It is important to know what the accountant who audits and certifies the financial statements is saying. He is not saying that there is no possibility of error in the financial statements. He is saying that the financial statements substantially reflect the correct financial position of the business. His certificate on a set of financial statements is the buyer's assurance that he can rely on the statements without further investigation to determine that they were prepared correctly. Some adjustments may be needed, however, to make the statements more useful in valuing the business.
Cash. No revaluation of this item is likely to be needed unless the business has deposits in foreign currencies. In that case, a revaluation may be necessary for possible loss in conversion of foreign currencies into dollars.
The buyer should also be aware that some of the cash may not be available to pay current debt and operating expenses. For example, some cash may have to be kept in change and petty-cash funds.
Marketable securities. Marketable securities are often recorded on the balance sheet at their cost, which may be below current market value. These assets should be stated at market value. Short-term Treasury notes or bonds that will mature shortly after the sale of the business could be valued at their maturity value. There would probably be little difference between this and their market value.
Accounts receivable and allowance for bad debts. These two accounts must be examined together. The buyer should make certain that the net receivables on the balance sheet are really collectible. The most common way to do this is to prepare an aging of the accounts receivable to show how old each account is. Thus, if the business normally sells merchandise on 30 days' credit and many of their accounts receivable are more than 90 days old, it is doubtful that these accounts can be collected.
If there are large accounts due from individual customers, the buyer might be wise to correspond directly with the customers to verify the amounts receivable. At the very least, invoices and signed shipping receipts should be studied to make sure that the customers have received the merchandise and have not yet paid for it.
The objective of the valuation of the accounts receivable is to state them at the true net collectible amount.
Notes receivable and notes receivable discounted. These two accounts must also be examined together. Unless the business normally receives a note at the time of a sale, a note from a customer usually means that the customer was unable to pay his account when it was due. The customer has, therefore, already shown some financial weakness, and the number of notes that will prove un-collectible may be fairly high. The buyer should try to find out whether notes still held by the business are likely to be paid at maturity.
The objective is to state the notes at their estimated collectible value and the amounts the business is likely to have to pay on default of discounted notes.
Accounts receivable and notes receivable from officers, employees, and owners. Since these items represent amounts due from people who have an inside interest in the business, there maybe a serious question as to whether they will be collectible. Care should be taken to see that they are stated at their realizable value to the business.
Inventories. If inventories are stated on the balance sheet at cost, this cost may be what was paid recently, or it may be only indirectly related to the present value of the inventory. If the buyer does not feel competent to appraise the condition of the inventory, he should obtain the service of someone who is. He should not rely on the valuation of the seller.
One way to verify or correct the inventory value in a small business is to get the company's supplier to value the inventory. This is especially suitable if one principal vendor supplies the business. Since he or his representative will have to visit the business regularly in the future, it will be to his advantage to make sure that the valuation is fair. Also, the suppliers know the value of their own goods. The valuation should allow for all trade discounts and damaged or obsolete stock should be rejected.
Prepaid and deferred items. These items will be valued at their un-recovered cost to the business. The buyer should make sure that he can use any prepaid items he buys. Suppose, for example, that the business has recently purchased substantial quantities of stationery and other printed office supplies bearing the name of the present owner. Unless the name of the business is to be carried over, any amount that appears in the prepaid items for these supplies should be removed.
The buyer should also make sure that any prepaid insurance premiums and the insurance policies to which they apply can be transferred to him without loss of coverage or requirement for additional premium payments. He should be aware that premiums on workmen's compensation insurance are subject to later adjustment. Any insurance the buyer doesn't't want, of course, will be canceled, and the balance sheet should be adjusted to show this.
Property, plant, and equipment. A professional appraisal of buildings, plant, and equipment may be useful, but many intangibles enter into a selling price. The fact that the building is appraised at $100,000 doesn't necessarily mean that the building is worth that much to the buyer. On the other hand, it may be worth more.
Another common way to value an asset of this kind is to establish a replacement value, allow depreciation for the length of time the asset has been held, and use the remainder as the value of the asset. The main problem in using replacement value is that fixed assets are seldom replaced with identical assets. A 20-year-old building is not likely to be replaced with a building just like it. Building methods change and needs of the business change. Therefore, it is unrealistic to think in terms of replacement cost for an asset that would never be replaced.
The seller of the business may want to value these fixed assets on the basis of values established by the insurance company in determining the amount of fire and extended-coverage insurance. The buyer should realize that these values are not necessarily equal to sale or market values. There is probably no one good way to value assets of this kind. Their true value will depend on the amount of income that can be generated through their use.
Intangibles. Intangible assets are recorded on the balance sheet at their cost to the business less any amounts written off. The buyer is mainly concerned with whether the intangibles really exist and will benefit the business in the future. Patents and trademarks may have a market value and could, in some cases, be sold. But their market value is very hard to determine until they are sold.
The buyer may recognize that patents and trademarks will benefit the business but be unable to determine the degree of usefulness with any accuracy. He should at least recognize that patents have a limited life, and he should find out how much time is left before the patent expires. A trademark, if registered, is not limited and may benefit the business indefinitely.
Any goodwill on the balance sheet reflects an amount paid at some time in the past, less what has been charged off. There is no assurance that any goodwill still attaches to the business.
In the case of liquidation, intangibles are usually of no value. Anything paid for them is not likely to be recoverable.
Claims Against Assets
Accounts payable to trade.
Accounts payable to trade. If the business is in financial difficulties, the creditors may be willing to adjust downward the amounts due them.
In that case, the balance-sheet item should be adjusted to show only the amount required to satisfy the creditors' adjusted claims.
If some of the accounts are past due, it may be found that some of the creditors have mechanics' liens against assets of the business. This is primarily a legal matter. The buyer should consult his lawyer about this possibility.
Notes payable. It is possible that substantial interest accrued on notes payable has not been entered in the accounts of the business. This account should be valued at the face amount of the notes plus interest accrued up to the date of the buy-sell agreement. If some of the notes are past their maturity dates, the buyer should consult his lawyer about the possibility of pending legal action against the business.
Accrued taxes payable. These amounts due are subject to audit by the taxing authority concerned. It is entirely possible that past discrepancies or failure to report taxes due might result in substantial penalties, interest, and back tax payments.
The buyer should try to ensure that a clear distinction is made between the seller's responsibility for taxes collected in the past and the buyer's responsibility for future tax liabilities. He must make certain that the account properly reflects all sales taxes collected and not yet remitted to the taxing authorities; all withholding taxes collected and not yet remitted; and all excise taxes. He should also make certain that the business is not liable for any taxes it has failed to collect in the past.
Income taxes payable. A business organized as a single proprietorship or partnership does not pay income taxes as a business and therefore will not have this account. If the business is a corporation, the buyer should see that income taxes of the business have been paid and that there is an adequate income tax accrual in the books for current income taxes payable. If income taxes have been improperly reported in past years, the corporation, even if it has changed hands, will have to pay any back taxes, penalties, and interest assessed against it.
Unearned revenues. The principal concern here is to make certain that all unearned revenues that have been collected are included in this account. Some businesses may record unearned revenues as earned revenues at the time of receipt.
Long-term liabilities. Most long-term liabilities will be evidenced by a formal agreement such as a note payable or a mortgage payable. They should be valued at the total amount owed, including interest.
Unrecorded liabilities. It is always possible that some notes payable, accounts payable, or accrued liabilities have not been included in the sellers' latest balance sheet. The buyer should be aware of this possibility and make at least a reasonable search for unrecorded liabilities such as these.
Contingent Liabilities. This broad group includes a number of items that may become liabilities to the business even after it changes hands. Usually few, if any, contingent liabilities appear on the seller's balance sheet.
For example, a delivery truck owned by the business may have been involved in a serious accident. If the business had inadequate insurance protection, there is a very real possibility that the business will have to pay substantial claims. Or perhaps warranties, express or implied, go with the merchandise or services sold. Future costs may be involved in honoring warranties already given by the seller. Such items could conceivably have an appreciable impact on the future profitability of the business.
The searching out of contingent liabilities is difficult. In fact, there may be no way to discover some of them. But any prospective buyer should search out whatever information he can about contingent liabilities of the business he is considering. Some of these investigations might best be done by the buyer's attorney. If the buyer knows the real answer to the question "Why is the seller willing to sell?" he may decide the business is not a good investment.
Owner's equity. If the above examination of the balance sheet has resulted in any changes in assets or liabilities, the owner's equity will have to be adjusted. It must equal the difference between total assets and total liabilities.
The buyer should examine the income statement closely to make certain that it gives a reasonably accurate picture of the results of past operations. He should determine that the revenues reported on the income statement were earned in the period covered by the statement. No prepaid or unearned revenues should be included in the income reported, and no revenue items that properly apply to the period should be omitted.
Expenses. Expenses should be examined to determine that all have been included and that all items included are proper expenses of the business. If any personal living expenses of the owners have been paid by the business and included as business expense, these items should be eliminated.
Owner's salary. The amount of salary paid the owner is always a troublesome area. It may appear too high - or completely inadequate. The buyer should know the market value of his services. If the business will not provide him an adequate salary plus a satisfactory return on the capital he invests, he may be better off financially to work as an employee and invest his money elsewhere.
Depreciation. The buyer should pay close attention to any write-off for depreciation expense. The amount of depreciation expense claimed is basically a decision based on the judgment of the seller and his accountant as to which method to use in computing depreciation.
Common ownership. In some cases, the buyer may find that the business is one of a group of businesses under common ownership. If this is the case, the buyer should make certain that the business has been charged for all expenses that should be attributed to it. For example, has the business been charged for its clerical and bookkeeping services, or have these been supplied by the parent company at a nominal charge or no charge at all? If they have been supplied by the parent company, the income statement should be adjusted to include this expense.
Occupancy charge. Another item about which the buyer should be concerned is the occupancy charge. Is it unusually low? This might happen for any of several reasons. Probably the most common reason is that the seller owns the property and, once it had been fully depreciated, entered no charge for rent or depreciation. If this happens, an unrealistically high net income may be reported.
Another possibility is that the business may have been paying an abnormally high or low rent for the real property occupied. This situation often occurs when the business is one of a group of businesses with common ownership.
The buyer should take care that a realistic charge for occupancy of real property is included in the adjusted income statement.
Notes to Financial Statements
A financial statement may or may not have accompanying notes. If there are notes, they should be considered an integral part of the statement and read carefully. Often important contingent liabilities or contractual obligations are described in such notes. Unless the notes are read and interpreted, the analysis of the financial statements will be incomplete.
Incorrectly Prepared Financial Statements
Many financial statements prepared by small businesses are not prepared in conformity with generally accepted accounting principles. Often no clear distinction is made, for example, between the operations of the business and the owner's personal business affairs. Such items as gasoline and car expenses that are actually personal living expenses of the owner of the business may be recorded as a business expense. The balance sheet may include as an asset the personal residence of the owner of the business. There may also be some items of business expense that were not recorded in the financial statements.
The buyer should keep in mind that the statements are only as reliable as the information that went into them. If the information is only estimated or is overstated or understated, the statements will reflect the inaccuracy. They should be adjusted to bring them as nearly as possible into line with accepted accounting principles.
Accrual Method of Accounting
If financial statements were prepared strictly on a cash basis, all cash inflow would be revenue and all cash paid out would be expense. Even fixed plant and equipment assets would be recorded as expense items at the time they were paid for instead of being charged off over the life of the assets through depreciation charges. Under the accrual method, all items of income are included in gross income when earned, even though payment is not received at that time. Expenses are deducted as soon as they are incurred, whether or not they are paid for at that time.
Normally, the accrual method of accounting is the only one that shows results of past operations accurately. If the seller's financial statements have been prepared on a cash basis, the buyer should make whatever adjustments are necessary to convert the statements to an accrual basis.
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