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Buying a Business, Financial Statements

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The discussion of buying a business financial statements in this section assumes that the statements are prepared in accordance with generally accepted accounting principles. Here is a brief statement of some of the more important of these principles:

  • A business should have financial reports prepared at the end of each calendar or fiscal year, with interim reports during the year. Use of the "natural" business year as the formal accounting period has been increasing. The natural year is the 12-month period ending at the lowest point of business activity for the period.

  • Since many business transactions will be incomplete at the end of any accounting period, some estimates will be necessary. Such estimates are an acceptable part of financial reports as long as they are made according to procedures that have proved reliable in the past.

  • Each business is considered a separate accounting unit, with the affairs of the business kept entirely separate from the owner's personal affairs. All records and reports should be prepared on this basis.

  • Financial statements are prepared on the assumption that the business unit will continue to function in its usual manner.

  • For some accounting objectives, two or more methods are possible. For example, there are several methods of computing depreciation and also of valuing inventory. They are all valid, but once a method has been selected for use in the records of a business, it should be used consistently.

  • Accounting must be practical. Strict adherence to a principle is not required when the increase in accuracy is too small to justify the increased cost of compliance. A uniform policy should be adopted to guide such exceptions, however.

  • All assets and services required by a business should be recorded on the date they are acquired at their cost to the business. This cost includes costs incurred to procure the asset or service and to place it in position or condition for business use. Donated assets are recorded at their cash equivalent value as of the date of donation.

  • A major objective of accounting is to determine income by matching costs against revenue. The net income of a business is the increase in that company's net assets brought about through profitable exchanges of product and services or through sale of assets other than stock in trade.

What Is Being Sold

In the usual buy-sell transaction relating to a "going concern," what is being bought or sold is primarily a future stream of income. Not the assets or property of the business, but the income these assets will generate in the future. But future income is impossible to compute and hard to estimate. Therefore, the buyer and seller often ignore this unknown quantity. In trying to set the price, they concern themselves with known values relating principally to the replacement cost of the tangible assets being sold. This is a mistake.

Use of Past Financial Data in Valuing Future Income

It has been said that history repeats itself, but this is not always true of the financial history of a business. First of all, the question arises, "Why is the present owner willing to sell the business?" One reason may be that he foresees adverse change of one sort or another.

Keep in mind, too, in trying to predict the future from present results, that there will be a change of ownership. Will the new owner be able to produce the results the former owner did? Is he trained and experienced in management as well as in the mechanical or technical needed?

There are many reasons why past operating results may not be a good indication of future income. Still, they are at least concrete facts. They should be examined carefully for whatever insight they may provide into the future.

What Data To Expect

Most businesses will have at least two basic financial statements prepared at the end of the annual accounting period - a statement of income and a balance sheet. There may also be other statements containing important information. These might include a reconciliation of retained earnings in the business, a statement of source and application of funds, and listings of such items as inventories, accounts receivable, and accounts payable. However, the statement of income and the balance sheet are the basic financial statements. Any business can reasonably be expected to have these two available.

If they have not been prepared, it may be necessary to construct approximate statements -particularly statements of income based on the best information available. If they are available but were not prepared in accordance with generally accepted accounting principles, they will probably have to be adjusted.

It is essential to understand what the accountant means by the amounts shown on the financial statements. The items discussed below should appear on most such statements. The listing is not all-inclusive, but most major items are discussed.

The Balance Sheet

A balance sheet lists in one section all the assets of the business as of the last day as of the accounting period and in another section all claims against these assets. Claims against assets include creditors' claims, or liabilities, and owner's claims, or investment ( also called equity or net worth ).

Assets

Cash. This asset includes cash balances in the bank, cash on hand (including change and petty-cash funds), funds held in trust, sinking funds, and funds in time deposits. Not all the cash will necessarily be available for payment of liabilities. Change funds, for example, must be retained in order to have the change necessary for doing business.

Marketable securities. Included in this classification are such items as Treasury bills and perhaps stocks and bonds. These assets are most commonly shown on the balance sheet at their cost to the business or at their market value.

Accounts receivable. An entry that is identified merely as "accounts receivable" or has the designation "trade" after it refers to accounts receivable from customers only. Notes or accounts receivable from officers, employees, or owners of the business are considered non-trade receivables and should be entered as a separate item.

Allowance for bad debts. This is an account that is deducted from the accounts-receivable account to give a more accurate valuation to accounts receivable. Suppose the business has accounts receivable of $100,000 and experience indicates that 5 percent of this amount will

be un-collectible. There is no way of knowing which specific accounts will not be collected, but it can be estimated that $5,000 will eventually be un-collectible. To reflect this fact on the balance sheet, accounts receivable are shown at $100,000. An allowance for bad debts of $5,000 is also entered and deducted from the accounts receivable, leaving a net of $95,000 as the estimated collectible accounts receivable.

Notes receivable. This account includes the face amount of all notes that have been given the company and that are still un-matured, even those that have been discounted at the bank.

Notes receivable discounted. This is a contingent (possible) liability account. If a note receivable has been discounted at the bank, the company has had to guaranty its payment. Thus, until the maker of the note pays the bank, the company has a possible note payable.

The amount of the notes receivable discounted is entered on the balance sheet under the notes receivable entry and subtracted from the notes receivable total. An alternative method is not to include it in the notes receivable total but to show it in a footnote.

Notes and accounts receivable from officers, employees, and owners. This amount will include amounts due the business from persons connected with the business in some way. Advances for employee uniforms or cash loans may have been made, for instance.

Inventories. Inventories are the major asset in some kinds of businesses, particularly those in the merchandising field. Methods of valuing inventories are similar in manufacturing and non-manufacturing companies, but the mechanics of computing the values differ. Therefore, valuation methods are discussed separately.

Purchased inventories. If the business buys merchandise or raw materials which it merely holds for a time and then sells with little or no alteration, the inventory is valued either at cost or at the replacement price if the latter is below cost. If the replacement price is higher than cost, the inventory should be valued at cost.

It is generally agreed that if the cost of transportation of the goods to the company is a significant item, the inventory account should include this cost. In fact, all costs involved in preparing the goods for sale could justifiably be included. Such costs might include, for example, certain costs of dividing and repackaging.

Once it has been decided what costs are to be included in the inventory account, there are at least four major methods of valuing the inventory:

1. If a business specifically identifies items in costing inventory, it must be able to tell what was paid for each item. This method is practical for items with a high unit price, such as new automobiles or major appliances. As the unit price falls, however, and the number of items in the inventory increases, this method of valuation becomes less practical.

2. First in, first out, or FIFO, is another method of costing inventory. It assumes that the first units purchased are the first units sold, that those still in inventory are the last ones purchased. Thus, the inventory is valued at the cost price of the last items purchased by the business.

3. Last in, first out, or LIFO, assumes the opposite - that the last goods purchased are the first ones sold. The inventory is thus valued at the cost of the first inventory items to be available for selling. The inventory valuation under LIFO does not necessarily correspond very closely to current replacement costs.

4. The average cost method is merely an average of FIFO and LIFO. It aims to find a middle ground between the two extremes.

If prices of the goods purchased have been rising, the FIFO valuation will come closest to current market prices - the use of LIFO will tend to value the inventory at less than current market prices. The choice of inventory valuation will affect the reported cost of goods sold on the income statement and also the reported net income.

Manufactured inventories. If the company manufactures goods from purchased raw materials, the inventory costing or valuation method is somewhat different. Any raw materials on hand are valued by one of the methods described for purchased inventories. Valuation of work in process and finished goods inventories involves three elements:

1. Cost of the raw materials used. This can be computed very exactly.

2. Cost of the direct labor used in converting the raw material into its present state of completion. This, too, normally lends itself to fairly exact measurement.

3. Factory overhead, or indirect cost. These are the costs of such items as insurance, indirect materials, indirect labor, taxes, and so on. They must be allocated to the units produced on some reasonable basis.

Total indirect costs do not vary with the amount of goods produced, or at least not proportionately. This means that if the plant is not operated at its maximum capacity, the indirect costs per unit of production will be more than would be the case if the plant were operated at a higher level of production. Therefore, idle time or idle capacity in a plant may cause the inventory value of manufactured goods to be unrealistically high.

Prepaid and deferred items. Prepaid expenses are prepayments for goods or services that will be consumed in the near future prepaid rent, prepaid insurance premiums, office supplies, and so on. Deferred charges are prepayments that will benefit the company over a period of years, such as the cost of moving to a new location.

Property, plant, and equipment. This classification includes all the fixed assets of the business-land, buildings, equipment, and other tangible items that will last more than a year and will be used in the normal operation of the business. These items, under generally accepted accounting principles, should be recorded at their original cost to the business.

Occasionally, a buyer may find that the seller has raised the valuation of these assets by appraisal write-ups. If this has accrued, the buyer must satisfy himself that the value of the assets has in fact increased by the amount of the appraisal write-up.

Accumulated depreciation and depletion. This account shows the amount of depreciation, or loss of usefulness, that has been charged against the property, plant, and equipment while they have been held by the business. On the balance sheet, the amount in each depreciation account is deducted from the corresponding property, plant or equipment total. This leaves the net book value, or un-recovered original cost. A depreciation account is merely a technique for distributing the cost of a fixed asset over its estimated useful life. It is quite possible for assets that are fully depreciated on the books to be still serviceable, and for assets not fully depreciated to be no longer serviceable.

There are a number of methods of figuring depreciation. Four of the most common are the straight-line method, the declining-balance method, the sum-of-the-years-digits method, and the units-of-production method.

The first three methods record depreciation on the basis of time. The straight-line method records the depreciation uniformly over the years of the asset's estimated service life. It is by far the most commonly used because of its simplicity. The declining-balance and sum-of-the years-digits methods record larger amounts of depreciation in the early years. With these two methods, increased maintenance expenses in later years are offset somewhat by the reduced charges for depreciation. Also, there are some income-tax advantages.

The units-of-production method is based on the estimated productive capacity of the asset rather than time. It is useful where the amount of usage varies considerably from time to time.

All four methods will record the same total depreciation over the life of the asset. There may be a substantial difference in the amount recorded in any one year, however.

Intangibles. This classification includes such items as patents, trademarks, and goodwill. The value recorded is their cost to the business. The amount entered for a patent, for example, will be either the cost of purchasing the patent right or the cost of developing the patent. Goodwill will not appear on the balance sheet unless the business purchased the goodwill and has decided to leave it on the books.

Liabilities and Owner's Equity

Accounts payable to trade.

Accounts payable to trade. The amounts recorded in this account are the amounts owed to regular trade creditors (except notes payable) for merchandise and other items needed in operating the business.

Notes payable. This item includes all amounts owed by the business for which a formal note payable has been given if the note is due in 12 months or less from the balance-sheet date.

Accrued taxes payable. This account will show the amounts owed to various taxing authorities. It will include taxes that have been collected or withheld but not yet forwarded to the authorities. The account may also include accruals for items such as property taxes, franchise taxes, and use taxes the business owes but has not yet been paid. The amount shown on the balance sheet should be the amount that the business is legally liable for.

Wages and salaries payable. This account will show all wages and salaries of employees earned but not paid as of the balance-sheet date. Any unclaimed wages due former employees will also be included in this account.

There are some rather rigid legal requirements about the handling of taxes collected from the employees as opposed to ordinary business liabilities.

Income taxes payable. This account may not appear on the balance sheet if the business is operated as a single proprietorship or partnership. It should be shown for a corporation. The amount may be only an estimate but will usually be quite accurate.

Unearned income. Some types of businesses receive fairly large amounts of prepaid or unearned income. The publisher of a newspaper or periodical, for instance, is paid for subscriptions before the publications are delivered. If a business rents property to others, the rent will be received in advance. The amount of such income that has been received but not earned at the balance-sheet date is recorded here. There may or may not be a legal requirement that the unearned amounts be returned if the company fails to deliver the services or products.

Long-term liabilities. For a liability to be considered long term, its maturity date should be more than 12 months from the balance-sheet date. If unearned income is prepayment for services covering more than a year from the balance-sheet date, a proportionate amount of it should be included here instead of under unearned income.

Owner's equity. Two elements enter into owner's equity: the initial investment of the owner or owners, and retained profit or loss. The computation of owner's equity is based on the recorded value of the assets and liabilities of the business - it is merely the difference between the total assets and the total liabilities. If the assets are recorded at less than their true value, the owner's equity will be understated. If the assets are recorded at an inflated value, the owner's equity will be overstated.

If the business is a corporation, the original investments of the owners will be kept in separate contributed capital accounts. The net results of operations will be summarized in one or more retained earnings accounts. All these accounts together make up the owners' investment in the business.

If the business is a single proprietorship or a partnership, each owner will have a capital account that summarizes his investments, his share of net income or losses, and withdrawals he has made.

Income Statement

The income statement is a summary of the income and expenses of the business for the period covered. It shows the net result of operations - profit or loss - for the period.

Revenue. All income of the business from whatever source should be included. However, income from operations is usually shown separately from other income such as interest or rent. Charge sales are included in sales income at the time the sale is made, regardless of when the cash is received in payment.

Cost of goods sold. The cost of goods sold equals the cost of goods purchased during the accounting period (including transportation) plus the beginning inventory and minus the ending inventory.

Gross margin. This is the difference between income from operations and cost of goods sold. The gross margin must cover operating expenses, taxes, and profit.

Operating expenses. Types of operating expenses vary with the type of business, but all businesses have some - building expenses, utilities, wages, supplies, some kinds of taxes, insurance, and so on. These expenses for the accounting period are subtracted from the gross margin to give the net income (before income taxes).

Auditing of Financial Statements

If the buyer in a buy-sell transaction asks an accountant to audit the financial statements of the seller, the accountant will want to make a "purchase investigation." A purchase investigation is a normal audit with intensified examination of certain items critical in a buy-sell situation. The accountant may go to greater lengths, for example, to make sure that the physical plant and all equipment are present and in serviceable condition.

What If There Are No Financial Statements

The buyer may find, in a very small business, that the owner has never prepared financial statements. Furthermore, there may be no records available from which to prepare them.

There is no realistic way to determine the results of past operations without financial statements. However, there are a few records that even the smallest, most poorly run business must have. The buyer should try to construct from these records as realistic as possible an income statement and balance sheet. Here are some of these records:

The seller will have had to file Federal income-tax returns that include an income statement for the business. At least part of this income statement will probably have been prepared on a cash basis and will not reflect the results of operations as accurately as a statement prepared on an accrual basis would. However, it is a fairly safe bet that the seller has not overstated the receipts from the business on his income-tax return. He may have tended to overstate expenses, though, particularly by including some personal expenses as expenses of the business.

If the seller has a retail store and make sales in a State that has a sales tax, he has had to file sales-tax returns. The buyer should examine these returns to determine the amount of gross sales during the period covered.

If the business has employees, the seller will have made deductions from the employees' pay for income taxes and Social Security. The returns prepared for the Director of Internal Revenue covering these deductions will show the wages paid.

Almost any business will have certain types of expenses such as property taxes and insurance. The buyer can call the County Treasurer and the insurance agent to learn the amounts of these expenses.

A fairly good evaluation of the financial position of the business can be made by talking to the seller's principal suppliers and to his bank to determine the amounts owed by the seller and the credit standing of the business.

Meir Liraz

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