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Robert N. Cantor: Making adjustments to financial statements

Valuations are necessary for a variety of reasons, but most commonly they are completed for mergers and acquisitions, tax or litigation purposes. The valuator must first determine which standard of value to apply to the assignment as there are various standards of value.

“Investment Value” is the value of the business to the current owner or a particular investor. Another standard of value is called “Fair Value” which is typically used in connection with certain litigation cases such as stockholder disputes and divorce in some states. “Synergistic Value” is a concept that refers to the unique economic benefit that a specific buyer would derive upon acquisition, such as increased market share or increased economies of scale.

A valuation for tax and most litigation purposes requires a company to be valued at “Fair Market Value” rather than one of the other standards of value. According to the IRS, “Fair Market Value” is considered to be the price at which property would change hands between a willing buyer and a willing seller when neither is being forced to buy or sell and both have reasonable knowledge of the relevant facts.

For tax purposes, the “Fair Market Value” standard is used because the IRS needs to know what the business would be worth on the open market, not to the current owner. Normalizing adjustments are the adjustments made to the earnings stream to convert the cash flow of a company to the cash flow recognized by an unrelated third-party with non-owner management.

One of the first steps in valuing a business is the collection of historical data, including a detailed review of that data to determine what, if any, normalizing adjustments are required. It is important to consider the different types of adjustments that can be made to financial statements. The general purpose of normalizing adjustments is to present data in conformity with accounting principles and to eliminate non-recurring items.

The goals are to present information on a consistent basis over time in a way that is comparable to other companies and to provide a foundation for developing future expectations about the subject company. The following are some examples of accounts that may require normalizing adjustments:

• Depreciation

• Extraordinary or non-recurring items

• Gains or losses from the sales of business assets

• Discontinued operations

• Insurance payouts for fire, flood or other casualty

• Litigation costs, payments or recoveries

• Non-operating assets and liabilities and related income and expenses

• Taxes

• Discretionary expenses

• Officers compensation

In certain circumstances, owner/officer compensation adjustments are made for those who are over/under paid. Rent expense is typically adjusted for a company that doesn’t pay market rent because it leases from a related party. Another common adjustment is for extraordinary transactions (income and expense items that aren’t part of normal business operations) such as gain/losses from a lawsuit or the sale of a business asset. The resulting financial information (after adjustments) must demonstrate the cash flow of a company without any related party, discretionary, or one-time items influencing the bottom-line earnings stream.

Many questions that arise from clients revolve around the adjustments made to their company’s income stream. Confusion exists because they believe that the value of the company should be based upon the financial results attributable to their managing and operating the business.

Owners must understand that a valuation using unadjusted earnings provides a value to the current owner while a valuation utilizing adjusted earnings produces an indication of value to an outside buyer who is looking for what earnings/cash flow could be produced with a normalized level of revenues and expenses.

In the end, it is important to emphasize that the “Fair Market Value” standard is used for most purposes and is required by the IRS. Since normalizing adjustments are based on hypothetical assumptions, the value derived may not reflect the saleable value of an owners business. Furthermore, failure to develop the appropriate normalizing adjustments may result in a significant overstatement or understatement of value.

Robert N. Cantor, CPA, CVA, CFE is a supervisor with Hertzbach & Company, P.A.

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