Normalizing earnings can provide insight into a company’s
history and future. Performing this step is key in
valuing a
business, but it’s also difficult work that involves more than
merely reading the company’s financial statements.
Normalizing earnings require detailed analysis as well as an
understanding of the company’s current and future operations.
Once you have that knowledge at your disposal, however, you
can begin to see the true picture.
Adjustments to normalize earnings typically fall into three
categories, economic, discretionary and nonrecurring.
Economic Adjustments
Economic adjustments relate to items affected by a company’s accounting methods. For
instance, the most common economic adjustment is for the basis of accounting. Many small
businesses use the income tax basis. In addition to accelerating expenses such as depreciation,
it also can ignore expenses (such as vacation pay and bad debts) or defer revenue (such as
completed contracts.)
Other companies use the simple cash basis of accounting. This method records income only when cash is received and records expenses when they’re paid. An analyst typically converts
earnings to an accrual basis, which records income and expenses in the period earned or
incurred, to determine normalized earnings.
Inventory also is important to examine. Some businesses record inventory on a last-in-first-out
(LIFO) basis, which often understates inventory value and depresses earnings. Converting to
first-in-first-out (FIFO) may provide a clearer picture of the company’s balance sheet (financial
position) but might not be the best picture of the cost of sales (earnings.)
Businesses should determine depreciation and amortization of their fixed or intangible assets by
allocating the cost over the estimated lives of the assets. But many companies use lives and
methods that have little, if any, relation to an asset’s economic use and reduction in value. For
example, a business may use accelerated tax methods to depreciate its fixed assets. These
methods may allow it to depreciate equipment over five to seven years even though it may use
the asset for 10 to 15 years.
Even more drastic, the company may elect IRC Section 179, which allows for immediately
expensing the asset in the year acquired. Intangible assets may be amortized over 15 years as allowed under the tax method, or not amortized at all, as allowed under a new proposal for
generally accepted accounting principles.
Discretionary Adjustments
Discretionary adjustments relate to items that are incurred or recorded at management’s
discretion. The most common discretionary adjustments are to the salaries, wages, and
bonuses paid to owners and their family members and friends. These may be unnecessary
business expenses (for example, payments to children who supposedly work for the company
but really don’t) or unreasonable in amount (say, a year-end bonus equal to 100% of regular
salary). Estimating what the market would pay as reasonable compensation for such services
and adjusting from the amount actually paid creates more representative, normalized earnings.
Another important issue relates to related-party transactions or business with customers or
vendors who are related to the owner. An analyst will determine whether these transactions
occurred at arm’s length. An owner or a relative might, for example, own a building that’s
leased to the company. Does the rental rate reflect fair market value, or is excess rent a
disguised dividend?
Similarly, a company may buy or sell products or services from a related party. In this case, it’s
worth asking if the company is paying too much, or even too little. If so, an adjustment could
be necessary.
Perquisites and benefits should be counted as discretionary adjustments. In fact, in this area,
owners have maximum flexibility to disguise a business’s true costs. Often, these expenses are
difficult to uncover because the owner engages in “creating accounting”, such as the burying
expenses in payroll taxes, employee benefits or “miscellaneous operating expenses.”
In addition to accelerating expenses such as depreciation, the income tax basis can ignore
expenses or defer revenue. Or the owner might assert that these are reasonable and necessary
business expenses such as pension/profit-sharing/401(k) matching; auto expenses (lease
payments, gasoline, insurance and repairs and maintenance); insurance (life, disability and
health); or travel and entertainment (country club dues and costs, vacations, sporting event
tickets, personal meals, and other personal expenses). Professional fees (financial planners,
legal and accounting) and utilities (cell phones and long-distance charges) also may fit within
this category.
Nonrecurring Adjustments
Nonrecurring items typically are unusual in nature, such as a lawsuit settlement. They are
onetime income or expenses included in the company’s income statement that isn't expected to
recur in the future.
These items may come up in the ordinary course of business, but are unlikely to happen again.
They may include a change in the company commission policy or a reduction of lease payments
after the lease has expired.
Unexplained Uncertainties
If a company’s financial statements show that it lost money this year, but the owner has just
bought a vacation home in Hawaii, you need to know why. Perhaps the answer requires an
adjustment to determine the company’s normalized, or true, earnings.