Business Valuation: Financial Statement Adjustments. Why do they matter?

Last time we looked at the approaches to valuation. Today let us talk about one of the first steps in the financial analysis part of the valuation process. After the financial information is received, the valuator must “spread” (prepare a year by year format) of the financial data. Then we can begin reviewing, analyzing, and comparing the subject company to itself and the industry. Often, there is a need to adjust or “normalize” the company's financial information to make the financials’ reflect the company’s true economic position and for comparability purposes to its industry peers. There are three general categories of adjustments:

• Comparability adjustments,

• Non-operating/nonrecurring adjustments, and

• Discretionary adjustments.

Comparability Adjustments

These adjustments are made to the subject company’s financial statements in order to make the subject company more comparable to companies in its respective industry. For example, a comparability adjustment would be made if the subject company uses the last-in, first-out (LIFO) method to value inventory while the rest of the industry uses the first-in, first-out (FIFO) method. 

Non-operating/Nonrecurring Adjustments

Non-operating assets or liabilities are removed from the balance sheet in order to reflect the operating value of the Company. Nonrecurring income or expense adjustments are removed from the income statement because they are either unrelated to the business operations or unlikely to occur in the future. The non-operating assets or liabilities are then added or subtracted to the indicated value to determine the total equity value of the subject company. The nonrecurring adjustments are not replaced since they do not reflect the ordinary business operations of the subject company. 

Discretionary Adjustments

Discretionary adjustments are usually expenses that are not essential for the operation of the business. These expenses are generally under the sole discretion of management or the owners of the subject company. Discretionary expenses are often described as personal wants or desires, as opposed to actual business needs. Therefore, the adjustments stand for the difference between the recorded expense and what the expense would have been in an effectively run public company.

Often, discretionary adjustments are some of the most heavily scrutinized adjustments in both M&A engagements and litigation. Below is a list of some of the most commonly seen adjustments. The list is not complete and there may be more or less depending on the engagement, subject company, and industry.

• Owner’s compensation

• Entertainment expenses

• Automobile expense

• Compensation to family members

• Rent expense (specifically to related parties)

• Interest expense

In the example of a closely held business, owners have much, if not all, of the control over a business’s expenses. This allows them to pay salaries to themselves that may be more or less than the market value for the services they provide. Likewise, many owner’s also own the facility they operate from, either personally or in another entity. Therefore, they can charge rent that may be more or less than market value. These are just some of the examples of items that should be reviewed and considered in performing financial analysis in valuation. 

Understanding the adjustment process

Understanding the business, industry, economy, standard of value, purpose of the valuation, and approach’s being used are all key components when analyzing a company and knowing how adjustments effect the value. Valuation is a process that takes looking at the whole picture and the individual pieces carefully to come to the most accurate estimate of value. 

I’m Gregory M. Clark, MSA, CPA, CVA, MAFF of GMC & Company. I help attorney’s and their clients in litigation matters with business valuation, litigation support, forensic accounting, and consulting. If you have a shareholder dispute, or are going through a divorce and need a business valuation or forensic services, let’s talk! Call us at 219-554-9700 or email us at info@gmcandco.com. 

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