Most businesses, in their tax returns, attempt to show their income as small as possible, their expenses as large as possible, the net profit as small as possible and therefore, their tax impact as small as possible. This may work fine at tax time, but there could be a day of reckoning when they attempt to sell the business or to sell their interest.
Let's look at ABC Manufacturing Co., a closely held, private business. Included in their tax return are the following expenses:
* Rent: $400,000
* Officer's salary: $500,000
* Salaries and wages: $800,000
* Board of directors salary: $300,000
* Legal fees: $50,000
According to those tax returns the business lost $100,000. Therefore the business paid no taxes. Based on an income approach, the business has no value. The question: "Did the business really lose money?"
Part of the valuation process by the business appraiser consists of recasting the financial statements (profit-and-loss and balance sheets). The process consists of eliminating or adjusting all non-operational income and expenses, non-recurring income and expenses, non-arms-length expenses such as rent, perquisites, excessive or insufficient owner's compensation and pension and retirement accounts. Balance sheets are adjusted by recasting assets at current replacement costs and eliminating or adjusting non-arm's-length assets and liabilities. The adjusted net profit and net worth seldom looks like the original.
In the case of ABC Manufacturing, an in-depth examination of the financials indicated the following:
* The owner of the business, under a different name and entity, also owned the real estate where the business was situated. In other words, the landlord was also the tenant and could (and did) charge whatever rent he wished. In this case, the fair market rent was $200,000 but the business paid $400,000 and, based on comparative rents, was excessive by $200,000. What should have gone to the bottom line went into the owner's pocket in another form. In the event of a sale of the business, a reasonable buyer would not consent to pay that much rent.
* The sole officer (owner) of the business paid himself $500,000 in annual salary plus a board of director's fee plus the wages supposedly paid to his children. Compensation studies indicated that his fair and reasonable compensation should have been $250,000.
* Included in salaries and wages were the owner's two minor children, both of whom were away at private schools, who had no involvement in the business but drew salaries of $100,000 each. Their salaries ended up in dad's pocket.
* The board of directors consisted of three people: the owner and his parents who lived abroad and contributed nothing whatsoever to the business.
* Legal fees: Fees to defend a non-recurring lawsuit.
Here's how it looked pre-recasting:
Gross revenue $6,000,000
Cost of goods sold $3,000,000
Gross profit $3,000,000
Operating Expenses $3,100,000
Net profit /loss <$100,000>
EBITDA (earnings before interest, taxes, depreciation, amortization) equaled a loss of $100,000.
Here's how it looked after-recasting:
Net loss $100,000
Adjust rent to fair market $200,000
Adjust officer's salary
to fair and reasonable $250,000
Eliminate children's
salary from wages $200,000
Eliminate board of directors $300,000
Eliminate non-recurring
legal fees $50,000
Adjusted net profit (EBITDA) $900,000
After recasting, the business showed a profit of $900,000. If, through capitalization studies, a rate of 30 percent return of cash on cash was developed, the indicated value of EBITDA would be $3 million. (Divide $900,000 by .30%) This is a far cry from zero.
A proverbial joke is, "He keeps two sets of books." The truth is that, unless it is for unlawful purposes, there are many reasons why a business owner would want to keep two sets of books. Many personal-service businesses (real estate, insurance, accounting, law, and medical practices) keep two sets of books; cash for tax purposes and accrual so they know what the real profits/losses are.
What's the difference? Cash reporting recognizes only revenue actually collected and expenses actually paid. Accrual reporting recognizes all revenue earned, collected or not, and all expenses incurred, paid or not.
Under cash reporting the tax return (income and expenses and balance sheet) would not show accounts receivable or payable including sales that have been made but not yet billed. The differences between cash and accrual reporting can have a considerable impact on the value of a business. For example:
Cash Accrual
Gross revenue $1,000,000 $1,000,000
Accounts receivable -0- $250,000
Total revenue $1,000,000 $1,250,000
Expenses paid $600,000 $600,000
Expenses unpaid -0- $100,000
Net profit (EBITDA) $400,000 $550,000
Assuming that the earnings have a value of three times EBITDA, the value of the business on a cash basis is $1,200,000. The value of the business on an accrual basis is $1,650,000.
As a taxpayer, which would you prefer?
As a seller, which would you prefer?
Jerry F. Golanty is president of BizVal in Reno and a former governor of the Institute of Business Appraisers. Contact him at wjerrygolanty@bizval.net or 332-4881.
