Accounting Articles

Financial Statements

Having properly compiled financial statements is important both to the buyer and the seller. The seller needs to have a clear understanding of the profitability of the business and a way in which to calculate the expected value of any potential sale transaction.

The buyer needs to have valid financial statements on which the buyer can determine their interest in any sales transaction and to determine how much they're willing to pay for the business being sold.

In order to satisfy the needs of both the buyer and the seller, there are three types of financial statements that can be prepared:

  1. Compiled Financial Statements
    This type of financial statements represent the most basic level of service CPAs provide with respect to financial statements. In a compilation, the CPA must comply with certain basic requirements of professional standards, such as having a knowledge of the client's industry and applicable accounting principles, having a clear understanding with the client as to the services to be provided, and reading the financial statements to determine whether there are any obvious departures from generally accepted accounting principles (or, in some cases, another comprehensive basis of accounting used by the entity). It may be necessary for the CPA to perform "other accounting services" - such as creating your general ledger, or assisting you with adjusting entries for your books - before the financial statements can be prepared. Upon completion, a report on the financial statements is issued that states a compilation was performed in accordance with AICPA professional standards, but no assurance is expressed that the statements are in conformity with generally accepted accounting principles. This is known as the expression of "no assurance." Compiled financial statements are often prepared for privately held entities that do not need a higher level of assurance expressed by the CPA.

  2. Reviewed Financial Statements
    These statements require that the CPA perform inquiry and analytical procedures in addition to the procedures described above for a compilation. Upon completion, a report is issued stating that a review has been performed in accordance with AICPA professional standards, that a review is less in scope than an audit, and that the CPA did not become aware of any material modifications that should be made in order for the statements to be in conformity with generally accepted accounting principles, or if applicable, another comprehensive basis of accounting. This is known as the expression of "limited assurance." Reviewed financial statements are often prepared for entities that have bank loans, outside investors, or trade creditors, but those third parties do not require audited statements.

  3. Audited Financial Statements
    A company's financial statements which have been prepared and certified by a Certified Public Accountant (the auditor) are referred to a Audited Financial Statements. In the U.S., the auditor certifies that the financial statements meet the requirements of the U.S. GAAP. An auditor can have an unqualified opinion, in which he or she agrees with how the company prepared the statements, or a qualified opinion, in which he or she states which aspects of the company's statements he or she does not agree with. In extreme cases, the auditor may express no opinion on financial statements at all, in the case that the scope of the audit was insufficient.

Tax Strategies

Accounting firms are an excellent source of help for business owners trying to minimize tax payments before, during and after a sales transaction. Other advisors such as law firms, estate planning firms, and investment companies may also have important tax expertise.

The following is a partial list of strategies that a business owner can use in minimizing income, gift and estate tax payments:

  • Move assets into a Family Limited Partnership to avoid paying capital gains.
  • Change from a C-Corp to an S-Corp to eliminate double taxation.  There are, however, many tax considerations that must be considered before making this election.
  • Create an ESOP for your company and pay no income tax on the sale of your stock to the ESOP if you are an S-Corp or if you sell at least 30% of your C-Corp stock to the ESOP.
  • Create an A/B trust to utilize the full amount of the Unified Credit.
  • Use life insurance to provide tax-free benefits for beneficiaries.
  • Use minority shareholder and marketability discounts to increase the amount of C-Corp shares transferred into Family Limited Partnerships, resulting in paying less gift or estate taxes, where the grantor is over the Unified Credit.
  • Make gifts in 2012 where the Unified Credit is still $5 million for each spouse.
  • Use a Grantor Retained Annuity Trusts to reduce the amount that is subject to the Federal Gift Tax.
  • Create an Intentionally Defective Grantor Trust (IDGT) to avoid paying capital gains on appreciated assets and to receive tax-free income on the interest paid to the grantor on the note.
  • Create an Irrevocable Life Insurance Trust (ILIT) to move life insurance benefits out of your estate.
  • Donate company shares or other appreciated assets into a Charitable Remainder Trust to receive a tax donation and income for life. Upon death the designated charity receives the remaining value of the donated asset.
  • Set up a Qualified Personal Residence Trust (QPRT) to gift your home. You remove the home and any future appreciation from your estate and you are allowed to stay in the home. Works well for higher valued properties.
  • Create a Dynasty Trust or an Asset Protection Trust to pass on assets to multiple generations tax-free.

 

Asset Allocations

Often a key issue in a sales transaction is the allocation of the sales price to various types of assets. The IRS has specific guidelines regarding these allegations, but accounting firms can help the buyer and seller both come to a fair asset allocation for both parties. The IRS requires that both parties use the same asset allocation.

Generally speaking, the IRS requires each tangible asset be valued at its Fair Market Value (FMV). The total FMV of all assets in each class are added up and subtracted from the total price paid before moving on to the next asset class. 

These asset classes are (in order):

  1. Cash
  2. CDs, government securities, readily marketable securities and foreign currency
  3. All other assets, except intangible assets
  4. Intangible assets

The buyer typically wants to maximize the value of depreciable or amortizable assets, in order to maximize write-offs.  The seller typically wants to allocate as much as possible of the sale price to goodwill, which is taxes a capital gains rates.  So some negotiation as to the Asset Allocation is likely to be needed on most business sales.

Valuation

The formal process of estimating the worth of the business. Various valuation methods include Comparable Transactions Analysis, Discounted Cash Flow, Industry Rules of Thumb, and Asset-Based Evaluations.  Each of these are summarized below:

Comparable Transactions Analysis

A method of determining the value of the company by obtaining data regarding other similar, recently sold companies and applying the data to the subject company. This information may not be readily available for privately owned companies.

Discounted Cash Flow

The valuation tool that looks at projected cash flows, and discounts them to present value. The discounting factor is in part determined by the Capital Asset Pricing Model.

Industry Rules of Thumb

A method to value a company by using historical transaction multiples which are then multiplied times a company's EBITDA (Earnings Before Interest, Taxes, Depreciation, and Taxes) to estimate a company's value. Rules of Thumbs can also be applied to other than EBITDA, such as a multiple times total revenue.

Asset Based Evaluations

A method to value a business that adds the value of all the company's assets and subtracts the liabilities, leaving the net Value of its assets. Different approaches to Asset-Based Valuations include Book Value, Replacement Cost, Appraised Value, Liquidation Value and Market Value. Asset-based valuation methods ignore the importance of a company's earnings and cash flow. For this reason, this valuation approach is not typically used to determine the market value of a company that is being sold.

Accounting Due Diligence

For both buyer and seller, it is important to perform due diligence on the other party to determine if their representations are accurate and complete. 

The buyer wants to make sure that:

  • The seller has the financial ability to conduct the transaction.
  • The seller has no issues that might impact the ability of them to complete the transaction.
  • If a strategic sale, to make sure there is a good fit between the two companies.
  • If an earn-out is involved, to make sure that the newly combined companies will likely be able to achieve the earn-out objectives.

The seller wants to make sure that:

  • The financials provided by the seller are accurate.
  • That there are no undisclosed liabilities.
  • That all of the disclosed assets are solely owned by the seller.