Here’s a great question from a colleague: can I appraise using only tax returns (cash basis) when (accrual basis) financial statements are not available (and I am not qualified to prepare accrual statements, and /or my client is balking at the extra cost to prepare them)? Accrual-based statements are preferable because they give me a more complete picture of the financial position of the business (its receivables, payables, etc.).
The first thing I do when this issue comes up is to check the RMA data for the industry. It reports the number and type of statements (unqualified, reviewed, compiled, tax returns, and other) in the sample. If most of the statements are tax returns, then I feel comfortable using the subject’s tax returns not only to do a comparative analysis but also for the Market Approach, Direct Data Method using IBA or similar data. If not, I am going to want accrual basis statements. I check with the company’s CPA to get a qualitative idea as to how different accrual based statements would be from the tax returns, and how much it would cost to prepare them. (I am not qualified to do this work, not being a CPA.) I then discuss the alternatives with my client.
The answer also depends on the valuation approaches and methods to be used. If we are going to use the Asset Approach with a liquidation premise of value (the Asset Approach under a going concern premise would be hugely expensive: I rule that out immediately), then I am going to have to know the receivables, payables, and other major accruals to use it.
If I am going to use the Market Approach, I also need to know those things to make packaging adjustments to convert operating asset values to equity values. An exception might be if the valuation is for sale, only operating assets will be sold, and the seller will retain the receivables, payables, and other accruals.
If I am going to use the Income Approach, with net cash flow to equity as the ownership benefit metric, I need to know how different net cash flow to equity will be on an accrual versus cash basis. The company’s accountant can help me here (see above). In the long run, they should be very similar, but there could be short-term differences that I need to be aware of.
A more global issue is whether the willing buyer of such a business would require accrual based statements or work off the tax returns. That is also suggested by the RMA data, which is why I check it out first.