Normalizing the Statements Isn't Always Normal

Definitions

Expense - anything that a company buys that has an economic life of less than one year. It shows up immediately on the income statement.

Capitalized items - have an economic life of one year or more and the cost is moved to the balance sheet, and then these costs can be written down by depreciation or amortization over time.

Normalized financial statements - statements that have been adjusted for items not representative of the current status of the business. Normalizing statements could include such adjustments as a non-recurring event such as attorney fees expended in litigation. Another non-recurring event might be a plant closing, or adjustments of abnormal depreciation. Sometimes owner's compensation and benefits need to be restated to a competitive market value.

As Americans have discovered over the past few months, many public companies will stop at nothing to maximize earnings and therefore increase the price of their stock. Most private businesses take the opposite tack and try to minimize earnings to reduce their tax liability. After all, they don't have Wall Street and shareholders to please. The less their tax obligation - the more discretionary money they have personally available.

Unfortunately, when it comes time to sell, it's also time to "pay the piper." However, many business valuation professionals are aware of this incongruity, and make allowances for it in their approach to valuing the company. It is called "recasting" or "normalizing" the statements.

Due to all of the recent publicity concerning the accounting irregularities among some of the country's largest companies, Fortune magazine stated that America has lost its way. In fact, the magazine's exact words were: "Stop the abuse of restructuring charges. The cost of things like plant closings and lay-offs is just part of doing business and should count as an operating expense, not as a special one-time charge." These words were specifically addressed to very large, publicly held firms, but the examples can carry over to smaller privately held companies.

For example, determining what is capitalized and what is expensed can be a gray area. Some costs are clearly expenses, and others clearly should be capitalized. But there can be a fuzzy distinction among other expenses. Research and development is a gray area. It develops new products that, in turn, hopefully create future profits. Despite the long-term outlook for R&D, many companies expense this item. Another example is advertising. Its purpose is to create long-term brand awareness and to sell products or services in the future. However, advertising is also normally expensed. By expensing these items, the profits of the company decrease, and the tax ramifications are reduced. Does this fairly represent the earnings of the company?

However, in selling private companies, it is common procedure to reconstruct or normalize the earnings of a company to attempt to show a prospective buyer the company in the best light. By normalizing the income statement, the "real" earning power of the firm can be shown, which can translate into a higher price. Using a multiple of EBITDA, one can show a company is worth a million dollars more by simply identifying the "add backs" of $200,000. One way of doing this could be by eliminating any extraordinary items; e.g., non-recurring legal and consulting expenses, a new roof on the plant or tooling for a new product. As Fortune pointed out so vividly: "The cost of things like plant closings and lay-offs is just part of doing business and should count as an operating expense, not as a special one-time charge." Recurring legal expenses, major annual equipment maintenance procedures, etc., are really just part of doing business.

Sellers and their outside advisors should be careful in normalizing the income statements of the companies they are working with - expenses that are just part of doing business should not be added back to create higher profits. It may seem very easy to add back $100,000 on the premise that a new CEO will be paid $100,000 less than the current one. Chances are - it won't happen. By the time a new CEO is provided appropriate incentives and generous "perks," there will be no savings.

The moral here is that the reconstructed earnings should not be puffed up to impress a potential buyer. The buyer is no fool - he or she will see right through it all. Some normalization is required and accepted, but excess add-backs will surely come back to bite the seller.

Copyright 2007 Business Brokerage Press