Question

Normalizing adjustments to a firm's historical financial statements may be necessary to apply the income approach. Such adjustments may be necessary to measure a firm's true economic earnings, which may differ from the amounts reported on its financial statements. These kinds of adjustments to historical financial statements are relatively common when valuing privately-owned businesses because private owners tend to run their firms differently than managers of public firms who have many shareholders and are regulated by SEC. Forensic accounting skills are often needed to make these adjustments.

1. Identify one normalization adjustment you might make in a business valuation and explain why it affects a firm's value.
2. For this adjustment, discuss whether you need to consider any income tax effect.
3. Discuss any nuances you might face in making this adjustment depending on whether you are valuing a controlling interest in a firm or a non-controlling (minority) interest.
4. Discuss how you might quantify this adjustment.

Answer 1

Normalizing adjustments to the income statement are made for numerous reasons, but typically involve discretionary expenses, one-time gains or losses, other unusual or extraordinary items, discontinued business operations, and expenses or revenues related to non-operating assets. Adjustments to the balance sheet generally require adjusting certain assets and liabilities to reflect fair market value. Below are examples of the most common normalizing adjustments made by appraisers:

Owner Salary & Perquisites
Business owners have discretion over the amount of compensation they draw from their companies. Additionally, it's common for owners to expense personal items (or "perks") such as vehicles, cell phones, insurance, or travel and entertainment, through their company. A primary objective of many owners is to minimize their tax liability, so they sometimes draw above-market salaries or pass personal items off as business expenses to reduce their taxable income.

From a business valuation perspective, we must assume that a hypothetical buyer of a company would need to pay someone to take over the operational role of the current owner. This person would likely be compensated at the market rate that reflects his level of responsibility and industry norms. We must also assume that discretionary spending would not exist if the business were a reasonably well run, publicly traded company.

Therefore, appraisers often adjust income statements for discretionary expenses by adding them back to the company's earnings. These add-backs include perks, as well as the difference between the owner's actual salary and the appropriate market rate for compensation.

Income tax will need to be recalculated on pretax income including the normalizing adjustments. Tax rates at the valuation date should also be used.