August 22, 2016
Can You Trust Financial Statements When Buying a Business?

By Cliff Ennico
SucceedingInYourBusiness.com


I don't often review new business books because, quite frankly, most of them don't have much to say (unless of course they're mine).

But every once in a while a book comes along that's a real "game changer" - it challenges accepted wisdom, shows you a new way of looking at an old problem, or highlights some new development that will force you to change the way you do business.  Such I book I feel I need to let my readers know about - especially if it agrees with a position I've been taking with my own clients for years.

Such a book is "The End of Accounting and the Path Forward for Investors and Managers," by Baruch Lev and Geng Fu (Wiley $29.99).

Now, be forewarned:  this is no "beach read".  The authors are writing primarily for executives of big corporations and Wall Street players, not simple folks like us.  There's a fair amount of MBA jargon.  But if you have the patience to work through that, this book will change the way you look at financial statements, and accounting in general.

People often prefer to buy a small business rather than start one from scratch because when you buy a business, you have greater certainty about how the business will perform. As long as you sign a nondisclosure agreement (NDA), the business owners will share their financial statements, tax returns, Quickbooks files and other performance data that will help you determine how long it will take to recoup your initial investment in the business, calculate how much you and your partners will be able to take out of the business as compensation, and identify some things the current owners have been doing wrong that you may - may - be able to improve.

For years I've been telling my clients to take a small business' financial statements with a grain (heck, a ton) of salt.  First, many small business don't do proper books of account, either due to a lack of experience (if the company bookkeeper is Aunt Sally, watch out) or - trigger warning - the aim to deceive.  Show me a liquor store with only one set of books and I will show you a liquor store that is probably struggling, although the owner should be put up for sainthood.

But even the best financial statements have a flaw that can sometimes be fatal:  they only look backwards.  When you read financial statements, you are looking at how the business has performed, not how it will perform.  Things may be happening in the company's industry, market or area of operation that may dramatically change those numbers after you buy the business, and the seller isn't obligated (at least legally) to disclose those "contingencies" to you.

For example, a major corporation headquartered in my own home town recently announced it will move its offices out of state at the beginning of next year.  If I were selling a small business in this town with a closing before year-end, would I tell the buyer about that?  After all, the move has been publicized in all the local newspapers, and if the buyer sees "for sale" signs on every other home when driving through town he really should be asking some questions about that, shouldn't he?

Messrs. Lev and Fu take this a step further, by arguing that the entire concept of "reported earnings" is antiquated and should be scrapped in favor of other metrics which are more predictive of a company's future success.

Criticizing today's accounting rules, the authors point out (correctly) that reported earnings:

• Do not take into account value-creating investments the company may have made in patents, brands, information technology and other intangibles, which the accounting rules treat as expenses like salaries or rent having no future benefit (one of the authors, Mr. Lev, has also written an excellent book on valuing intangible property) 


• Combine long-term items indicating future growth with one-time gains and losses (such as restructuring costs and foreign exchange losses)


• Are based on subjective estimates and projections by the company's management (for example, depreciation, asset writeoffs, prospective bad debts, and future pension liabilities) that are prone to errors and manipulation.

The authors make a compelling argument that forward-looking metrics such as customer growth and turnover (churn) rate, test results of products under development, and contract renewal and cancellation rates are much more predictive of a company's success than reported earnings. And it is precisely these metrics that traditional accounting rules do not require to be included in financial statements.

When buying a business, you should definitely tear apart the financial statements.  But you should also spend some time hanging around in bookstores, libraries and coffee shops, chatting up the locals, and finding out what's really going on in town that might negatively affect the business' performance.  

Whenever you see a disconnect between reported financial information and the local gossip, believe the gossip every time.  You will seldom go wrong.      



Cliff Ennico (cennico@legalcareer.com) is a syndicated columnist, author and host of the PBS television series 'Money Hunt'.  This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state.  To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our Web page at www.creators.com.  COPYRIGHT 2016 CLIFFORD R. ENNICO. DISTRIBUTED BY CREATORS SYNDICATE, INC.Permission granted for use on DrLaura.com.

 

Posted by Staff at 1:33 PM