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Understanding normalizing adjustments
Disagreements
may develop when a valuator makes adjustments to generally accepted
accounting principles (GAAP) financial statements. Are the modifications
reasonable and necessary? Did the appraiser consider all relevant items in
his or her adjustments?
One category of financial statement alteration called “normalizing
adjustments” is designed to allow meaningful comparisons between a company’s
past and future performance. That in turn enables financial experts to
compose meaningful value conclusions.
Establishing financial harmony
When a valuator makes normalizing adjustments, he or she typically converts
GAAP net income to normalized earnings. The International Glossary of
Business Valuation Terms defines normalized earnings as “economic
benefits adjusted for nonrecurring, noneconomic, or other unusual items to
eliminate anomalies and/or facilitate comparisons.”
Normalizing adjustments may be essential when valuing a company. These
modifications help valuators compare the subject company’s operations to its
competitors’, forecast the company’s future cash flows, and modify the
earnings of comparables used in the market approach.
Performing normalizing adjustments
Normalizing adjustments require a valuator to use his or her judgment. It is
often difficult for non-valuation professionals to understand valuation
adjustments. To clarify matters, normalizing adjustments can be grouped into
three categories:
Odd accounting conventions. Many accounting conventions don’t make
sense from a valuator’s perspective. For example, accountants match expenses
to the revenues for which they were incurred; therefore, when a customer pays
upfront for a three-year magazine subscription, the publisher gradually
records the income over a three-year period. When projecting the magazine
publisher’s future cash flows for valuation purposes, however, the actual
timing of cash flows may be more important than the matching principle,
because of the time value of money.
Depreciation expense is another common normalizing adjustment that brings
accounting conventions in line with economic reality. Some private companies
use accelerated tax depreciation methods for both book and income tax
reporting. These accelerated methods minimize a company’s tax liability. But
they also understate future cash flows if the valuator uses the company’s
depreciation expense to approximate its future capital needs.
Atypical industry norms. Some industries have unique accounting habits
that industry participants often apply inconsistently. Many law firms, for
instance, use a hybrid of revenue recognition that combines elements of cash
and accrual accounting.
To illustrate, some law firms report no receivables; others record
receivables only for reimbursable expenses the firms paid on behalf of their clients.
Furthermore, because many law firms bill only at month-end, reported
receivables likely are underestimated by unrecorded outstanding contingency
cases and unbilled work-in-progress. Consequently, when valuing a law firm,
the professional valuator must consider the industry’s financial reporting
oddities.
Unusual and nonrecurring items. Most normalizing adjustments fall into
this category. If a company earns income or incurs expenses that are unusual
and not expected to recur, the valuator may need to eliminate these items.
When adjusting for these items, it’s important that the valuator look beyond
the narrow GAAP definitions of “extraordinary,” “unusual” and “nonrecurring.”
Common examples of unusual and nonrecurring adjustments include changes of
accounting methods, discontinued operations, insurance proceeds, lawsuit
expenses and settlements, gains or losses on asset sales, and the effects of
a strike or act of God.
A valuation expert may also consider the adequacy of the company’s working capital
and reserve accounts, such as its allowances for bad debts, pensions and
deferred maintenance.
Explaining adjustments
When a valuator makes normalizing adjustments, certain clients and related
parties may object. Valuation professionals generally should provide detailed
explanations of their adjustments and, whenever possible, support them with
authoritative references, thus greatly minimizing potential confusion and
arguments between the parties.
Remember, too, this article is brief and normalizing adjustments are just the
tip of the iceberg. Valuation professionals can legitimately modify some of a
company’s financial results — in ways not covered here. Other types of
adjustments include control adjustments, nonoperating asset addbacks and
valuation discounts.
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