Unrecorded Liabilities in Valuation vs. Rambo

Rambo: First Blood Part II is one of those movies that I have to watch whenever I come across it while channel surfing. I can’t think of a movie that has more unintentionally hilarious moments: Rambo cracking his knuckles around a microphone and threatening his old commander at coincidentally the same time as a massive lightning and thunder strike; Rambo blowing up the bad guy leader with an exploding-tip arrow; Rambo miraculously dodging thousands of bullets in an hour and a half. Growing up, my friends and I would watch these scenes again and again, doubled over from laughing. My personal favorite, however, is when Rambo covers himself in mud, camouflages himself in a mud wall, and is only noticeable when he opens his eyes right behind an unknowing enemy soldier – just before he takes him down.

Rambo’s ability to hide from the enemy soldiers in a wall of mud isn’t all that different from unrecorded liabilities on a company’s books. Accounting rules generally exempt companies from recording contingent liabilities unless specific criteria are met. As a result, a company may be in the midst of a lawsuit that would cause material damage if it were to lose, but typically, no liability for this potential loss is recorded in the financial statements. Even disclosures related to the lawsuit in the footnotes may be so generic that determining the potential impact may be impossible from a review of the financials alone. These contingent liabilities are just like Rambo, camouflaged, and potentially dangerous for those not keeping an eye out for them.

During a typical valuation analysis, an analyst should ask management whether any contingencies may not be recorded as liabilities on a company’s balance sheet. It is essential to identify what, if any, contingencies may be material to the valuation analysis and, if such material contingencies exist, to determine their impact on the company’s value. Determining the impact of a contingent liability on the value of a company is a subjective process that involves consideration of the potential amount of the contingency and the likelihood that it will wind up being paid by the company. The related impact on the company’s value may be reflected in the discount rate used in the valuation analysis, the calculation of an additional liability for the contingency, an adjustment to the discount for lack of marketability applied, or in other ways deemed appropriate by the valuation analyst. What is important is that consideration is given to the potential liability and that the related risk has been factored into the valuation analysis.

Let’s dive into an example to illustrate this point – construction contractors in numerous industries participate in multi-employer retirement plans for their union employees. The scary reality is that a number of these retirement plans are severely underfunded and, based on the way that multi-employer retirement plans are structured, as contractors go out of business, the ones left standing become responsible for the funding shortfall for the plan as a whole even if the liability doesn’t relate specifically to their union employees. While disclosure requirements have been improved in this area, there is still significant risk associated with contractors that may be on the hook for these large underfunding liabilities. It is critical that this risk be considered in the valuation analysis, or the contractor will be overvalued.

In any valuation, consideration must be given to whether contingent/unrecorded liabilities may be present. These liabilities have a way of being camouflaged, just like Rambo in the mud wall, so it is important to be vigilant enough to identify them and determine how they may impact the value of a company. Not doing so may result in the determined value of the company being overstated as of the valuation date.