tax accounting and book accounting (Schedule
M-1 on corporate tax returns). This is a practical place to begin understanding this important
difference.

Financial Statement Analysis

When analyzing financial statements, remember that they are intended to provide a "continued
history, quantified in money terms, of economic resources and obligations of a business
enterprise, and economic activities that change those resources and obligations." This is the
official description of financial statements according to GAAPs. The general area of interest here
is financial accounting and reporting, which entails the financial statements and supplementary
information that must be published externally under GAAPs. Ideally, all businesses will prepare
their statements in accordance with GAAPs, but most small businesses, whose securities are not
publicly traded, are not overly concerned with GAAPs. Their statements normally are not audited
but are occasionally reviewed, which amounts to a watered-down audit. Most commonly they are
compiled, which simply means that the accountant has taken the information provided by the
owner at face value and constructed the statements accordingly. The garbage-in, garbage-out
principle applies very well here. This is why the purchaser of a small business with unaudited

statements typically must rely on the assistance of an accountant to verify the presented financial
information, at least in a minimal fashion.
If you are purchasing a business with audited statements, they must be audited in
conformance with generally accepted auditing standards (GAASs), and they must be presented in
accordance with GAAPs. The role of the CPA as external auditor is to verify that the statements,
as prepared by management, are accurate and in conformance with GAAPs. If they are not, the
CPA must issue a "qualified" report, indicating that he or she finds that the statements are not
prepared per GAAPs. An "unqualified" report is what you hope to find. Remember, though, that
the only implication of the "unqualified" finding is that the statements are materially accurate
and are prepared in accordance with GAAPs. The CPA is in no way assessing the current or
future profitability of the company, nor is he or she recommending the company as a sound
investment. The CPA is attesting only to the accuracy and conformity of the statements.
What exactly are GAAPs? Check out an introductory or intermediate accounting text at
your local library for a complete review. As a business owner, you should understand the
accounting process as best you can. GAAPs are the foundation of the accounting profession and
is one of the reasons why the United States has the most developed capital markets in the world.
GAAPs consist of the financial accounting and reporting assumptions, standards, and practices
that a business entity must use in preparing external financial statements. They are based on
practical as well as theoretical considerations and tend to represent a consensus among
accountants as to what is the appropriate accounting procedure for a given event. GAAPs
provide guidance to preparers and confidence to users. They foster the ability to compare one
company with another and to make important decisions affecting the direction in which resources
flow.

The truth is, however, that GAAPs have many shortcomings and imperfections, but they
yield the best results. The problems associated with GAAPs are related to the wide latitude given
accountants in terms of estimates, professional judgments, and assumptions. This latitude can
lead to problems based on personal bias, misstatements of facts, errors in estimation, and general
ambiguities. The goal is to have financial statements that are credible to outside users.
When purchasing a company that has audited statements, keep in mind that the auditor
preparing the statements probably has worked for the company for several years and has been
remunerated handsomely for his or her efforts. Despite their fiduciary duty to the public and their
possible liability regarding the accuracy of the statements, bias may still affect the results.
Audited financial statements should include much more information than just the four
primary statements (income statement, balance sheet, statement of retained earnings, and
statement of cash flows). Consider the following additional data included in comprehensive
annual reports:

Notes to Financial Statements

Accounting policies (depreciation, sales recognition, accounts receivable write-offs)
Inventory methods (e.g., LIFO, FIFO, specific identification)
Contingencies (e.g., lawsuits, product recalls)
Shares outstanding (e.g., sales of stock by officers, options, and warrants outstanding)
Market value information (e.g., land, buildings, patents, securities)

Supplementary Information
Disclosures related to changing prices (Financial Accounting Standards Board [FASB] #33)

Foreign currency translation (FASB #52)

Oil and gas reserves (FASB #69)
Statement of cash flows (FASB #95)

Other
Management discussion and analysis in annual report
Letter from chair to shareholders
Discussion of competition and order backlogs (SEC Form 10-K)
Reports by industry analysts
Economic statistics (e.g., gross domestic product, consumer confidence)
News articles

The concept of full disclosure plays an important role in the preparation of financial
statements, just as it does in the sale of real estate or the sale of a business in general. In fact, full
disclosure is at the heart of our efficient and powerful economy. In terms of financial statements,
full disclosure means that any economic information related to the business entity that is
significant enough to affect the decisions of an informed and prudent user should be incorporated
into the prepared statements. For example, GAAPs allow the use of alternative accounting
procedures, such as depreciation methods, methods of revenue recognition, and inventory
methods. Users of financial statements, including potential purchasers of the business, must be
aware of these differing policies and procedures.

In terms of reviewing the prepared statements for purposes of analyzing the company's
performance, financial statement analysis refers to the use of various analytical techniques,
including:

Common size analysis

Trend analysis
Common size analysis on a trend basis
Ratio analysis

The term common size analysis refers to restating each of the key accounts on the balance
sheet and income statement on a percentage basis in relation to another key account. Restating
each separate expense as a percentage of total revenue (e.g., 5 percent of sales) is one example.
The goal is to use such information to learn about the subject company and its operations and
effectiveness. Trend analysis calls for analyzing account balances or other figures over time (e.g.,
gross profit over the past five years). Either absolute figures (gross profit dollars) or relative
percentages (gross profit margin) can be evaluated over time. Ideally, such analysis includes both
common size and trend analysis at the same time (e.g., comparing advertising as a percentage of
sales over time).
Another important financial statement analysis tool calls for comparing the subject
company's account balances and common size figures with industry averages (as introduced in
the ARM Approach Questionnaire). Comparing the subject company's advertising as a
percentage of sales with the industry average can provide insights into the company's marketing

efforts. Gross profit, net income, and other measures can be compared with industry norms as
well.
Finally, effective financial statement analysis also calls for the use of ratio analysis. In
general, ratios can be classified into one of four categories:

Liquidity
Solvency
Profitability
Activity

Liquidity is a company's ability to meet its current debts as they come due. The current
ratio is a common measure in this category and is calculated as:

Current assets/Current liabilities

Generally speaking, a ratio greater than 2 is considered favorable, but each industry or
type of company is subject to unique circumstances and tendencies, so care must be exercised in
this regard. The quick ratio is the same as the current ratio except that inventory is subtracted
from the current assets (thus making cash and receivables the most relevant assets, which are the
most liquid assets).
Solvency is a measure of the company's longer-term ability to meet debts. The times
interest earned ratio and the fixed charge ratio, respectively, are two of the more common
solvency ratios:

1. Earnings before taxes plus interest expense/Interest expense

2. Earnings before taxes plus interest expense plus all mandatory payments/Interest expense plus
all mandatory payments

Examples of mandatory payments include lease payments, sinking fund requirements,

and any other contractually fixed payments.
Profitability is self-explanatory and involves measures of the company's ability to
generate profits. Profitability ratios include return on assets, return on equity, and less traditional
measures such as profit per employee. Return on assets and equity, respectively, are calculated as
follows:

Net income/Total assets

Net income/Total equity

Activity ratios involve measures of operational performance and include ratios such as
day's sales in receivables and inventory turnover. Other measures include sales per employee or
sales per dollar of assets. Day's sales in receivables and inventory turnover, respectively, are
calculated as follows:

Net sales/Average accounts receivable

Cost of goods sold/Average inventory

Day's sales in receivables indicates the length of time needed to collect the average
account receivable balance, and the inventory turnover illustrates the number of times the typical
inventory holding is liquidated over the course of a year. As always, ratios take on meaning only
in comparison with prior periods or with industry averages. In a vacuum, ratios are meaningless.
The ARM Approach Questionnaire contains useful Web links for access to more
information about financial statement analysis. Many good books are available, ranging from
accounting texts to practical guides on using and interpreting financial statements. Financial
statement analysis in the form of common size, trend, and ratio analysis is one of the most potent
tools available for evaluating companies for purchase.

Use of the Income Statement

As is now obvious, the cash flow calculation is derived primarily from a review of the subject
company's income statement. Recall from the discussion of the Five-Page Tool in Chapter 3 that
the ideal place to begin a business valuation is with the income statement. Income statements
serve as scorecards for how a company does over a certain period of time (e.g., over one month
or over one year). Specifically, the income statement presents inflows and outflows, typically in
the form of revenues and expenses (also gains and losses). Because income statements (and
balance sheets) are prepared primarily on the basis of GAAPs, they may not reflect a company's
fair market value (FMV) on a going-concern basis.
For example, a company's pretax income may be based entirely on the gain associated
with the sale of an asset or chiefly on the recognition of sales that have not yet been turned into
cash (a sale made on terms that may or may not be collected). A company's balance sheet is
based primarily on the historical cost principle, which in most cases is at odds with market

values. As a result, adjustments are necessary to recast the financial statements for purposes of
evaluation and comparison across similar businesses. Several terms are used to refer to the
adjusted statements, including recast earnings, normalized earnings, and economic earnings. In
regard to the ARM approach, we use the term adjusted cash flow (ACF).

Cost of Goods Sold and Gross Profit

Depending on the type of company (manufacturing, retail, service), the specific format of the
income statement will differ, reflecting the types of costs incurred by such companies. For
example, only manufacturing and retail companies are associated with a CGS and gross profit
component before deducting other expenses in the "General and Administrative" or operating
expenses category.
The gross profit of such companies is an important indication of profitability, calculated
as the difference between net revenues (gross revenues minus returns and allowances) and CGS.
For example, a retail business that uses a keystone markup will show a gross profit margin of 50
percent (goods purchased are sold for two times cost). Service businesses do not have a CGS
account because they do not produce or sell goods. The gross profit percentage (gross profit as a
percentage of sales) is an important indicator of how much pricing power a company has. The
higher the gross profit margin, the more power the company has in pricing its goods.
In economic terms, products that are associated with an inelastic demand have a higher
markup percentage. A good is subject to inelastic demand when a given percentage change in
price leads to a smaller percentage change in the quantity purchased (e.g., price is raised 10
percent but quantity demanded falls only 5 percent), thus increasing total revenue. The primary
determinant of elasticity is the quality and quantity of good substitutes available to the consumer.

Unique products with no close substitutes enjoy the most inelastic demand, which ultimately
means that the company can raise prices substantially without a major loss in customers or
quantity sold.
An alternative interpretation of the gross margin is found when considering extremely
low gross profit margins. The lower the gross profit margin, the riskier the business is. Low gross
profit margins (low markups) mean that each sale contributes very little to cover all other
expenses (G&A expenses such as advertising, payroll for office staff, office supplies, rent, and
utilities). Small gross profit margins mean that if the company's sales decrease dramatically, the
risk of bankruptcy or insolvency is greater (compared with a higher gross profit contribution
situation). Companies that enjoy substantial pricing power via inelastic demand are worth more
than companies with minimal pricing power.
Another way to analyze gross profit margins calls for comparing the growth in revenues
with the growth in earnings or pretax income. If revenues are growing faster than pretax income,
the gross profit margins may be declining or under pressure for one reason or another. If pretax
income is growing faster than revenues, on the other hand, it may be necessary to evaluate the
probability that the current revenue growth is sustainable or that the growth in earnings may have
resulted from one-time or unusual events such as an aggressive strategy to reduce operating
costs. The ARM Approach Questionnaire will lead you to this specific comparison and others in
Section Four.

Accrual Versus Cash Basis Accounting

Another important distinction regarding the income statement is the difference between cash
basis and accrual basis accounting. Many small businesses use cash basis accounting for both

book purposes and tax purposes, whereas more substantial companies are more likely to use
accrual basis accounting, which is a major part of the foundation provided by GAAPs. To
complicate matters, certain businesses use a hybrid method containing both cash and accrual
components.
Accrual accounting calls for matching revenues as they are earned with costs as they are
incurred, regardless of when cash actually changes hands. For example, a company that sells
product on terms (e.g., 2/10, n/30: if payment is made within ten days, a 2 percent discount is
offered, and the entire balance is due within thirty days) will record the sale before receiving
cash from the customer. The accrual element here calls for a journal entry that reflects the sale
(credit to sales revenue) and the accounts receivable (debit to accounts receivable). When money
is ultimately received for payment in full, cash will be debited and the accounts receivable will
be credited to eliminate its balance. All receivables, payables, deferrals, and accruals are a result
of accrual basis accounting.

Sales Recognition
A seemingly simple question such as when a sale should be recognized under accrual basis
accounting can lead to confusion. Whether a sale is recorded sooner or later can affect the bottom
line and thus ACF in a material manner. This area of concern is heightened whenever a company
chooses to change its sales recognition procedure because it complicates comparisons from year
to year and can be used to manipulate the numbers. For example, publicly traded companies that
have enjoyed several consecutive years of growing earnings per share may resort to windowdressing maneuvers such as changing accounting procedures (e.g., accelerating sales recognition)
to ensure continuance of the trend that analysts have come to expect.

Several different possibilities are available in establishing a sales recognition policy, any
of which could trigger the formal recognition of the sale in the accounting books:

When the order is received over the phone or by fax

When the order is filled by inventory specialists (placed into a box)
When the order is shipped (leaves the dock)
When the customer receives the goods (signs for the delivery)
When the customer's check is received
When the customer's check has been deposited
When the customer's check has cleared and entered company accounts

GAAPs allow discretion as to when the sale should be considered complete (within the
parameters spelled out in various promulgations from the FASB or other influential accounting
bodies). By changing its sales recognition policy, a company could either speed up revenue
recognition (higher sales and profits in the current period) or slow it down (lower sales and
profits in the current period but more in the later period). This type of decision making permeates
GAAPs and leads to difficulty in comparing one company with the next.
Other revenue-related concerns from a valuation perspective include companies with
product sales that entail subsequent installation and service attention. Such companies may not
record the complete sale until a later time. Sales that are subject to frequent returns and
allowances also warrant special attention. In addition, increased revenue as a result of substantial
discounting will typically harm future sales results and undermine the quality of current sales. A

skilled valuator is always on the hunt for any peculiar, unexpected, out-of-the-ordinary events or
changes because these situations serve as red flags that normally prompt additional investigation.
It is partly because of this type of situation that you may need to adjust the income
statements when attempting to value a company. Technically speaking, the presence of accrual
accounting complicates the calculation of cash flow as used by business brokers and other
valuators. As described later in this chapter, even the term cash flow takes on different meanings
in different applications. Fortunately, common practice dictates the process used to calculate the
figure known as ACF without overcomplicating the process. Nonetheless, a brief discussion of
this type of change and other potential adjustments when evaluating the subject company's
income statement is now warranted.

Potential Adjustments to the Income Statement

The information presented in this section is intended to provide you with as much insight as
possible before you actually evaluate a company under real-world circumstances. As just noted,
the calculation of a company's ACF for purposes of implementing the ARM approach often is
straightforward and uncomplicated. In fact, you might choose to skip this section and go directly
to the sections explaining how ACF is calculated without affecting your overall valuation
estimate using the ARM approach. Many of the potential adjustments covered in this section will
arise automatically during the valuation process and completion of the ARM Approach
Questionnaire.
Simply adding the various addbacks to the company's pretax income often is uneventful.
However, special circumstances can arise that complicate this process. Should you choose to be
extremely thorough in your analysis, paying close attention to the following list of potential

adjustments will be quite beneficial. The following areas are those most likely to require
adjustments to calculate a pure ACF figure and will be evaluated one by one in this section of the
primer:

Sales recognition and uncollected receivables

Inventory valuation and CGS implications
Fixed asset accounting
Sales and warranty or return policies
Unreported sales revenue

In addition to these fairly common adjustments, other areas may warrant attention as
well. Although the following potential areas of adjustment are less common, they may have a
material impact on the ACF and asset values associated with the company under evaluation:

Investments in affiliated companies

Company/shareholder transactions
Unrecorded or unfunded pension plans
One-time expenses or losses and owner's compensation

Sales Recognition and Uncollected Receivables

Our introduction to accrual accounting addressed the issue of when a sale should be recognized
on the company books. Given the spectrum of possible answers, differences between one
company and another may be substantial. Obtaining the answer to this question is a matter of

asking the company's owner or accountant. Perhaps the most important consideration regarding
sales recognition is whether the company has been consistent from year to year. If changes were
made, possible adjustments might be needed to compare apples with apples. Sellers will be
tempted to change this recognition policy the year before they put the company on the market for
sale because of the favorable impact on reported revenues and profits.
Sales recognition can be even more problematic for companies that use accounting
procedures that are unique to the industry. For example, construction companies commonly use a
percentage of completion method when accounting for individual construction jobs. This method
is based heavily on estimates related to profit margins per project and the percentage of the job
completed as of the date of financial statement preparation. When evaluating a construction
company, you must give special consideration to this accounting method. Also bear in mind that
for tax purposes, such construction companies use a different method called the completed
contract method. Consult your CPA or consider purchasing a construction accounting primer to
support your analysis.
The use of trend analysis (see the ARM Questionnaire, Section Four) is invaluable for
many key accounts and ratios, including those related to accounts receivable. For example, rising
accounts receivable balances may be the result of a strong increase in sales or the result of overly
generous credit or a poor collection effort. Once again, looking for material changes in account
balances will help you focus on potentially important value-related events or concerns.
Uncollected receivables are in essence recorded sales that were not ultimately paid for by
the customer. Thus, if uncollectible receivables are not written off, both sales revenue and
accounts receivable will be overstated. A sale that is not paid for is not really a sale at all. Even if
the sale is still recognized after writing off the receivable, the company's bad debt expense or

uncollectible receivables accounts will shed light on the company's collection skills or the
strength of the customer base. When attempting to value a company, it is always prudent to ask
for and review the company's A/R aging report, which lists all receivables by customer in order
of delinquency. Typically, they are presented in thirty-day increments (e.g., receivables that are
thirty days or less, thirty-one to sixty days, sixty-one to ninety days, and more than ninety days
overdue). Obviously, the more accounts are overdue, the less value they will have. Most accounts
more than ninety days old will not be collected unless special circumstances exist that are
documented and credible.
In regard to bad debt and ACF calculations, the main point is that the reported sales
figures might include a material percentage of revenues recognized that will not be collected.
Thus, it may be necessary to reduce the reported ACF figure by the related amount (the A/R
balance may be overstated as well).

Inventory Valuation and CGS Implications

This area can be extremely confusing for people without a finance or accounting background.
However, the potential adjustments to the related accounts of inventory and CGS can be material
to the valuation conclusion. A manufacturing or retail business is associated with a CGS account
near the top of the income statement, reflecting the cost of producing goods for sale
(manufacturing) or purchasing goods for resale (retail). Accounting for CGS and inventory is
also a function of accrual accounting, whereby an attempt is made to match the revenues earned
with the expenses incurred (matching sales revenue with the CGS).
Recall from our earlier analysis that gross profit is the difference between net revenues
and CGS. A retail business that uses the keystone markup method will show a gross profit

margin of 50 percent (goods purchased are sold for two times cost). Service businesses do not
have a CGS account because they do not produce or sell goods. Consider the following top-line
measure of profitability:
Amount

Percentage

Gross revenues

$100,000

100%

Returnsandallowances

$2,000

2%

= Net revenues

$ 98,000

98%

Less CGS

$49,000

49%

= Gross profit

$ 49,000

49%

Interpreting the top portion of the income statement for either a retail or manufacturing
business would be similar, except for the fact that the calculation of CGS for a manufacturing
company is much more complicated because of the inclusion of a labor component and overhead
to the raw materials used in production (the realm of cost accounting or managerial accounting,
if you want to learn more). In general terms, the following conclusions can be reached by
reviewing this portion of the income statement:

The gross profit margin is 49 percent.

The average markup is two times (cost of X is priced at 2X).
Returns and allowances are 2 percent of sales.

Of course, the practical aspect of such a review would include both trend and
comparative analysis. Listing and comparing these same percentages for the subject company

over the past three to five years would provide insights, as would comparing these percentages
with industry averages from Robert Morris Associates or similar data providers. At present,
however, we are looking at these figures in regard to calculating the subject company's ACF for a
given period of time. The manner in which inventory and CGS are accounted for varies across
companies in the same industry, possibly necessitating adjustments for comparison purposes. In
addition, companies may change their accounting methods from year to year, which leads to
confusing results in need of adjustment.
In general, CGS is calculated as follows:

Beginning inventory
+ Purchases
= Goods available for sale
- Ending inventory
= Cost of goods sold

As this formula illustrates, several accounts affect CGS and thus gross profit, pretax
income, and ACF. Given the several GAAP-approved methods for calculating CGS, the exact
same business undertaking the exact same transactions could be accounted for in different ways.
First of all, the valuator must recognize the type of inventory accounting used by the company
(e.g., does it use FIFO, LIFO, or specific identification?).
The bottom line is that a choice between FIFO or LIFO leads to higher or lower CGS,
which in turns leads to a lower or higher pretax income and thus ACF and taxable income as well
as a lower or higher ending inventory balance. If inventory costs are rising, using FIFO results in

greater reported income than LIFO because the goods purchased before the price increases are
deducted against revenues before expensing the goods purchased most recently at higher costs.
The general implication here is that if LIFO is used, the ending inventory will be based on the
older, lower-cost units (inventory may be understated on the balance sheet) and the CGS will be
based on the more recent, higher-cost units (net income may be understated). The opposite holds
true as well: Use of FIFO (compared with LIFO) may overstate average inventory value and
overstate net income (through a lower CGS). The important assumption for both of these
conclusions is that inventory costs are rising. Note the following summary facts, assuming that
inventory prices are rising over time:
Use of FIFO Use of LIFO
CGS

Understated

Overstated

Ending inventory

Overstated

Understated

Pretax income

Overstated

Understated

ACF

Overstated

Understated

In general, FIFO leads to a more accurate representation of the condition of the business
because inventory is carried at the more recent costs, and CGS reflects the actual pattern of sales
out of inventory. Restating income statements and balance sheets to an FIFO basis is one of the
more common adjustments made to compare subject companies with other similar companies.
In regard to tax issues, note that there are strict IRS guidelines that can tie the use of an
accounting method for inventory to both book and tax purposes. In other words, a business
owner typically is prohibited from using one inventory approach for tax purposes (to minimize
net income and income taxes) and another for accounting or book purposes (to maximize net

income). Thus, if a company chooses to use LIFO for tax purposes (understate income), then it
must also use LIFO for book purposes. The LIFO impact on reducing reported income will
continue as long as company sales stay at the same level or increase relative to purchases of
inventory. Should sales fall relative to new inventory purchases, the opposite effect will emerge
as the older, lower-cost inventory items are sold and charged against revenues. Note also that the
process of forecasting future cash flows is complicated by the use of LIFO. The act of using
artificial costs for both inventory and CGS that do not reflect the actual out-of-pocket expenses
will necessitate adjustments to the forecasted cash flow results.
An interesting real-world situation involving the LIFO versus FIFO choice concerns
automobile dealerships. The IRS requires dealers to include an analysis of the impact of LIFO
under inflationary conditions (the so-called LIFO inflation adjustment). Problems arose when
numerous dealerships chose to omit this analysis (either intentionally or negligently) or
performed improper calculations. Legally speaking, such omissions could allow the IRS to
prevent these dealers from using LIFO for purposes of saving tax dollars. However, the
exceptional influence of dealers (through the National Automobile Dealers Association [NADA])
led to an agreement that allowed dealers who failed to properly submit the LIFO adjustment to
make a payment equal to 4.7 percent of their LIFO reserves as of the preceding year end.
In strict business valuation terms, the evaluation of privately held auto dealerships calls
for an adjustment of market comp data (if using the guideline public company method) to reflect
the fact that almost every publicly traded auto dealership uses FIFO, not LIFO. Use of FIFO
tends to maximize reported earnings, in line with a legitimate goal of companies that report their
earnings publicly. This adjustment affects both the income statement and the balance sheet. In
most cases, it is wise to enlist the support of your CPA or tax attorney to ensure proper

adjustments (for both the LIFO adjustment for tax purposes and the adjustment to the financial
statements of market comp candidates).
Given the importance of inventory accounting in regard to both the income statement and
balance sheet, another example that illustrates the dynamics of this area is worthwhile. We will
walk through the impact of changes in the following accounts that make up the CGS calculation:

Beginning inventory (BI)

Purchases
Ending inventory (EI)

Starting with BI, let's see what happens if it is subsequently determined that a large
portion of the BI was obsolete or damaged. Consider the impact:

Before

After

BI

200

150

+ Purchases

600

600

GAS

800

750

- EI

200

200

CGS

600

550

Difference in CGS and ACF

-50

+50

A decrease in BI reduces CGS and increases ACF accordingly. Now we look at a change
in purchases over the course of a year:

Before

After

BI

200

200

+Purchases

600

400

= GAS

800

600

EI

200

200

= CGS

600

400

Difference in CGS and ACF

-200

+200

This shows the importance of the level of purchases made in the year before a business is
placed on the market. A business owner can manipulate purchases to increase the reported ACF
by simply reducing the amount of new purchases to inventory. Of course, there is a danger of
going too far and having insufficient inventory to meet customer demand, and sales may fall.
However, carefully engineered reductions in purchases of new inventory can increase ACF for
that particular year. Lower purchases during one year may also lead to a lower BI for the next
year, which in turn would lead to a higher CGS and lower ACF. If the company is sold during the
year after the reduced purchases, however, this may not be readily apparent to all buyers.
Now we look at the effect of adjustments to EI on CGS and ACF. Consider the following
scenario:

Before

After

BI

200

200

+Purchases

600

600

= GAS

800

800

EI

200

300

Difference in CGS and ACF

= CGS

600

500

-100

+100

In this case, let's assume that the EI is improperly valued because of recent significant
increases in the cost and thus market price of such inventory. This is not unrealistic for certain
industries over time (e.g., values of gasoline inventories fluctuate because of major political and
economic changes). If the EI is valued higher, then CGS will be reduced and ACF increased by
the amount of the change. This particular situation should help clarify the importance of
inventory accounting (i.e., the differences between FIFO and LIFO). The higher EI balance could
be the result of an accounting change as well (e.g., from LIFO to FIFO). This switch would mean
that the older, cheaper units will be expensed, and the newer, costlier units will be held in EI (EI
is thus higher and CGS is lower than under LIFO).
Operationally speaking, inventory analysis revolves around the inventory turnover ratio,
which is the average number of times the average inventory level is turned over or sold during
the year. The recent popularity of just-in-time inventory has increased this ratio in many
industries. The usefulness of this ratio and many others is found in comparing it over time for the
subject company and with industry averages. The specific background of a given company in a
given industry must be taken into account because rising inventory, for example, may be
interpreted in different ways. It may signal a decline in sales or a rise in obsolete, difficult-to-sell
goods, which could necessitate a sale or discounted pricing that would reduce the gross profit
margin. Alternatively, it may simply reflect the accommodation of rising sales levels overall,
which obviously is a positive development. In every case, however, focus on the change from
period to period and compare the subject company's position with the industry norms.

The main point from this analysis is that accounting for inventory and CGS has a
substantial impact on the income statement and ultimately on ACF. It is necessary to ask the
owner or his or her accountant to clarify the company's accounting procedures for inventory and
to confirm whether an actual count is made at year end to verify the reported balances. Overall,
changes in inventory and inventory accounting procedures can materially affect total assets,
current assets, and financial statement analysis insights regarding liquidity (current or quick
ratio), profitability (return on assets), and activity (inventory turnover) and thus business value.
In regard to business valuation via the third ARM component (market-based valuation),
Chapter 5 covers the related valuation techniques that rely on sale prices paid for similar
companies. Note that the BIZCOMPS database does not include inventory in its price to cash
flow and price to gross revenue multiples. Their logic is that inventory values vary greatly from
one company to the next, even in the same industry, because of the owner-specific decisions
related to the purchase and storing of inventory before and near the time of selling the subject
company. In other words, the purchase price may include a certain amount of inventory that
differs dramatically from the optimal holding amount. Thus, inventory amounts tend to distort
the FMV figures presumed to arise out of actual business sales. However, because BIZCOMPS
normally includes inventory data, these amounts can be added back and the multiples adjusted on
a case-by-case basis to compare apples with apples (other market comp databases).

Fixed Asset Accounting

Purchases of furniture, fixtures, and equipment (FF&E) or property, plant, and equipment
(PP&E) involve the purchase of fixed assets that must be capitalized and then depreciated over

their useful lives. Such purchases raise many interesting issues in terms of evaluating a company
to estimate its FMV. Such issues include:

- Depreciation for tax versus book purposes

- Adjusting depreciation methods to allow meaningful comparisons of companies when using the
market approach to business valuation
- Estimating the FMV of these assets for certain valuation methods

Depreciation is the process of allocating the value of a fixed asset with a useful life of
more than one year over the period of time in which the asset is believed to contribute to the
economic production of the company. Depreciation (similar to amortization) is a noncash
expense because it does not reflect an actual current period cash outlay. Fixed assets are
capitalized at their original cost and then depreciated over their useful lives in one of several
possible fashions. The two most common alternatives are straight-line and accelerated
depreciation, whereby straight-line involves a consistent depreciation expense each year over its
useful life (e.g., the original cost is divided by the estimated number of years of service, and this
result is entered each year on the income statement as an expense that reduces net income).
Larger companies are likely to have different depreciation procedures for tax as opposed
to book purposes. For tax purposes, they seek to minimize taxable income as much and as soon
as possible because of the time value of money. Even though the overall deductions are the same
amount whether straight-line or accelerated methods are used, the accelerated depreciation
techniques can reduce current tax obligations and thereby allow the company to use these tax
savings until the difference is paid in later periods. For book purposes, these larger publicly

traded companies seek to maximize reported income and earnings per share. As a result, they are
more likely to use a straight-line method for financial reporting purposes.
Smaller companies are likely to use only one method of depreciation. Typically this
means that they will use accelerated depreciation to minimize their tax obligations.
Unfortunately, this also reduces their reported book income as well as the book value of the fixed
assets and the total assets of the company.
As described later, depreciation expense typically is added back to pretax income to
arrive at a company's ACF because this is a noncash expense and no actual cash outlay was made
in this amount during the current period. Savvy entrepreneurs will realize that even though
depreciation expense is included in ACF, many companies need annual capital expenditures to
maintain or expand their productive capacity. Therefore, they will account for this necessary
expenditure in one manner or another. Because of a generally accepted custom among valuators
and the manner in which privately held market comp statistics are presented, however, adding
back or counting depreciation and amortization expense toward a company's ACF figure is
necessary in practice.
Operationally speaking, a trend analysis of the subject company's FF&E and annual
depreciation expense levels will help the valuator assess the historical sufficiency of this
important investment (for many companies in manufacturing or other asset-intensive industries
such as dry cleaning or print shops). A common detractor from business value is the
underinvestment in fixed assets for such companies (i.e., deferred investments in capital assets
lessen business value). If future investments are needed to maintain current production levels, the
related debt service reduces future period ACF. Clearly, the lower the future cash flow generated
by the business, the less it is worth today.

For companies that pay a CPA to prepare a statement of cash flows, information about
capital expenditures is readily available. Unfortunately, most small businesses use compiled
statements rather than reviewed or audited statements, which contain this useful financial
statement. Without a statement of cash flows, the valuator must evaluate changes in original cost
of FF&E in light of the current year depreciation expense to make progress in verifying the
actual amount of such expenditures. Simply asking the owner to list all such expenditures may be
helpful, as is a careful review of the company's federal tax return.
One of the more important valuation steps is locating and evaluating similar companies
for purposes of applying the guideline public company valuation method. As explained in
Chapter 5, bringing the market comparable companies in line with the subject company entails
several adjustments. Notably, restating each company's income statement to reflect similar
depreciation accounting is one of the more important adjustments. Although this process can take
time and create certain clerical challenges, it is necessary to compare apples with apples. For
more insights into depreciation and fixed asset accounting, consider purchasing an introductory
or intermediate accounting textbook or primer such as Accounting for Dummies, written by John
A. Tracy, CPA, and published by IDG Books Worldwide (Chicago, Illinois).

Sales and Warranty or Return Policies

The central concern here is obvious: What percentage of reported sales will be returned or
subject to potentially costly warranty repairs? Many small businesses fail to account for this
issue in a rigorous, useful manner. It may be that the reported sales, gross profit, pretax income,
and ACF are overstated because of a sizable amount of probable warranty work or returns. This

can be a critical due diligence concern for a buyer or a valuator. If you don't ask, you may not
know until it is too late.

Unreported Sales Revenue

Without a doubt, unreported revenue is one of the most challenging aspects of evaluating a
business for purchase. Many businesses (perhaps a majority) fail to report all revenues for a
variety of reasons. Certain types of businesses (typically those with substantial cash sales) are
notorious for skimming revenues off the top of the income statement. Restaurants and other
food-related businesses, industries with low-price services such as air conditioning service and
repair or landscaping businesses, and any other business that collects cash from customers (as
opposed to checks or credit card payments) are likely to underreport revenues.
Interestingly, the response to such underreporting varies greatly from one party to the
next. More often than not, the buyer will understand this situation and accept it as part of the way
small businesses are operated. Occasionally, however, a buyer will respond with anger and
disappointment because of his or her personal preference for playing by the rules. These buyers
figure that they have paid taxes, so everyone else should pay their fair share. More importantly,
underreporting will lead some of these buyers to wonder what other records of the subject
company are false or based on lies and deceit.
Regardless of the rationale behind each person's preference in this area, underreporting of
revenues presents a problem for valuators. The challenge is to determine the following:

Was income earned but not reported?

If so, how much, and can it be proven by the owner?

Many buyers take the position that the owner has enjoyed the benefit of avoiding tax
obligations, so he or she should not be able to reap benefits on the other side as well (each dollar
of cash flow increases company value by a factor of one to three for small businesses). On the
other hand, if the revenues can be verified, they represent real cash flow generated by the subject
company. Accordingly, the business value should be increased by this extra cash flow. A common
reaction from buyers is to give at least partial credit to the nonreported revenues, which typically
represent bottom-line profit and cash flow. Because of the sensitive nature of this situation (the
IRS considers nonreporting of income the cardinal sin of taxpayers), the buyer or valuator may
not learn about this extra income until a strong rapport has been built between the parties.
The primary consideration in terms of business valuation is the determination of how
much verifiable income (cash flow) was not reported and what impact this extra cash flow will
have on business valuation. A complete valuation analysis will incorporate these findings into the
final analysis.
A similar situation arises when business owners intentionally postpone recognition of
revenues into the next year to avoid current period tax liabilities. There is a huge difference
between tax avoidance and tax evasion, so this is very different from hiding income. However,
the postponement of revenue recognition can be at odds with GAAPs.
The valuator's main concern is the impact of this delayed recognition on business value.
If there is a pattern wherein the owner postpones similar amounts each year, it will tend to
balance out in the long run. Today's postponed revenue is tomorrow's revenue, so the primary
difference is when and how much tax is paid by the owner. Postponing revenue from a good year
into what may be a bad year reduces the overall taxation by shifting revenue to lower bracket

rates. The major implication of postponing these revenues is found in the time value of money,
whereby the owner has the money that would have been paid in taxes for one more year. In other
words, by postponing the tax payment, the owner can invest the related tax cost for one year and
hopefully earn a positive return.
In conclusion, the valuator must carefully assess the potential underreporting of revenues
and determine its impact on business value. If the business is being valued for purposes of
acquiring the company, this nonreporting may elevate the overall risk associated with the
company and its operations. The IRS has been known to seize assets and shut down businesses
even if the pertinent tax liability was that of the prior owner. It may be possible to recoup any
such damages from the original owner, but only at great cost in terms of time, emotional capital,
and money for legal counsel.

Investments in Affiliated Companies

We now turn to the second list of potential adjustments with the understanding that these areas
are not encountered as often as the items on the first list. Although they are not encountered as
often, they can have a substantial impact on the company's reported versus actual ACF.
Handling investments in affiliated companies can be either straightforward or perplexing,
depending on the details. Affiliated companies can be affiliated in the sense that they are directly
related to the subject company (e.g., a manufacturing company may establish a separate
marketing company to facilitate tax planning for the owners, or a water utility may establish a
separate construction company to maximize the recorded investment costs in fixed assets to
maximize their regulated rate of return). Affiliation in this sense means related in their business
activity.

If only one or the other affiliated companies is being valued, situation-specific

adjustments must be made to reflect the economic viability of the subject company. Its value may
be decreased as a result of this affiliation if the relationship is in jeopardy (e.g., if the subject
company is being purchased by new ownership without the benefits of the affiliated company). If
they are being valued jointly, the ideal situation would be consolidated statements (i.e., an
income statement and balance sheet that combines the economic activity of both companies).
Although this is not always possible for several reasons, it is worth the time involved to request
such statements when evaluating the companies.
A second type of affiliation refers to common ownership only. In other words, the only
link between the companies is common ownership. The real challenge occurs when the two
different companies are accounted for on the same financial statements (e.g., a retail business in
which the owner also owns and operates a ranch for recreational purposes and accounts for them
on the same financials). Carefully segregating the ranch revenues, expenses, assets, and liabilities
is necessary. Complete disclosure is necessary for a meaningful assessment of the core company.

Company-Shareholder Transactions
Also called intracompany transactions, these events alter the income statement and balance sheet
as a result of unique transactions that benefit the relevant parties. For example, it is not
uncommon to see loans made to and from the company from and to one of the shareholders. If
the company lends money to the shareholder, the shareholder typically pays the loan back with
interest. This is one way to take money out of the business and give it to the shareholders without
paying income taxes. If the shareholder lends money to the company, the company will pay back
the loan plus interest. This is one way for the shareholder to earn an above-average return on his

or her idle cash or a way for the company to obtain funds at low rates of interest. In each case,
the rates charged and received often differ from market rates.
Regardless of the direction of funds, adjustments may be necessary to normalize the
income statement and balance sheet. As described later, all interest paid by the company is added
into ACF, so in a sense the amount is irrelevant. If the company earns interest income from loans
made to shareholders, this income should be backed out of ACF for the same general reason that
interest expense is added into ACF. All financial implications related to the company's capital
structure (primarily interest expense) should be factored out because of the wide variation in debt
levels from one owner to the next. Interest expense is added into ACF to arrive at a figure from
which the new owner can service his or her own debt levels, which may be higher or lower than
those of the current owner. Thus, all interest expense and interest income, regardless of their
source, should be incorporated into the ACF results by adding back the expense and deducting
out the revenue.
Whether dealing with affiliated company transactions or company-shareholder
transactions, a key premise is to adjust these events to what is considered to be an arm's-length
transaction. Another good example concerns the handling of real estate. It is common for
business owners to be advised by their CPAs to establish a separate holding company to hold the
real estate on which the business is located for tax purposes. In these situations, the business
typically pays rent to the affiliated company at a level that minimizes taxable income for the
holding company (as opposed to market-level rents). Thus, the rent expense may be understated
or overstated relative to market rates. The business ACF figure should be adjusted accordingly to
reflect market levels of rent for similar properties.

Another type of intracompany or intercompany transaction is the payment of

management or consulting fees. Such management fees are more likely to be intercompany
transactions that are designed to minimize income for one entity to reduce the overall tax burden.
This is based on the fact that a given amount of profit split between two entities will result in a
lower effective tax rate than if all profits were contained in one entity. This important fact is a
result of bracket creep, or a progressive income tax system wherein higher profit levels are taxed
at higher rates.

Unrecorded or Unfunded Pension Plans

This situation typically is an issue only for larger companies, e.g., Enron Corporation. Of course,
the larger the employee base and payroll, the greater the potential danger of improperly funding
the related pension obligations. In general, two potential misfunding situations may arise,
necessitating current- or next-period cash outlays to bring the funds into compliance with
regulations:

Amount owed to employees as a result of prior years of service

Amount owed to employees as a result of probable future service

As of 1993, the FASB has required full funding of all past and future service-related
pension obligations. Larger companies hire out pension management services and make an
annual payment into the pension fund based on statistical and actuarial estimates based on the
number of employees, hours worked, wage and salary amounts, and so on. The manager of the
fund (called the trustee) invests these funds. The difference between the present value of all

future pension obligations and the value of the fund determines the amount of the annual
payment.
The following problems may be encountered when evaluating a company's pension
situation:

- Insufficient payments into the fund in prior years out of neglect

- Incorrect actuarial estimates regarding future (now historical) rates of return or future employee
or salary levels leading to improper fund levels
- Overpayments resulting from incorrect estimates or managerial incompetence

Obviously, overpayments might add value to a company, but underpayments will

certainly detract from value. In regard to ACF figures, prior year figures may need to be reduced
to reflect the proper contributions, or future period cash flows will be reduced to make up for
prior year deficiencies.
As noted earlier, it is typically only in larger companies with dozens to hundreds or
thousands of employees that this situation becomes extremely problematic. However, even
smaller companies can have problems related to their pension plans. For example, whether the
small business uses a Simplified Employee Pension (SEP) or 401(k) plan, these too can be
underfunded. It is important to verify that such plans are properly funded when attempting to
value (or purchase) companies that offer pension benefits. Each company must meet its legal
funding requirements or risk future financial and legal difficulties. If such plans are underfunded,
then once again the prior year ACF figures or future period estimates of ACF or cash flow must
be adjusted to reflect the economic reality associated with these retirement plans.

One-Time Expenses or Losses and Owner's Compensation

With this category of adjustments, we move closer to the more traditional type of analysis that is
done when estimating the cash flow-generating capacity of small businesses. It may be that all or
none of the prior issues (e.g., underfunded pensions, intercompany transactions, unreported
income) warrant attention. In all cases, however, certain mandatory, routine calculations must be
made and added together to arrive at the customary figure of cash flow known as ACF. As
described later, ACF is the sum of pretax income, owner's salary and benefits, depreciation and
amortization expense, interest expense, and any one-time, unusual, nonrecurring expenses or
revenues.
Whether or not you delve into the numerous prior issues that can affect a company's ACF,
calculating ACF based on the formula just listed is your gateway to understanding how small
businesses are commonly valued by business brokers and valuation professionals alike. Any onetime or nonrecurring expenses, losses, revenues, or gains should be accounted for (added back or
deleted from ACF) when calculating a company's cash flow generation to obtain a measure that
reflects the amount a new owner can expect to earn. Clearly, a one-time event such as a favorable
settlement of a lawsuit that included receipt of treble damages is not expected to occur each year
and should not be included in the company's ACF results. Payment of a one-time severance
package for a key employee probably is a nonrecurring event and should not be deducted from
ACF.
Earlier, we discussed in some detail the top line of an income statement: gross profit. We
noted that net revenues minus CGS equals gross profit, which we deemed an important indicator
of financial success to the extent that the greater the gross profit margin is, the more room for

error there will be in terms of other expenses further down the income statement. We interpreted
this gross profit figure as being the contribution toward covering other costs and generating
profits made from the sale of product after accounting for the direct cost of the product.
After gross profit is presented on the income statement, the next section of costs concerns
general and administrative or operating expenses. These expenses are deducted to arrive at either
net income before taxes and interest (earnings before interest and taxes [EBIT]) or net income
before taxes (pretax income, or earnings before taxes [EBT]). Finally, income tax expense is
deducted to arrive at after-tax earnings or net income.
Depending on the type and size of company, EBIT or earnings before interest, taxes,
depreciation, and amortization expense (EBITDA) may serve as the foundation for applying
multiples to arrive at an estimate of company value. Middle-market and larger small businesses
may be best valued using EBIT or EBITDA. Specific industries may also be known for use of
these multiples. For example, one of the largest national real estate brokerage franchises uses
EBITDA as its preferred measure of income for estimating value in regard to acquisitions (on
average it pays approximately three times EBITDA, whereby an adjustment is made if the
owner's salary is above or below market).

Intangible Assets
The final section of the primer is intended to supplement the information presented in the "Asset
or Cost Approach to Business Valuation" section of this CD-ROM. All businesses can be viewed
as a collection of assets being combined in ways that seek to maximize profit. Assets come in
many forms, as a quick glance to any company's balance sheet shows. Current assets and fixed
assets, liquid assets and hard assets, clean assets and encumbered assets are all different

categories of assets. One more relevant distinction exists: tangible and intangible assets. It is
important to realize that every company possesses at least a minimal amount of both types. The
most common association with the term assets is to tangible assets such as cash, accounts
receivable, inventory, and equipment. Less common but in many ways more important are
intangible assets, which also take many different forms, including goodwill, trade names, patents,
and covenants not to compete.
Realize that not every balance sheet includes intangible assets. Items such as goodwill
and a covenant not to compete, for example, are formally recognized (per GAAP) only after one
company or buyer has acquired another company and its assets. In other words, the fact that a
business enjoys the goodwill of its customers does not merit recording of goodwill on the
company's balance sheet. On the other hand, recall that if a business is purchased for $200,000
and there are only $100,000 in tangible assets, the balance must be allocated to a variety of
intangible assets, often in an arbitrary manner. There should be a logical, coherent, and justifiable
allocation, but it will inevitably be subjective.
For example, goodwill is an intangible asset that typically represents the fact that a
business is worth more than the sum of its tangible assets. The entire $100,000 from our example
could be allocated to goodwill. More commonly, particularly for the purchase of smaller
businesses (non-Fortune 500 companies), the $100,000 would be allocated to different types of
intangibles such as trade name, customer list, and covenant not to compete. How much is
allocated to each category is at the discretion of the buyer and seller. The entire $100,000, no
matter how it is allocated, will be amortized over future periods. The only significance for book
accounting (as opposed to tax accounting) is the chosen period of amortization, which should

reflect the useful life of the asset. The shorter the useful life, the greater and sooner the
deductions against revenues will be in the determination of net income.
The choice of amortization period for tax purposes can have much greater importance
because a deduction today is worth more than a deduction in the future (time value of money).
As the tax laws currently stand, however, all intangibles are to be amortized over a fifteen-year
period. Previous laws allowed quicker write-offs for covenants not to compete but left the
deductibility of goodwill as a questionable practice. The recent law was a tradeoff. All
intangibles can be amortized (tax deductions), but only over a fifteen-year period. Once again, it
is possible to use different deductions (amortization) for accounting purposes and tax purposes.
Tax purposes require a straight-line, fifteen-year amortization and book purposes are more or less
discretionary.
Another minor application of the concept of intangibility relates to due diligence
proceedings. Service businesses are almost exclusively based on intangible qualities such as
customer service, availability, and pricing advantages. The proper way to view intangibility in
this regard is that a customer is purchasing a bundle of promises, including general customer
satisfaction. In terms of evaluating a service business acquisition, the qualitative review hinges
on assessment of these intangible qualities.

Valuation Issues
Many of the valuation formulas for businesses call for analysis of intangible assets. Intangible
assets are one of two asset categories that are long term in nature; the other is fixed assets.
Intangible asset valuation can be approached either generally as a loose collection of
miscellaneous, nonphysical assets in the context of valuing a going concern or in terms of a

single, specific asset such as a patent. In almost all cases, valuation of intangibles is necessary as
part of some larger event, ranging from the sale of an entire business to calculating damages
resulting from a patent infringement. Other reasons for valuation include:

Facilitation of bankruptcy proceedings (liquidation or reorganization)

Calculation of value as collateral for a loan
Tax planning (gifts, estates, intercompany transactions)
Miscellaneous dispute resolutions

As always, there is great latitude in selecting and applying the various concepts and
approaches used by appraisers and brokers in their attempts to value these interesting assets.
Before looking into the valuation concepts, consider the following accounting definition
of intangible assets:

Noncurrent, nonmonetary, nonphysical assets of a business. Although they generally lack

physical characteristics, they have values because of the advantages or exclusive
privileges and rights they provide a business. They generally arise from two sources:
exclusive privileges granted by governmental authority or by legal contract and by
superior entrepreneurial capacity or management techniques.

From a valuation point of view, intangible assets normally incorporate the following
characteristics:

Identifiable as to creator, existence, and ownership

Associated with past, present, or future economic benefit (increase in revenues or decrease in
costs)

In legalese, intangible assets comprise a legal "bubble of rights," which vary dramatically
from one type of intangible asset to another. The two broad characteristics just described refer to
the legal existence and economic value that make up the foundation of valuation for intangible
assets. Without both of these components existing simultaneously, there is little need for
discussion or analysis. For example, a legal patent for a worthless product is as unattractive as a
cutting-edge technology without patent ownership (patent owned by another party).
Professional business appraisers will tell you that the selection of valuation approaches
generally depends on the purpose of the valuation (e.g., divorce settlement versus taking a
company public). This same idea applies to the valuation of intangible assets. A professional
appraisal of intangible assets includes the following sections:

Description of subject assets

Precise date of valuation
Description of valuation techniques (including premise of value)
Purpose of valuation

The first two sections are fairly straightforward; the third and fourth are more complex.
The variety of valuation techniques for intangible assets mirror those that exist for valuing
businesses in general. Specifically, they are offshoots of the basic classic or traditional valuation
approaches:

The income approach

The cost approach
The market approach

An important aspect of all appraisals hinges on a premise of value. A premise of value

elaborates on the context in which the appraisal is being completed. Differing premises of value
lead to differing results. This concept applies to valuing intangibles as follows:

- Value in use: This value relates to the value of the intangible asset in the context of a going
concern, combined with other assets to generate income.
- Value in place: This is similar to value in use, but the relevant group of assets is not currently
producing income.
- Value in exchange: This is a type of FMV concept (willing buyer, willing seller, sold
independently of other assets).
- Value in liquidation: This refers to an auction-like environment in which the business is sold
quickly to the highest bidder.

Another way to analyze intangible assets is by type. A great variety of intangible assets
exist in even the smallest businesses. They can be grouped into many different categories:

- Intellectual property: patents, trademarks, and copyrights

- Business acquisition: goodwill, covenant not to compete, customer lists

- Miscellaneous: trained work force, supplier contracts, leasehold interests

When purchasing a business, any one of these intangibles might be important. Remember
the definitions of goodwill as it is applied to business acquisitions? It has three distinct meanings
to the practicing businessperson. Generally, it is used to reflect the idea that a business has an
established, loyal customer base and going-concern value. Second, and more academically, it
refers to the fact that a business is earning an above-normal rate of return, however defined. The
existence of this first type of goodwill will not surface on a company's balance sheet but is
reflected in a higher sales price or value for the business. Most technically, in an accounting
sense, goodwill is an asset recorded on the books only as the result of an acquisition wherein the
purchase price paid exceeds the FMV of the identifiable tangible assets. Looking at goodwill in
this light, it has a meaning that is fairly easy to grasp.
All three of these working concepts seem to meld together. The fact that you are willing
to pay more than the value of the hard, tangible assets means that there is additional, intangible
value, often lumped together conveniently in the asset called goodwill. In reality, what we are
calling goodwill here represents some of the other intangible assets, such as customer lists, trade
names, and leasehold interests. Note that if you are reviewing the balance sheet of a company
that carries goodwill, customer lists, covenants not to compete, trade names, or going-concern
value, you know that this company was purchased by the current owner (as opposed to being
started from scratch). On rare occasions, a company purchases only the customer list of a
business (not the entire business), and this should be recorded as the asset "customer list".
Consider the following additional intangible assets:

Advertisement expenditures from the past

Brand names
Computer programs (software)
Chemical compounds
Space in major retail outlets
Options and rights
Employee training manuals
Easements
Royalty arrangements
Order backlogs

When purchasing a business, the most commonly identified intangible assets are:

Goodwill
Customer lists
Covenant not to compete
Trade name
Going-concern value
Leasehold interest
Franchise agreements

Regardless of the specific allocation among these intangibles, they must be amortized.
Once again, there may be a difference between book accounting and tax accounting. As

indicated, the IRS currently requires all intangibles to be amortized over a fifteen-year period.
For book purposes, there is more latitude. In fact, different intangibles clearly have different
useful lives, which forms the basis of properly amortizing intangibles. Per GAAPs (and common
sense as well), intangible assets should be amortized in a rational and logical fashion.
In practice, this means establishing a useful life for the asset and using appropriate
amortization techniques. For example, a customer list may be useful for four years (depending on
the industry) and should be amortized over four years in equal amounts. For those who are
fanatically precise, it may be determined that some type of accelerated amortization would be
more logical, but in practice this might be unnecessary. Different customer lists and other
intangibles may have shorter or longer useful lives, and reasonable people disagree as to what is
appropriate.
All depreciation and amortization deductions are considered addbacks because they
represent noncash charges against net income. The accounting logic is that the cost of fixed
assets, although perhaps paid for entirely in one year, should be allocated over future periods to
match revenues earned with expenses incurred (matching principle from accrual accounting and
GAAPs). The same idea applies to intangible assets.
In a sense, the cost of the intangibles included on an asset list was paid for completely on
the day the company was purchased, but the recognition of this expense was spread out over the
useful life of the intangibles. As these future period charges are recorded (depreciation and
amortization), there are no associated cash outflows. They are only bookkeeping entries with no
cash implications. Accordingly, ACF includes net income (accounting or book income) plus all
noncash expenses such as amortization and depreciation. In a due diligence framework, one
important task is to determine whether there is a difference between the recorded expenses of

depreciation and amortization for book and tax purposes. This will often clear up potentially
disturbing discrepancies between the two. Companies clearly have incentives to:

Attempt to understate taxable income by rapidly depreciating or amortizing assets (minimize

taxes)
Attempt to overstate reported book income by slowly depreciating or amortizing assets
(maximize company value)

As mentioned earlier, today's tax laws impose mandatory depreciation schedules for fixed
assets (which vary by asset type, e.g., land, buildings, equipment) and amortization schedules for
intangible assets (fifteen years), so the first of these practices is illegal. Remember, though, that
tax laws change every year. Consult your accountant for current and expected depreciation and
amortization guidelines.
As regards the second practice, there is great room for manipulation. For book purposes,
a company whose financial statements are unaudited can choose any time period desired. Let's
use the example of customer lists once again. It may be a fact that a customer list for a specific
industry is good for only two years. However, the company or its accountant could choose to
amortize this list over twenty years.
There is a significant difference between these choices. Assume the amount allocated to
customer lists on IRS form 8594 is $50,000 for tax purposes, and this same amount is used for
book purposes. Whether the $50,000 is amortized over two or twenty years for book purposes
will have a great impact on reported net income (not taxable income). For example, $50,000/2
gives a $25,000 deduction against net income for the first two periods after acquisition and none

for the next eighteen periods. If the $50,000 were written off over twenty years, each year there
could be a charge against net income of $50,000/20 = $2,500. Look at the following simplified
income statements:
Year 1 of 2-Year Useful Life
Sales

$1,000,000

CGS

$500,000

= Gross profit

$ 500,000

- G&A

$ 300,000

Amortization

$25,000

= Net income

$ 175,000

Year 1 of 20-Year Useful Life

Sales

$1,000,000

CGS

$500,000

= Gross profit

$ 500,000

- G&A

$ 300,000

Amortization

$2,500

= Net income

$ 197,500

In short, the quick amortization reduces net income substantially for the first two years
but leaves it unaffected thereafter. The slow amortization reduces net income only marginally
over each of the twenty years. The choice between two or twenty years has a significant impact
on reported net income.

Despite the current inflexible tax laws regarding amortization of intangibles, which
makes the relative allocations to various categories less important, it is still worthwhile to
consider these allocations carefully because of their potential impact on accounting net income.
Additionally, it is often necessary to value all intangible assets collectively as part of the general
valuation of a business (goodwill and the excess earnings method) or to simply establish the
value of an individual, possibly marketable intangible asset (patent and the discounted cash flow
technique).
In light of this information, we can begin to discuss the valuation of these often
mysterious assets. First, recall that many of the popular business valuation techniques explicitly
or implicitly account for goodwill and its various components and interpretations. For example,
the excess earnings method generates business values equal to the sum of the company's net,
identifiable tangible assets and the capitalized value of the company's excess earnings, which is
loosely defined as any profit or cash flow above a fair return on the company's tangible assets.
Ignoring the details here, it is easy to visualize the logic. A company that is earning abovenormal profits (however defined) is worth the sum of its tangible assets and its goodwill, which
is contributing to the company's healthy earnings. This is an example of an explicit usage of an
intangible asset in the valuation of a business.
Most rules of thumb implicitly incorporate goodwill into their formulas. For example, a
business selling for two times ACF (e.g., 2 times $100,000 equals $200,000) with only $80,000
in assets is being sold for the value of the assets, tangible plus intangible (e.g., goodwill,
customers, covenant not to compete, trade name). Interpreting rules of thumb as being based
partially on intangible asset values (generally goodwill) is clearly accurate. However, this is very
different from adding the FMV of tangible assets to the FMV of the intangibles on an asset-by-

asset basis. This last idea is applicable to the asset-based valuation approaches (e.g., the sum of
the assets approach or the adjusted book value approach). Theoretically, these methods (which
are used rarely in practice compared with the cash flow-based techniques) should address not
only the subtraction of liabilities but also the addition of intangible asset values to come up with
the FMV of the net assets of the company. The determination of intangible asset values is
covered in Chapter 5 of the text because of their importance in many valuation scenarios. In
general, if you are to include the value of specific intangible assets in the valuation of the
business, they should meet the following conditions:

The acquirer can enjoy real economic benefits.

Their value can be determined via organized, secondary-type trading (e.g., liquor license).
Each of their values can be calculated separately and independently.

The truth is that most intangible assets will have greatly diminished value the minute they
are separated from the business. Of course, goodwill is unique in that it is a bundle of intangible
assets and cannot be sold separately from the business. Practically speaking, the value of a
specific intangible asset (other than goodwill) can become the focal point of debate between
buyer and seller.
For example, a company may be generating very little revenue or cash flow but own a
valuable patent. When trying to sell or value a business in that condition (minimal and dropping
sales), the buyer or valuator naturally asks, "What am I paying for, and what is its value?"
Besides a customer list and maybe some training, it is normally valuable to offer a registered,
protected patent as part of the sale. Valuation of a patent (and other intangibles such as

copyrights, trade names, and trademarks) is a legitimate issue and worthy of the seller's, buyer's,
and valuator's attention, preferably early in discussions and negotiations in the case of a potential
business sale.
Many business opportunities are presented for sale with a recommended, prenegotiation
purchase price, complete with offered allocations to the various asset categories, including
specific intangibles such as customer lists and covenants not to compete. However, presenting
this allocation before any discussions between buyer and seller occur is unnecessary and might
derail a deal before it can gain sufficient momentum.
If the asking price is $300,000 for a business with tangible assets of $100,000 and an
ACF of $150,000, for example, it should not be a major initial concern that a great deal of the
price in excess of the tangible asset value consists of particular values for a customer list, a trade
name, and a patent. This precontract allocation can serve as a starting point, but in the big picture
it can cloud the most important issue, which is the relationship between the price of the business
and its ability to generate cash flows currently and into the future. In other words, an
inexperienced buyer could be offended by being seemingly asked to pay $75,000 for a customer
list that he feels should be included as part of the goodwill or is simply overvalued. Even if the
buyer's logic is faulty, it might unnecessarily taint their relationship early on.
If the valuation of a specific intangible does become an issue, the following questions
must be answered:

Which valuation method is to be used (income, cost, market)?

What is the premise of value (value in use, place, exchange, or liquidation)?

In practice several unique approaches are available to value intangible assets, all of which
are variations of the income, cost, or market approach.

Income Approach
In this approach, specific contributions to sales, profits, and cash flow are analyzed, commonly
in a net present value context. The basic idea here is to isolate the net profit accruing to the
company as a direct result of the particular intangible asset. Depending on the specific intangible
involved, this could entail comparisons to other companies operating without the asset, such as
relative pricing advantages derived from a brand name or an analysis of the contribution to
profits made by repeat customers (customer list).
Clearly, these calculations can become cumbersome and demand precise and consistent
thinking. For example, when attempting to determine the advantage of a brand name in terms of
higher prices or margins, you must adjust for sales and trade discounts when establishing
appropriate wholesale prices. Next, you must determine (estimate) the useful life of the brand
preference, which will be a function of future advertising and service commitments.
A related issue is whether to adjust the anticipated net profit for the anticipated higher
levels of advertising expenditures, which can reach a high percentage of total sales. Finally, as is
the case for all net present value calculations, choosing the appropriate discount rate is difficult.
Once again, it comes back to logical and consistent applications of the techniques.
An interesting application of this method involves customer lists and the value associated
with future, repeat customers. Standard thinking in the management world is that it is far cheaper
(more profitable) to keep an existing customer than get a new one, hence the great value of
customer lists. To calculate the value of a particular list, many complications must be overcome.

This endeavor would be easiest if there were only a handful of major customers and only a few
products. For businesses with hundreds or thousands of customers and products, the necessary
analysis obviously differs.
In either case, the idea is to assess and quantify annual contributions to profit made by
each repeat customer, establish a useful life for the average customer (i.e., how long they
normally remain active customers), and execute a standard discounting (risk-adjusted rate) of
these numbers back into present value. It seems simple enough, but an economist could quickly
turn this into an expensive project. Only for the largest businesses would such professional
assistance be economically justifiable. Using the basic approach described here should suffice as
a good reference point for establishing the value of a customer list, but expect disagreement and
debate on the way to a compromise.

Cost Approach
In this approach, the probable cost of reproducing or recreating the intangible asset and its
associated benefits in its current condition is determined. Aside from the fact that what it would
cost to reproduce may be irrelevant to the buyer (just as a buyer normally does not want to know
what your business cost you), capturing and measuring all relevant costs (e.g., fixed, variable,
and semivariable; direct and indirect; labor and materials) is easier said than done. Finally, as
indicated earlier, if the intangible is of no practical value to the company, then its cost is
irrelevant.
If you do try to establish the cost of reproduction, be credible, consistent, and flexible
when negotiating. Professional appraisers are certainly qualified to undertake these types of

efforts, but most business brokers are not. If the need arises for a professional evaluation, choose
the appraiser carefully.

Market Approach
This is in many ways the ideal approach to valuation of any asset or business. Unfortunately, just
as the stock of small, privately held companies is not traded and therefore lacks fluid market
measures of value, customer lists and covenants are not traded actively. The simple question of
what a covenant not to compete is worth is staggering, no matter which approach you turn to.
Items such as liquor licenses and franchise rights have readily available market indicators in
most cases and should be closely investigated to establish their current value.

Final Comments
If you need to value a specific intangible asset such as a patent, software program, or customer
list, it may be necessary to consult additional sources of information to ensure a credible and
accurate outcome. The material in the book provides the tools needed to value the entire
collection of intangible assets owned by a given company via the excess earnings method. In
either case, if you need additional information, consider purchasing Shannon Pratt's book
Valuing Small Businesses and Professional Practices, published by McGraw-Hill (3rd edition) or
conduct an Internet search using keywords such as:

Intangible asset valuation

Valuing intangible assets
Valuation of patents

Valuing customer lists