Tag Archives: add-backs

Watchdog or Lapdog?

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Take a guess how many corporate accounting fraud cases the SEC has prosecuted through the first half of this year.

Give up? The answer is 79. And that’s the lowest level in over a decade, according to the Wall Street Journal.

A couple months ago, Craig M. Lewis, who heads the SEC’s risk division, unveiled the SEC’s “new”, pro-active approach – an accounting quality model that helps “assess the degree to which registrants’ financial statements appear anomalous.” The analysis will also look at the wording in financial reports concerning companies’ results and future prospects, particularly those under “management discussion and analysis.”

Sounds like a good idea, but…this is “new”?  I’m a bit surprised no one has thought of this before, but apparently that is the case. The SEC acknowledges that its previous means of uncovering fraud have been primarily passive and market-based (i.e., trading irregularities). Really? Isn’t that akin to always closing the stable door after the horse has bolted? Even my $30 tax software has an algorithm that alerts me to audit risk, based on the numbers in my return, before I file my taxes.

I don’t mean to cast stones. I appreciate that accounting fraud is actually very difficult to find, prove, and successfully prosecute. Gathering evidence requires detailed, often forensic accounting work to see whether a company has failed to report its results according to the then prevailing “accounting rules” (my emphasis). And proving there actually was a violation – most often relative to generally accepted accounting principles (GAAP) – includes an additional layer of difficulty because GAAP itself is often vague and malleable.

Case in point…in a recent accounting fraud prosecution in California involving a high-tech company, the United States Court of Appeals for the Ninth Circuit overturned the conviction of the company’s chief financial officer because the government could not prove that his aggressive accounting in recognizing revenue violated GAAP. On the contrary, the appeals court actually opined that the government’s evidence showed he was “doing his job diligently” by skating right up to the line.

Mary Jo White, the SEC’s new chairwoman, has said that she wants to turn the agency’s attention back to what was once seen as its core mission: policing corporate disclosure to ensure everyone is protected. I wish her luck. It’s a crazy world out there, and there’s not much active oversight. Caveat emptor, my buyside brethren. Good thing I’ve got my trusty copy of Financial Shenanigans handy…

Posted by: Mory Watkins

Adjustments To Cash Flow

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Today’s subject is add-backs and deductions — collectively, “adjustments” — to cash flow.

Now that we have carefully derived and projected our cash flow (not just any cash flow, mind you, but the cash flow that gives the best insight into the target company’s business model and capital structure…and also the one that allows for the best comparison with industry peers and the most accurate valuation…), it’s time to adjust it for unnecessary and one-time expenses.

An add-back is an historical expense or other deduction to cash flow that is unlikely to reoccur in the future after ownership changes. The seller therefore gets additional cash flow “credit” added back, making his salable cash flow stream larger*. Agreed upon adjustments can also go in the opposite direction too and mean that a buyer will necessarily incur new expenses as a result of the ownership change. In these cases, the seller would incur a “deduction” to the entity’s salable cash flow stream.

As a strategic buyer, there is no need to worry about finding the add-backs to cash flow; they’ll find you. The add-backs to cash flow will appear naturally as negotiations progress. Sellers know that valuation is calculated as a multiple of adjusted cash flow, and they are only too happy to flag adjustments and bring them to the buyer’s attention. This does lead to some interesting confessions about the bookkeeping and accounting games that sellers play with the IRS, but more on that in a later posting… It’s actually the surprise deductions that you have to find (and worry about later).

Here are some of the most common adjustments to cash flow:

  • Far and away, the most common add-back concerns owner’s compensation. Many private company owners of successful, closely-held companies pay themselves abnormally large salaries, bonuses, and benefit packages. There is nothing illegal about this, of course, and a new owner may indeed reap supplementary cash flow when total compensation packages are adjusted back to the proper (market) level.
  • Private businesses are sometimes padded with unnecessary headcount. I’ve seen toddlers, nannies, grannies, wives, and even non-existent employees run through private company P&Ls. Any variant of redundant or nepotistic employment, though questionable from an IRS perspective, is a legitimate add-back to cash flow if the buyer and seller can agree the position won’t truly be needed post-acquisition.
  • A wide variety of owner and personal expenses are also typically run through private companies. Cars, clubs, travel, meals, etc. that are personal rather than business in nature are probably valid add-backs to cash flow — but only if there are not sales or customer relation implications…
  • Legal expenses are a rich area for cash flow adjustments. The trick, of course, is in figuring out which are one-time events (such as settlements), and which may be an on-going cost of doing business (reoccurring and nuisance law suits). Too much legal activity in general is an obvious red flag and should merit additional due diligence.
  • Lastly, facility expenses sometimes can change dramatically as a result of an acquisition. Non-market rent, most often seen when the real estate is owned or controlled by a related party, can have a large and permanent effect on a business’s fixed operating expenses. Best to check this out thoroughly and know facility and landlord details from the outset.

That completes the most common adjustments to cash flow, but this list is by no means comprehensive. In theory, any line item on the P&L could have cash flow add-back/deduct implications post-acquisition.

One last thought on cash flow add-backs and deductions: common sense should always prevail. Don’t forget that, as a strategic buyer, your task is relatively simple. You’re just trying to understand the real, recurring, annuity-like cash flow of the business and then get comfortable with how many times over you’re willing to pay for it. Period.

Posted by: Mory Watkins

*As a buyer, don’t pay for your own add-backs or synergies. It’s surprisingly easy to do.