A closely-held private company may provide additional returns to its stockholders other than reported profits. These additional returns may include above-market salaries, rents or perquisites. When valuing a business under the income approach, a valuator looks beyond the reported profits in order to reveal the business’s true economic value.
Adjusting Back to Normal
The income approach calculates the expected economic benefits of a company into a single amount by converting some level of earnings into a value. When valuing the business, an appraiser must first analyze the financial statements and, if appropriate, adjust or “normalize” them.
The ultimate objective of normalization adjustments is to convert the cash flow of the business to a stream of cash flows that reflect what the hypothetical buyer would have access. A valuator may use normalization adjustments to adjust or normalize the following:
- Remove nonrecurring, unusual or unnecessary expenses from the business’s income statement that decrease its true economic earnings.
- Identify items that artificially inflate (one-time or unusual income items) or reduce (abnormally low items) income.
- Present consistent financial data regarding the subject and guideline companies.
- Adjust from reported values to current fair market values.
- Amend revenues and expenses to levels that are reasonably representative of continuing results.
- Revise for non-operating assets and liabilities as well as any related revenues and expenses.
Normalizing historical cash flows generally result in a more accurate estimate of fair market value, though a valuator should make the adjustments only if the hypothetical buyer could implement the necessary changes.
Examples of Common Adjustments
Normalization adjustments can arise from many sources. Examples of some of the more common adjustments include:
Some business owners may deplete earnings through compensation, leaving little within the company for distributions. When developing a value opinion, an appraiser would consult salary surveys, industry studies or other sources to determine reasonable compensation.
The results of this research may lead the appraiser to add back income to the business if compensation was excessive or to subtract income if compensation was below industry standards. Other compensation-related adjustments, for items such as payroll taxes, benefits and other amounts that fluctuate based on wages, may also be warranted.
If the company pays rent to a related party, the payments may be above or below market rates. The appraiser may investigate rental rates for similar neighboring facilities, consult with realtors and even obtain a real estate appraisal.
Often, certain expenses occur solely at the owner’s discretion. For example, he or she might decide to contribute large amounts to a favorite charity, attend an expensive “business-related” golf vacation or pay country club dues through the business. Such costs may not be ordinary or necessary for the business and call for adjustment.
These may include legal fees related to a lawsuit, one-time computer consulting fees or large and unusual purchases. The appraiser may need to add back such costs to the company’s income.
Businesses sometimes garner funds from one-time sources such as discontinued operations and vendor refunds. Although each of these amounts may be relatively small, when aggregated, they can add up and affect the company’s value, requiring adjustments. Inventory
There are several methods to account for inventory. When the “last in, first out” (LIFO) method is used, ending inventory figures may not reflect those assets’ economic value. Further, higher purchase expenses are typically charged against revenues under the LIFO method, lowering net income. In these situations, a valuator often must make a normalization adjustment.
Depreciation is an accounting mechanism that allocates asset costs over a “useful life.” Some businesses use tax-driven methods that accelerate depreciation, while others use a “straightline” method.
The decision on the type of depreciation method to use can be based on factors such as a company’s basis of accounting or tax planning initiatives. In either case, net asset values may be understated on the company’s balance sheet. After considering commonly used industry methods, a valuator may adjust asset values and depreciation expense. In some cases, he or she might also obtain an appraisal of the fixed assets.
Adjustments may be warranted for items such as bad debt expense, installment sales, capital versus operating leases, notes receivable and payable and contingent liabilities.
The normalization adjustments discussed here are just a few of the more common ones. Each appraisal, having unique circumstances, may warrant different adjustments. In any case, revising an income statement with normalization adjustments allows a valuator to accurately depict the entity’s true economic condition to a company’s current or prospective investors. These adjustments can significantly affect how much the business is worth. IBI