The rule for large, publically held companies is clear. If you are going to list your stock on a stock exchange, your company must present financial statements that are created in compliance with Generally Accepted Accounting Principles (GAAP). These statements are presented to the public and banks to get investors to invest or obtain loans. If your company is a small, privately held company, there is no such rule. All a closely held company is required to do is to prepare tax returns on an annual basis.
The Issue with Tax Returns
The problem with most tax returns is that they are prepared in accordance with the Internal Revenue Code. The goal of these documents is simple, reduce tax liability within the letter of the law. As a consequence, the data presented to the government contains numbers that are formulated to show as low of a profit as possible. Obtaining credit or finding a buyer for your business becomes impossible to achieve when you are using documents prepared with the specific purpose of reducing tax liability.
Recasting the Income Statement
The income figures from the tax return will accurately represent revenue from all sources. However, the expenses taken make the tax return unsuitable for presentation elsewhere. Items such as depreciation, discretionary spending, owner’s perks and pensions lower the net profit figures, sometimes past zero on tax returns. Presenting a bank with a financial statement showing a small or no profit is simply unacceptable when applying for credit or a mortgage. Banks will lend a borrower money with adverse information only in limited situations.
The benefit of recasting the income in this scenario is that the recasted income statement will show a better representation of the business, more than likely with more favorable numbers for the borrower. In order to recast financial statements, the following items should be adjusted to reflect reality: owner salaries, nonrecurring expenses and income, investments and nonoperating expenses, interest payments, depreciation expense, rent expense, discretionary expenses, and pensions.
The result will be a more accurate and reliable presentation of income that a bank or buyers can use to gauge the activity of the business and that an owner can use to make better business decisions.
Recasting the Balance Sheet
The figures presented on the balance sheet attached to the tax return are so inaccurate that only the government finds them useful. Everyone else, business buyers and banks included, need more accurate numbers to work with and make decisions. The balance sheet computed per the tax rules is simply not accurate. Assets such as buildings and equipment are depreciated per the tax rules. However, in reality, this may not be the case. Another problem with the balance sheet is that inventory expressed on the tax return usually never reflects reality. The reason for this is because most private companies do not make the effort of maintaining accurate inventory numbers.
To accurately adjust the balance sheet, the company would adjust real estate and other assets, obsolete inventory, accounts receivable, loans to the owners, equipment not on the books, and goodwill as well.
The recasted statement will give a bank or investor a better idea as to what is actually owned and owed by the company and what its true market value is.
Privately held business owners are in a unique spot in the financial world. As business owners, they are not employees, so their income is not readily determinable by information from a W-2. Unlike those who own publically traded stocks in companies such as General Electric, Coca-Cola, and Wal-Mart, privately held businesses do not have a ready market and their value to the owner cannot be assessed quickly. While privately held business owners may be credit worthy or their businesses may be attractive to them, showing it is simply not possible without professionally prepared documents such as recasted statements or a valuation prepared by experts to make decisions with the statements. If you have any questions about recasting or would like to have your business valued for any purpose, be sure to give the professionals at The Center a call.
By: Roman Basi at the Center for Financial, Legal and Tax Planning for Transworld M&A Advisors