Can You Trust Financial Statements When Buying a Business?

By Cliff Ennico

June 28, 2016 6 min read

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

However, every once in a while one 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. I feel I need to let my readers know about such books, especially if they agree with a position I've been taking with my own clients for years.

"The End of Accounting and the Path Forward for Investors and Managers" by Baruch Lev and Feng Gu is one of these books. (It's part of the Wiley Finance Series and sells for about $30 on Amazon.)

Now, be forewarned: This is no beach read. The authors wrote this book 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 it, 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 a new business because 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 would take to recoup your initial investment, calculate how much you and your partners would be able to take out as compensation and identify some things the current owners have been doing wrong that you 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 for a couple of reasons. First, many small businesses don't keep proper books of account, which is either due to a lack of experience (if the company bookkeeper is Aunt Sally, watch out) or — trigger warning — an aim to deceive. Show me a liquor store with only one set of books and I will show you that it is probably struggling, although the owner should be put up for sainthood.

Second, even the best financial statements have a flaw that can be fatal: They only look backward. When you read financial statements you are looking at how the business has performed in the past, not how it will perform in the future. Things may be happening in the company's industry, market or area of operation that could 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 hometown recently announced it is moving its offices out of state at the beginning of next year. If I were selling a small business in this same town and pushing for a closing before year's end, would I tell the buyer about the corporation's move? After all, it has been publicized in all the local newspapers, and if the buyer sees "for sale" signs on every business and home when driving through town, well, he really should be asking some questions about that, shouldn't he?

Lev and Gu 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 that are more predictive of a company's future success.

While criticizing today's accounting rules, they (correctly) point out 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 rules treat as expenses that have no future benefit (like salaries or rent). (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 done by company management (e.g. depreciation, asset write-offs, 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 rate (churn rate), test results of products in 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 are included in financial statements.

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

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

Cliff Ennico ([email protected]) is a syndicated columnist, author and former 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.

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