Generally Accepted Accounting Principles (“GAAP”) were developed with the purpose of benefiting the various stakeholders of a business (e.g., creditors and shareholders) by ensuring that the same financial reporting methods are used consistently by all companies. For example, GAAP financial statements would help a bank determine a business’s ability to make interest and principal payments on a loan. GAAP are always being updated to help financial statement readers better understand the financial condition of businesses.
However, the value of an asset listed on a balance sheet prepared in accordance with GAAP might be much different from the fair market value of that asset.1 The three examples below describe situations when the fair market value of an asset might be much different than its GAAP, or book, value.
Consider a company with valuable internally developed trademarks, patents and other intellectual property (“IP”) that have been developed and supported over many years through research, development and advertising. The IP allows the company to enjoy strong market share and earnings margins compared to its competitors. However, when preparing the company’s financial statements in accordance with GAAP, any expenses associated with developing this IP would be expensed in the period incurred, and would thus not be recorded on the balance sheet. Under GAAP, IP assets would only be recorded on the balance sheet when they are acquired from a third party, as opposed to being created internally. Internally developed IP assets can often represent a large portion of a business’s total value, but a GAAP balance sheet would miss this important piece of a business’s “value puzzle.”
Consider a private company, “company A,” that owns a 20% investment in another private business, “company B.” Company A records the initial investment in company B on its balance sheet at cost in accordance with the Equity Method of accounting, which is consistent with GAAP. Each year, company A’s share of income and loss from company B acts to increase or decrease the book value of the investment on company A’s balance sheet. If the value of company B’s assets appreciate over time, the book value of the investment might not be representative of its fair market value. For example, company B may have developed valuable IP (as discussed in the previous example) since the initial investment, and that IP would not be reflected in company A’s investment balance.
Consider a manufacturing business that also owns the oil and gas rights underlying vacant land near the business’s campus. The land was purchased by the company 80 years ago for $20,000 and is still recorded at that price on the entity’s balance sheet in accordance with GAAP. Not only is it likely that the fair market value of the land has appreciated significantly over this time frame, but it is also possible that the oil and gas rights could have significant additional value, especially if the property is now leased to oil and gas drilling companies.
Financial statements should be prepared in accordance with GAAP so that stakeholders can consistently understand the financial condition of all businesses. All of the GAAP rules mentioned in the examples above were developed to serve various important reasons. However, when determining the fair market value of a business, it is important to recognize that there might be some differences between book/GAAP value and the fair market value of assets. In addition to considering the balance sheet, a valuation analyst considers various other factors and techniques (e.g., discounted cash flow analyses, market multiple analyses, etc.) when estimating the value of a business.
Schneider Downs has significant experience preparing business valuations for a wide range of purposes. Please contact Steve Thimons (412-697-5281; [email protected]) or Joel Rosenthal (412-697-5387; [email protected]) to ask a question or discuss Schneider Downs’ various business valuation services.
1The definition of “fair market value” is beyond the scope of this article. Used in this context, “fair market value” is intended to represent the price that an asset could be sold for on the present date.
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.