Buying or Selling a Business: Book Value vs. Fair Market Value

Buying or Selling a Business: Book Value vs. Fair Market Value

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The value of a business is a question on many business owner’s minds. Whether the owner is considering retirement, estate planning, succession planning, reviewing buy/sell agreements or possibly selling, it is important to know what a business may be worth. Considering these issues, business owners will generally question, what is my business worth, what provide value to a business or what can I do to increase value?

One of the first things to know about the business’s value is that no specific valuation method will be 100 percent precise, and each method can present a different result depending on the purpose of the valuation and the methodology utilized. In general, a company’s value is everchanging, and it is essential to understand that a valuation at a specific point in time may not apply to the current point in time. The fundamental concept for business owners to recognize before consulting with a valuation expert is the difference between the book and fair market value.

Book Value

  • Often referred to as liquidation value. Book value is an easy concept because it is the value recorded on the company’s books. By taking the total of the company’s assets and subtracting the outstanding liabilities, the remaining amount is book value. Book value is interchangeable with liquidation value because it is the value representing a situation if all assets were sold and liabilities paid. This is the amount creditors, and owners can expect to receive if the company is liquidated and closed. An example includes equipment auctioned, and the actual liquidation value is less than book value. Inventory may be sold for cents on the dollar, especially work in process or raw material inventory.

    Restrictions:
  • One of the major issues with book value is the value is based on a specific point in time. Usually, this value would be calculated on a quarterly or annual basis to coincide with financial statements or a tax return. As discussed above, a specific point in time may not reflect the company’s current financial position. 
    Example: 
    • Consider the effects of the COVID-19 pandemic on a company. A company’s book value at the end of February 2020, in many instances, would be substantially different than at the end of March 2020.
  • Book value is an accounting term and is not affected by a change in the market. Even though a company may be depreciating its assets under Generally Accepted Accounting Principles, it may not reflect how an asset’s value changes. Heavily used vehicles are an example of how book value may be different than market value. Vehicles will generally depreciate faster than the 5-year period assigned for accounting, especially if used in construction or other industries that require heavy usage.  
  • Book value may also not accurately consider the impact of debt on its assets. The book valuation may be different from the real value if the company is under economic distress or bankruptcy. 
  • The book value is not a useful tool for businesses heavily dependent on human capital. Human capital provides an intangible value that is not reflected on the books. A company may have great people in management or relationships with customers tied to specific individuals working at the business.

Fair Market Value

  • This type of value is what your business is likely to sell for on an open market. When a company has a business valuation performed, they are looking to determine the fair market value of their business. If a business is planning on selling, this is a good starting point to set potential buyers’ prices. 
  • Many view fair market value in terms of the publicly traded stock market(s). Whatever price a company’s stock is trading at on any given day or time would be considered the fair market value. Because ownership in smaller private companies is not bought and sold on a day-to-day basis, fair market value must be determined by other methods. Three generally accepted valuation methods used to determine fair market value are:
    • Asset approach 
    • Income approach
    • Market approach

Each method will most likely result in a different value of the company for a set point in time. All three ways use actual financial information from the company. From there, adjustments may be made to assets and liabilities or income and expenses on the company’s books to reflect the fair market value or represent normal operations.

While a business valuation is useful in setting a starting value in negotiating a sale, the fair market value will ultimately be reached upon its sale. 

Restrictions:

  • Determining fair market value in a business valuation for small private companies is derived from publicly traded companies’ data
  • The risk related to return on investment is not guaranteed, and a company’s earnings potential may be greater or worse than the value the company was purchased for.  
  • Fair market value is greatly affected by the economic environment at the time an asset or company is sold. The cost of sale today may not be worth the same tomorrow.

Book vs. Fair Market Value

If fair market value is less than book value, it is an indication that the market does not view the company as valuable as the financial statements report. It may be due to economic distress, pending lawsuits, or internal business problems. As a result, a potential investor does not believe the assets will produce a return on investment that the book value indicates. In terms of risk, investors might seek out companies in this category in hopes that the market indicators are incorrect, and the subject company will generate greater returns at a discounted price. 

If fair market value is greater than book value, the market indicates the company is worth more due to the potential of earning power. This may be due to economic growth, plans for expansion, or increased profits that will increase book value in the future. A profitable company will generally have a fair market value greater than its book value. On the other hand, a market value greater than a book value may also indicate a company is overvalued and subject to change in the unforeseen future.

Questions about Book Value vs. Fair Market Value?

There are many reasons a company may want or need a business valuation, including: 

  • Negotiating a merger or business sale
  • Estate and gift tax planning
  • Considering new shareholders
  • Attempting to resolve partner or other liability disputes
  • Determining shareholder equity
  • Marital dissolution

business valuation may also be useful for strategic planning and benchmarking purposes. Whatever purpose the valuation is fulfilling, it is vital to engage experienced professionals who will take a comprehensive view of all the company’s investments. Contact Smith Schafer’s Valuation Services Group to schedule a consultation.

4 Recent Accounting Changes

4 Recent Accounting Changes

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What Business Owners Should Know About Recent Accounting Changes

Whether it is working from home, virtual school, or curbside pickup at your favorite restaurant, 2020 has had no shortages of changes and required adaptations. Accounting in 2020 is not exempt from these changes. Below are four changes business owners need to know about related to accounting changes in 2020.

1. Revenue recognition (ASC 606) was delayed. One of the Financial Accounting Standards Board’s (FASB) largest undertakings in recent history was finally set to go into effect for non-public entities with years ending December 31, 2019, only to be delayed one more time in June of 2020. 

The problem? In the first six months of 2020, many companies wrapped up 2019 accounting, which included implementing ASC 606. Companies delayed in finishing 2019 due to COVID or with fiscal year ends in 2020 may not have implemented yet; however, another delay is unlikely. Either way, companies need to understand the effect the standard has on their financial statement. Perhaps the changes to 2019 were minimal (or unrecorded because of the delay), but as business slows and COVID’s effect on the company becomes more clear, it is crucial to understand the change and begin to plan for any year-end adjustment. Bank covenants may be harder to reach in 2020, and having a late change in revenue recognition may be hard to explain to the bank.  

2. Revenue recognition rules changed. As noted above, ASC 606 is the standard everyone will use for 2020. The standard removed existing standards and many industry-specific standards from Generally Accepted Accounting Principles. This means companies need to be careful to accelerate or change their revenue recognition policies without fully understating ASC 606. A delay in completing work due to supply shortages or a delay in payment from customers could affect when revenue can be recognized. 

3. In June, FASB also delayed the new lease standard (ASC 842). FASB had already delayed the standard by one year in November of 2019. The June delay makes the ever-pending Lease standard effective for years beginning after December 15, 2021, effectively 12/31/2022 year ends. However, a welcome delay from a reporting standpoint. One of the most significant issues with the lease standard is it will be affected by leases entered into now. ASC 842 requires virtually all leases to be added to the balance sheet as a lease asset and lease liability. Large leases or numerous leases could significantly change the look and feel of a balance sheet. COVID may change business practices between purchasing and leasing equipment. Leasing may become more enticing, but a lease signed today may end up balance sheet in the future.

4. Paycheck Protecting Program Loans. The CARES Act introduced companies to Paycheck Protection Program (PPP) loans. These loans have been beneficial to many companies; however, they have also been an administrative nightmare for banks, the SBA, and Congress. Slow and changing information has made the loans complicated to account for. The AICPA has sited four standards as options to determine the timing of recording the forgiveness of debt. The most conservative approach is to wait for the SBA to forgive the debt before recording the revenue officially. However, this could happen in a different fiscal year of receipt of the funds and payment of related payroll expenses. 

Companies need to review their PPP related expenses and determine when is the most appropriate time to record the forgiveness. There will be advantages and disadvantages to recording the forgiveness in either year. Working through those is key to determining the right time for your company to record the forgiveness. Items to consider include taxable income levels, extra expenses incurred in one year, overall business outlook, and future operations plans. PPP guidelines are in a constant state of change, making planning complicated.

Questions about recent accounting changes?

Accounting has not been left untouched in the changes required by COVID. Keeping up to date on the changing accounting landscape is vital for business. You are invited to join us for a free live webinar discussing how COVID-19 has changed business standards such as revenue recognition, leases, and accounting for PPP loans.

WHY SHOULD YOU ATTEND?

Be proactive with pending changes, so you have no surprises at the end of the year related to accounting changes and shifts in the PPP loan.

Tuesday, October 6 from 11 am-noon

IRS Publishes Release Regarding Business Interest Expense Limitations

IRS Publishes Release Regarding Business Interest Expense Limitations

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The Internal Revenue Service (IRS) finalized guidance regarding business interest expense limitations. Here is an overview of the rules.

Background of business interest expense limitations

The business interest expense limitation was created by the Tax Cuts and Jobs Act (TCJA) of 2017 and subsequently modified by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) of 2020. The TCJA established that for tax years 2018 and beyond, deductions for business interest expenses are limited to the total of three items:

  1. Business interest income
  2. 30% of adjusted taxable income (ATI)
  3. The interest expense of the taxpayer’s floor plan financing

The CARES Act made two changes: it adjusted item number two to 50% for tax years 2019 and 2020 and made it allowable for taxpayers to calculate their 2020 limit using their 2019 ATI. ,

New IRS Regulations

The IRS regulations offer instructions in four areas:

  1. Determining the interest expense limitation
  2. The definition of interest, for the purposes of the limitation
  3. Who is subject to the limitation
  4. How the limitation applies in various special cases

The guidance will go into effect 60 days from the date of its publication in the Federal Register, which has yet to be announced.

Additional Proposed Regulations

In addition to the new final guidance, the IRS published other proposed regulations regarding business interest expense deduction limitation issues, including how to allocate interest expense for passthrough entities and more. This proposed guidance’s release opens up a 60-day period for written and electronic comment submission and requests for a public hearing regarding the guidance.

Questions about Business Interest Expense Limitations?

We have over 45 years of experience helping businesses in numerous industries effectively manage taxes and their business. If you would like to learn more about how we can help, contact a Smith Schafer professional.

6 Cash Flow Tips for Manufacturing Companies

6 Cash Flow Tips for Manufacturing Companies

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Ways Manufacturing businesses can prioritize and improve cash flow

During these uncertain times, manufacturing companies face many challenges. Making cash flow a priority is something every manufacturing company owner needs to keep in the forefront of their mind. With the potential loss of work, change in timing for projects, increased costs for raw materials, and fewer project opportunities, many companies have begun to experience tighter cash flow. Below are strategies to help prioritize and improve cash flow in your manufacturing business.

1. Accelerate Receipts

  • Bill early and often, as the contract terms allow. The sooner you can get invoices out, the sooner you are likely to receive payment. Consider including upfront customer deposits or milestone payments for customers who have long-term projects. This will help to bring in cash flow ahead of time or over the life of the project. These customer deposits can cover the upfront costs related to the long-term order, which previously may not have been received until project completion.
  • Additionally, ask for payment when invoices become due. Do not allow unpaid invoices to accumulate and grow old. Also, consider adopting new policies and letting your customers know about it. Examples include having all invoices due on receipt or charging a penalty, interest for unpaid invoices within 30 days, or stopping work for a customer if payment is not received within 60-90 days for previous projects.

2. Defer Payments

  • Consider checking with vendors if they would allow you to defer your payments until a later date. Review your upcoming expenses and determine whether these items are required considering the current pandemic environment. Additionally, review your insurance policies, phone plans, health care plans, and any other plans to find savings, especially if you have not done so recently.

3. Renegotiate Terms with Banks & Vendors

  • Banks
  • Renegotiate terms of your line of credit agreements or other long-term debt agreements. Interest rates have dropped significantly in 2020. If you have a minimum interest rate on any variable debt agreements, now may be a good time to review and renew.
  • Go into the renegotiations with a plan. Do not be afraid to ask for a fee reduction and let the bank know that you monitor the fees and continue to do so. Consider extending the length of your renewals. Many bankers prefer to freeze pricing for 3-5 years as it is less likely for the client to switch banks. Many companies make the mistake of negotiating pricing every year, which leads to lower prices, but could risk damaging the banking relationship.
  • Vendors
  • Renegotiate terms with your vendors, but do not just focus on price. Negotiating for a discount related to early payments, requesting extended payment terms, or paying with a credit card can help improve cash flow while maintaining a positive relationship with key vendors.

4. Improve Inventory Management

  • Thoughtful inventory management is an easy way to improve cash flow. Liquidating excess or slow-moving inventory by finding a single large bulk purchaser or asking the distributor you originally purchased to buy it all back. Although you will likely be charged a fee to do so, this removes the inventory and can improve cash flow.
  • Manufacturing companies should also re-evaluate how much inventory needs to be kept in stock. Reducing the overall value in inventory may result in a simple improvement in cash flow. Additionally, manufacturing companies should consider establishing new purchasing procedures with an approval process to avoid over inventory purchasing. Do not make large purchases to get volume discounts if the purchased materials will not be used quickly.

5. Sell Assets

  • Review your listing of fixed assets to determine if any non-productive assets can be sold. These could be old items that have not been used for a while, or items no longer being used due to the pandemic’s reduced workload.

6. Take Advantage of Tax Opportunities

  • The Research and Development (R&D) Tax Credit is one of the best opportunities for businesses to reduce their tax liabilities, improve cash flow, and increase earnings-per-share. The R&D credit is designed to reimburse manufacturers who develop new products or inventions and offer a significant percentage back to qualified research activities and expenses. There is no limitation on the amount of expenses and credit that can be claimed each year. Smith Schafer can examine your company’s activities and determine which areas are eligible for the R&D tax credit.
  • Qualified Improvement Property (QIP) is now a 15-year, bonus depreciation eligible property, after the CARES Act provided a technical correction from Tax Reform in December 2017. QIP is a tax classification of assets generally including interior, non-structural improvements to nonresidential buildings placed in service after the buildings were initially put into use.
  • Net Operating Losses Carrybacks
    • The CARES Act introduced five-year net operating loss carryback opportunities for losses arising in taxable years after 2017 and before 2021. Suppose the taxpayer has a chance to carry back a 2018, 2019, or 2020 loss. In this case, it may be beneficial to maximize the loss to the extent that there are income and associated taxes to recover during the five-year carryback. A downturn in the economy offers many unique opportunities to enhance such losses.
  • Cost Segregation Study
    • These studies are among the most valuable tax-saving strategies available for manufacturing companies. A cost segregation study’s primary goal is to identify all construction-related costs for a manufacturing facility that can be depreciated over a shorter tax life than the building, which is up to 39 years for nonresidential real property.

Questions about applying these cash flow tips in your business?

How can we help your manufacturing business plan for the future? We work with approximately 100 Minnesota manufacturing companies helping them grow with accounting, tax, and consulting solutions. Contact us today to schedule a consultation with one of our industry experts.

Payroll Tax Deferral Guidance

Payroll Tax Deferral Guidance

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Payroll Tax Deferral Questions Answered

On August 8, 2020, President Trump issued an executive order and three memoranda providing or extending COVID-19 relief to individuals and organizations. On August 28, 2020, the Department of Treasury and Internal Revenue Service issued guidance for implementing the memorandum’s payroll tax deferral portion. Notice 2020-65 makes relief available to employers for wages paid from September 1, 2020, through December 31, 2020. This brief notice covers the deferral basics, but more questions remain unanswered. Here is what this notice does tell us.

Q: Which employers qualify for the relief?

A: Any employer affected by the COVID-19 emergency previously declared under section 501(b) of the Robert T Stafford Disaster Relief and Emergency Assistance Act and required to withhold Social Security taxes (6.2 percent).

Q: Applicable wages?

A: Any taxable wage or compensation less than $4,000 per bi-weekly pay period. Eligibility is determined by the pay period for each employee. An employee making more than $4,000 in any given bi-weekly payroll is not eligible for that payroll, but is eligible for previous or subsequent payroll periods as long as the given period’s wage is not over $4,000.

Q: Due date of deferred taxes?

A: The deferred taxes will be due ratably over the period of January 1 to April 30, 2021. During this period, an employer will withhold the deferred tax amount and remit to the appropriate agency. Remittance of taxes will be penalty and interest-free until May 1, 2021. Any unpaid taxes at that point will be subject to penalty and interest.

Q: Who is responsible for paying the deferred taxes?

A: The employer remains responsible for collecting and remitting any deferred taxes. The guidance does not address how employers should treat the deferred taxes of employees who later quit.

Q: Is the payroll tax deferral optional?

A: We believe the deferral is optional as the guidance states it is made “available,” but is silent as to if the deferral is mandatory. Currently, there is no forgiveness of the taxes; this is only a deferral. If an employer withholds the tax from employee pay, these amounts must be remitted using the employer’s regular deposit schedule.

Q: What recordkeeping is required?

A: Reconciliation of the withholding and deferrals will be required and happen on Form 941 starting in third-quarter 2020. The Form has currently been issued as a draft.

If an employer defers the employee’s social security, it is recommended that a signed statement is retained in the employment file identifying the repayment obligation. Detailed records of withholding deferrals for each employee, including which payroll periods the employee is eligible, will be required. Specific tracking, by employee, of repayment, will also be required starting in 2021.

Q: What if an employee leaves employment or reduces hours in 2021?

A: The guidance provided does not discuss what happens if an employee terminates employment. It also does not provide insight into when an employee’s earnings decrease and are not enough to cover the tax deferral owed in 2021. Guidance is unclear if the employer will be liable for the deferral amounts.

What’s next?

Many questions remain unanswered after the issuance of Notice 2020-65, but we anticipate more guidance to be forthcoming. Stay tuned for future updates from us as they are available.