The quarterback of a football team must know the responsibility of every player on the field. Although the quarterback may not have the required skills to block a blitzing linebacker or run a pass route, he needs to have a deep understanding of the roles of each of his teammates to ensure everyone is working together to execute the play effectively. This can be quite a challenge with the increasing complexity of football schemes today. Similarly, a valuation analyst, whose primary role is to apply valuation approaches and methodologies, must also, be knowledgeable of accounting, tax and legal issues in order to accurately value a business.
The value of a business is often dependent upon the future cash flows or earnings that the company is expected to produce. A multiple may be applied to expected future earnings, or future cash flows may be discounted to a present value. Tax and accounting issues can significantly impact a company’s earnings and, therefore, impact the conclusion of value determined from those earnings.
Tax rates are one of the more obvious ways future cash flows can be affected. It is important for a valuation analyst to understand which tax rates to apply based on the type of entity being valued and the level of earnings. When valuing an interest in a large C-corporation, the taxation of earnings may be accounted for differently than in the valuation of a pass-through entity such as an S-corporation or partnership.
Accounting pronouncements can also affect the future cash flows of a company. In a case study I recently reviewed, an adjustment was made to the company’s historical income levels to exclude a subsidiary that had been sold in an installment sale, but was inappropriately consolidated into the company’s financial statements after the sale. By removing the operations of this subsidiary, the cash flows of the company were significantly changed, but this was necessary to accurately reflect the future cash flows of the company. If the valuation analyst was not knowledgeable of the accounting requirements to consolidate subsidiary financial statements, he may have missed this important adjustment.
From a legal perspective, it is important that a valuation analyst understand how a company’s operating agreement, particularly its transfer restrictions and redemption provisions, impacts the appropriate discount for lack of marketability.
The ways that tax law, accounting pronouncements and legal issues can affect the cash flow of a company are countless. It is important for a valuation analyst to be aware of accounting updates and recent changes in tax legislation to ensure the valuation analysis is accurate. Just as the quarterback must understand how each of his teammates contributes to develop a successful play, a valuation analyst must understand how tax, accounting and legal issues contribute to develop an accurate conclusion of value.