We continue with our discussion of getting command of the numbers by discussing income statement adjustments. Normalizing adjustments are made in valuations to separate unusual or non-recurring or management discretionary items of income or expense on the income statement.
The objective of normalizing adjustments is to develop historical, adjusted income statements and percentage income statements that can be used in the valuation process.
Make sure you have considered all the obvious income statement adjustments such as non-recurring items, owner compensation, straight-line depreciation, LIFO to FIFO, and so on. Lay them all out on a valuation worksheet for consideration. Whether you use them or not, you must know what they are. Be sure your investigation picks up the adjustments that are less than obvious. Ask the necessary questions to find potential adjustments.
The following 10 questions can help provide an overview of the concept of income statement (normalizing) adjustments for business appraisers and for attorneys.
- Are there any discretionary items of income or expense that should be adjusted for in the valuation analysis? One of the first places to look for normalizing adjustments is in the area of management discretionary expenses. Owners of closely held and family businesses often pay above-normal salaries to themselves. Anything above a reasonable (market) level of compensation is usually added back to income (or eliminated from expenses) in developing adjusted income statements. Some businesses pay compensation to family members who are not working in the business. These expenses are generally normalized. Other discretionary expenses might include charitable gifts, one-time but substantial owner bonuses, and more.
- Are adjustments appropriate based on inventory policy? Managements of private companies often employ an inventory management policy known as LIFO, or last in, first out. Public guideline companies may use first in, first out, or FIFO, as a depreciation policy. If product or raw material prices are rising, under LIFO, the current, higher priced inventory will be expensed as cost of goods sold, while the lower priced historical purchases will remain on the books. The actual inventory consumed may then not be the same as the prices remaining. We can’t go into depth here, but inventory management impacts cost of good sold, margins, and ultimately taxable income. If the difference between LIFO and FIFO pricing is significant, the appraiser may need to make appropriate normalizing adjustments.
- Are adjustments appropriate based on depreciation policy? Some companies use accelerated depreciation for tax purposes to shelter current income from taxes. If comparisons are made with public companies, for example, most of whom use straight line depreciation policies, then appropriate adjustments may need to be made.
- What other types of income statement adjustments can we identify? Business appraisers generally consider making normalizing adjustments for unusual or non-recurring items of income or expense. Examples include receipt of life insurance proceeds on the life of an owner, litigation settlements or judgments (positive or negative), non-recurring litigation expenses, and many more. Other unusual items of income or expense can include one-time sales, the elimination of a division or product line, and more. Managements of companies often want seemingly non-recurring items to be considered as non-recurring in valuation reports. The appraiser needs to examine many of these so-called non-recurring items carefully. Nearly 35 years of appraising businesses have left me with this observation: Business life is filled with one so-called non-recurring event after another. So a particular event (say, moving costs for one or more executives) may not occur every year, but the company has to deal with turnover on a recurring basis. Next year, the non-recurring item might be executive placement fees of a similar amount, and the next year, training costs related to upgrading middle management skills and knowledge. The point is that the level of expense imbedded in seemingly non-related items may, itself, be recurring, and therefore no adjustments should be made. If the adjusted margins resulting from your adjustments are simply too high to be reasonable, remember this comment. We tend to make far fewer income statement adjustments today than we did a few years ago.
- What kinds of questions can you ask to ferret out potential adjustments? Going back to the spreadsheet analysis, you can ask questions about significant changes in numbers related to items of income or expense. This suggests that your spreads should examine operating expenses at a level of detail sufficient to pick up significant swings (say, at least ten to fifteen expense categories, hopefully more). Similarly, it is important to look not only at trends in total revenues, cost of sales, or major categories of expenses. Review the percentage income statement and look for trends or significant one-time jumps in categories of expenses. Find out what happened.One question that is always helpful in the context of a discussion of the spreadsheet analysis with management is simply this: “Other than the things we’ve talked about, can you think of any unusual events in the last couple of years that have had an effect on the income statement?”
- What kinds of data do we need to be sure we catch necessary adjustments? Regarding the income statement, it is always helpful to examine subsidiary, divisional, departmental, regional, or other income statement detail. If the business is multi-locational, individual unit statements or summaries may prove helpful. Also, sales by product category or by salesman can be useful. On the cost side, it is helpful to examine costs by supplier over time, or costs by major component. All these decisions must be made in the context of individual valuation assignments.Also, be sure to examine the cash flow statement carefully. Often, non-cash items that may be the subject of adjustment show up there when they might not be mentioned anywhere else in the financial statements (and management may simply forget to mention them). And, be sure to read the footnotes to the audited or compiled financial statements very carefully.
- When can a company’s financing create the need for income statement adjustments? Sometimes, owners finance a portion of their companies’ balance sheets with shareholder notes. These notes may be at above- or below-market rates. So owner financing is always an area of investigation for normalizing adjustments. At other times, a company may have historical, fixed rate debt with unusually favorable financing in the market at the valuation date. Adjustments are considered for such financing. In other instances, a company’s bank financing may be very favorable, not because of the company’s operations, but because the bank has obtained the personal guaranty of an owner with a very strong personal balance sheet. An adjustment may be necessary to increase interest expense to current market rates in the valuation process.
- Will management normally help you in identifying adjustments? In our experience, the answer is “yes.” But keep in mind that most of the items you are looking for are from the past. Managers and business owners don’t typically think about their companies in the same way that we do as appraisers. They are focused on the present and the future and you are digging into the past. So we have to help them to remember the details. Asking these probing questions as you jointly review a detailed spreadsheet analysis is an excellent way to begin to refresh a business owner’s memory. Also, owners sometimes remember isolated “nuggets” in the context of other discussions. For example, in discussing an overview of the business, an owner might mention something that should trigger follow-on questioning regarding an income statement adjustment in a prior year. You simply have to be aware and alert to these things, and to come back to them in a methodical fashion. Many appraisals are retrospective in nature, with valuation dates that are anywhere from several months to several years in the past. When conducting a retrospective appraisal and interviewing management, I always provide detailed historical spreadsheets that end at or near the valuation date, and other period documents for review. Then, as we begin, I say the following: “Our valuation date is April 30, 2012, which is more than four years ago. A great deal has happened since then. I know it is somewhat difficult, but do your best to put us back in that time period and answer our questions, again, as best you can, from that perspective.” It takes some doing, but most managements understand and will work with appraisers to accomplish this retrospective perspective.
- When does an income statement trigger a corresponding balance sheet adjustment? Assume that analysis of the income statement identifies significant gains on the sale of securities or substantial dividend income from securities that are non-operating in nature. The gains or dividends are normally eliminated from operating income to get a better picture of actual operations. It will then likely be appropriate to remove the non-operating securities from the operating balance sheet as well. They can then be treated as separate components of value, but segregated from operating value. This relationship between the income statement and the balance sheet, or vice-versa, holds for many different types of non-operating assets.We mentioned depreciation policy and inventory management policy as causing potential income statement adjustments. These same adjustments may well be the cause for balance sheet adjustments.
- Have we touched on all possible income statement adjustments? No, but we have talked enough to confirm that a valuation analysis must include investigation of potential income statement adjustments. A good valuation analysis will consider a variety of potential normalizing adjustments for unusual, non-recurring items of income or expense, and management discretionary expenses as well. An adjusted income statement may look substantially different from the corresponding reported income statement. It is the adjusted income statement that gives rise to value.
The concept of normalizing adjustments is important in appraisal. Agreement on appropriate normalizing adjustments is also critical to the due diligence process of buyers of companies and to sellers as well. Again, it is buyers’ concepts of adjusted income statements and earnings potential that support the prices they are willing to pay for businesses.
For more information, you can read a consistently popular article on Mercer Capital’s website entitled “Normalizing Adjustments to the Income Statement.”
My two most recent books are available in an Ownership Transition Bundle. The bundle, priced at $35 plus s/h, has been attractive for many business owners, appraisers and attorneys.