09 Aug Financial Statement Adjustments
Written by: Matt Safft, CVA
(5 -7 minute read)
Financial statements are typically prepared according to accounting principles or income tax standards. However, for small to mid-sized businesses, financial statements do not always portray the economic reality of a business. In a business valuation, the appraiser will often make adjustments to the company’s net income to get a more accurate picture of the true earnings of the business. In this newsletter, we will discuss financial statement adjustments which are typically considered within a business valuation. While this is not an exhaustive list, it is a representation of the most common adjustments.
Adjustments Considered:
Owner Compensation (including Payroll Taxes)
In general, business owners can pay themselves any salary they choose. This expense is typically reported as Officer Compensation on the Federal Tax Returns. However, the owner’s salary may be reported within Salaries & Wages, Contract Labor, or another expense. In these instances, the appraiser must be provided with the owner’s W2s or wage statements showing the salary paid to the owner in each applicable year.
When there is more than one full-time owner (or the equivalent of a full-time owner/operator), the appraiser will normalize the salaries for all working owners. Since a hypothetical buyer of the Company would only assume one full-time position, the appraiser must ensure that all positions/roles held by each owner are properly accounted for within the valuation report. For more information regarding Owner Compensation/Responsibility and how this adjustment impacts the valuation, please visit: www.reliantvalue.com/owners-responsibilities-major-impact/.
Manager Salary (including Payroll Taxes)
For some small to mid – sized businesses, the owner(s) are absent from the operations of the company and a manager is in charge of day-to-day operations. When this is the case, the appraiser adds back the manager’s salary based on provided W2s or wage statements. The theory is that a hypothetical buyer would run the business full-time, and the business would no longer have to employ a manager to handle day-to-day operations.
Related Employee Salaries
As previously mentioned, business owners can pay themselves a salary of their choosing. Similarly, business owners are also able to pay their family members a non-fair market wage. In fact, some business owners pay a salary to a family member who is not working at the business at all. When analyzing this addback, it is important to get W2 or wage statements for family members as well as details about the family members’ responsibilities. If salaries are not at fair market rates, the appraiser will add back the salary paid to the family member to the company’s net income and subtract a fair market salary that is reflective of the responsibilities of these family members.
Rent
In some cases, the business owner(s) own the real estate where the company operates from (whether it be personally or through a separate holding entity). In these situations, because there is a relationship between the landlord and the tenant (a non-arm’s length transaction), the tenant (the company) does not have to pay the landlord (the current owner) a fair market rate. When analyzing a company’s net income, the appraiser must assume a hypothetical buyer would not benefit from the existing relationship between the company and the real estate owner (an arm’s length transaction). Accordingly, the appraiser normalizes this expense by adding back the company’s actual rent expense and removing a fair market rent, which is typically based on one of the following: a real estate appraisal, a buyer – seller lease, or comparable online listings. Even if the real estate is being purchased and no rent expense will be incurred post-closing, the appraiser must adjust for a fair market rate. For more information about rent adjustments, please visit: www.reliantvalue.com/the-rent-adjustment/.
Owner Health Insurance/Retirement Benefits
Any health insurance or retirement benefits that are paid by the company on behalf of the current owner(s) are considered a direct owner benefit. These amounts can be added back to the company’s net income given the appraiser is provided with the proper documentation and is able to determine that these expenses are reported on the financial statements used in the valuation report.
Non-Recurring Items/Non-Operating Expenses
Businesses can occasionally report expenses that are non-recurring or non-operating. Examples include excess legal fees due to preparation for a potential sale, one-time repair charges, and non-operating auto expenses. When these expenses are deemed non-recurring or non-operating a normalizing adjustment will be applied to remove these expenses from the company’s net income.
Non-Business Related Income
Financial statements may reflect income from secondary sources (not derived from its main business), this income is typically reported as Other Income. Some common examples of Other Income are Grant Income and Net Gain on Assets. If this income is not expected to continue and is not related to the main operations of the business, the appraiser will deem it to be non-operating/non-recurring and remove the income from the company’s net income.
In general, the purpose of financial statement adjustments is to ensure the analyzed net income is what a hypothetical buyer would receive. It is also important to note that for these expenses to be adjusted, they must first be reported on the analyzed financial statements – certain expenses will be reported on internal financials but not tax returns, or vice versa. Additionally, for some adjustments, the appraiser would require adequate proof (W2 forms or paystubs, invoices, CPA letters, General Ledgers, etc.).
If you have any questions about potential adjustments or our rationale behind an adjustment, please give us a call at 908-888-6030 and an appraiser will be happy to discuss. Also, stay on the lookout for our next newsletter, which will discuss the most common proposed adjustments that are typically NOT performed in a business valuation.