How do you choose between valuation adjustments and valuation reserves?

1 What are valuation adjustments?

Valuation adjustments are changes that you make to the financial statements to align them with the market value or fair value of the company's assets and liabilities. For example, you may adjust the book value of inventory, property, plant, and equipment, intangible assets, or debt to reflect their current or expected market prices. Valuation adjustments can also include adding or subtracting items that are not recorded in the financial statements, such as off-balance sheet liabilities, goodwill, or contingent assets. Valuation adjustments are usually made at the end of the valuation process, after you have selected and applied a valuation method, such as discounted cash flow, multiples, or asset-based approach.

2 What are valuation reserves?

Valuation reserves are provisions that you set aside to account for the uncertainty or risk associated with the future cash flows or earnings of the company. For example, you may create a valuation reserve to reflect the potential impact of litigation, regulation, competition, or technological change on the company's performance. Valuation reserves are usually made at the beginning of the valuation process, before you apply a valuation method. They are deducted from the equity value or enterprise value of the company, depending on whether they affect the shareholders or the whole firm.

3 How to choose between valuation adjustments and valuation reserves?

When deciding between valuation adjustments and valuation reserves, there is no one-size-fits-all rule. Nonetheless, some general guidelines can help you make an informed decision. Valuation adjustments should be used when reliable and objective information about the market value or fair value of assets and liabilities is available, or when they can be estimated with reasonable accuracy and confidence. On the other hand, valuation reserves should be used when significant uncertainty or risk exists with regard to future cash flows or earnings of the company, or when they cannot be quantified accurately. Additionally, it is important to consider the materiality, relevance, and reliability of the adjustments and reserves in order to avoid making changes that are too minor or arbitrary. Lastly, all assumptions and methods used for making the adjustments and reserves should be documented and justified, then disclosed clearly and transparently in the valuation report.

4 What are the advantages and disadvantages of valuation adjustments and valuation reserves?

Valuation adjustments and valuation reserves both have their advantages and disadvantages, depending on the purpose of your valuation. Valuation adjustments can improve accuracy and comparability by reflecting the true economic value of the company's assets and liabilities, but they can also introduce complexity and subjectivity. On the other hand, valuation reserves can reduce the uncertainty and risk associated with your valuation, but they can also reduce the precision and credibility of your valuation by requiring arbitrary or conservative estimates to set aside provisions.

5 How to check the reasonableness of your valuation adjustments and valuation reserves?

After you have made your valuation adjustments and valuation reserves, it is important to check the reasonableness and consistency of your results. This can be done by comparing your results with those of similar companies or transactions in the same industry or market, to see if they are within a reasonable range or if there are any significant outliers or discrepancies. Additionally, you should perform a sensitivity analysis or a scenario analysis to observe how your results change under different assumptions or conditions, and review your valuation report to ensure that you have explained and supported your adjustments and reserves clearly and logically. Doing so will help you identify any gaps or errors in your calculations or arguments.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?