Summary
Many times, tax returns and financials do not show a business's true cash flow. Adjustments need to be made to the balance sheet and income statements as part of the business valuation process.
Tax returns and financials need adjusted to show adjusted net income for a business valuation
Seeking an appraisal of your business is beneficial for a variety of reasons. This benefit exists regardless of whether you plan to sell your company or transfer it to a family member. Knowing the actual value of a small business helps ensure that you, as a business owner, have the confidence needed to make the most appropriate decision for your company and business portfolio.
Please read what is a business valuation.
Although the internet provides access to online services that offer quick valuations, you should obtain a professional assessment. This is because a certified by an accredited Business Appraisal FL|GA|HI team member takes strategic and in-depth analysis to determine an accurate estimation of a company’s worth.
Since an accredited professional does the appraisal, adjustments to your business’s income statement or financial statements may occur. These adjustments, however, ensure that the valuation produced for your subject company accurately reflects its value. A CVA or similar accreditation can make the adjustments to the income statement needed for your company’s valuation.
Adjustments may also be necessary to accurately reflect taxable income, ensuring compliance with tax regulations and providing a true picture of the business’s financial health.
Why don’t financial statements reflect your business’s true worth?
Many business owners may believe they can rely on their company’s financial statement when estimating their enterprise’s value. However, business owners should realize that financial statements alone cannot reflect the true value of a business. Your evaluator may need to make adjusting journal entries for unearned revenue, accrued expenses, officer compensation, and depreciation expense as they make adjustments for your business appraisal.
This is because the accounting period statements do not reflect economic reality since they rely on accounting principles or tax regulations not designed with the market in mind. Additionally, bias may lead those who prepare financial statements for a company to exaggerate inputs that may skew interpretations of the business’s value.
Are financial statements used during a business appraisal?
Professional valuators, like those at BA FL|GA|HI, use financial statements strategically to assess a company’s value accurately. We will look at your revenues and expenses, your general ledger, and your business operations to see what best reflects the “truth” of your company.
To utilize the statements, the appraisers will first normalize them. During the normalization process, operating expenses are carefully reviewed to ensure they accurately reflect the company’s core operational performance. After conducting the normalization process, the appraisers will have a better ability to compare the business in question to similar industries and companies.
Normalized financial statements also more accurately reflect the company’s actual earning capacity, which is crucial to understand business value
What are adjustments in Business Valuation?
Many times, tax returns and financials do not show a business’s true cash flow. Adjustments need to be made to the balance sheet and income statements as part of the business valuation process.
Adjustments to income often involve recalculating gross income to ensure all revenue streams and expenses are accurately represented.
Understanding Adjustments to Income
Adjustments to income are crucial for accurately reflecting a company’s financial performance. These adjustments help to strip away anomalies and provide a clearer picture of the business’s true economic health. By making these adjustments, businesses can make more informed decisions about their operations and future strategies.
There are several types of adjustments that can be made to income:
Non-recurring items: These are one-time events or expenses that are not expected to recur in the future. Examples include gains or losses from the sale of assets or expenses related to a one-time event. By excluding these items, businesses can focus on their core operating performance without the noise of unusual events.
Discretionary accounting adjustments: These adjustments are made to better reflect the financial performance of the business, even though they are not required by accounting standards. For instance, adjustments to depreciation or amortization expenses can provide a more accurate picture of the business’s ongoing financial health.
Non-cash expenses: These are expenses that do not require a cash outlay but are still recorded on the income statement. Examples include depreciation and amortization expenses. Adjusting for these non-cash items helps in understanding the actual cash flow generated by the business.
By making these adjustments, businesses can gain a more accurate picture of their financial performance, which is essential for effective decision-making and strategic planning.
Why are adjustments necessary?
Normalized adjustments, or valuation adjustments, restate financial statement values to the Fair Market Value (“FMV”). The FMV is the most common standard of value that valuators use to create an agreed-upon assessment for a business.
By normalizing financial statements, appraisers can more accurately assess the company’s operating income, which is crucial for understanding its true profitability.
Normalization comes to be necessary when you’re selling a business because it helps more accurately reflect the true profitability or cash flow potential of the enterprise.
Without normalizing, a business’s financial statements could skew the value of the company because they may include personal or exaggerated expenses in the report.
What sorts of adjustments are made during the normalization process?
A variety of adjustments during the normalization process to facilitate the valuation of the business and give a true picture of operating cash flows.
Adjustments may also be necessary to accurately reflect taxable income, ensuring compliance with tax regulations and providing a true picture of the business’s financial health.
Some of the most common adjustments made include discretionary expenses:
Related party transactions
Transactions between a company and its owners are often not made in a manner that reflects market standards. These transactions usually include compensation and property rented from a business owner.
Adjustments to gross income are often necessary to ensure all revenue streams and expenses are accurately represented in the financial statements.
Appraisers analyzing this data will often compare these figures to industry statistics, job market data, and commercial real estate rates. We then adjust the amounts of these transactions to reflect market rates.
Discretionary expenses
We also remove expenses incurred as a result of the discretion of the business team members. Or reduce them to reflect industry standards better. These costs often include transactions in entertainment, travel, and charity, as well as expenses that primarily benefit the company owner.
Non-recurring expenses
Many non-valuation professionals will argue that non-recurring expenses should not be adjusted for because such costs are legitimate. However, many business appraisal professionals tend to conduct adjustments of these expenses regardless of their legitimacy because such costs are very costly.
We will find assets on the balance sheet that needs adjustment made because they are excess assets or personal property. Most privately held businesses will need adjustments to the balance sheet.
As a result, without adjustments made, non-recurring expenses can significantly skew profitability and cash flow and lead to an undervaluation of the company.
Owner’s Compensation
The final adjustment often made by professional valuators is the salary of an owner. This is because if the owner pays themselves an excessive wage, their company’s profits and cash flow will decrease. This will also lead to an undervaluation of the company.
Professional appraisers will determine an appropriate level of compensation for the owner based on the company’s size and revenue earned. The compensation may also be set based on experience.
Calculating Adjusted Net Income
Adjusted net income is a refined financial metric that provides a clearer view of a company’s net profitability by excluding the effects of non-cash and non-recurring items. This metric is particularly useful for business valuation as it offers a more accurate representation of the company’s ongoing financial performance.
To calculate adjusted net income, follow these steps:
Start with net income: Begin with the net income figure from the income statement. This is the profit after all expenses, taxes, and interest have been deducted from total revenue.
Add back non-cash expenses: Include non-cash expenses such as depreciation and amortization. These expenses reduce net income but do not impact cash flow, so adding them back provides a clearer picture of cash profitability.
Add back non-recurring items: Include any gains or losses from the sale of assets or other one-time events. These items can distort the true profitability of the business if not adjusted.
Subtract discretionary accounting adjustments: Make necessary adjustments to discretionary items like depreciation or amortization expenses to better reflect the ongoing financial performance.
The resulting figure is the adjusted net income, which offers a more accurate measure of a company’s financial health and profitability, free from the distortions of non-cash and non-recurring items.
Producing a Detailed List of Adjustments
Producing a detailed list of adjustments is a critical step in the business valuation process. This list ensures that all necessary adjustments are accounted for and provides transparency and support for the valuation.
To produce a detailed list of adjustments, follow these steps:
Identify all adjustments: Start by identifying all the adjustments made to the financial statements. This includes adjustments for non-recurring items, discretionary accounting adjustments, and non-cash expenses.
Determine allowable adjustments: Assess which adjustments are allowable under the relevant accounting and valuation standards. This step ensures that only legitimate adjustments are included.
Document each adjustment: For each adjustment, provide a detailed explanation and supporting evidence. This documentation is crucial for transparency and for justifying the adjustments during the valuation process.
Review and revise: Regularly review and revise the list of adjustments as necessary. This ensures that the list remains accurate and up-to-date, reflecting any changes in the business or its financial performance.
By following these steps, businesses can produce a comprehensive and detailed list of adjustments that supports a robust and accurate business valuation. This list not only aids in the valuation process but also enhances the credibility and reliability of the financial statements.
Adjustments to Financials Conclusion:
BA FL|GA|HI appraisers have over twenty years of experience evaluating businesses in Florida, George, Tennessee, and beyond. Our experts rely on various methods, techniques, and adjustments to ensure that your business is accurately and effectively appraised.
Additionally, our accredited valuation analysts (AVA) are credentialed to perform business valuations that conform to Internal Revenue Service (IRS), American Institute of Certified Public Accountants (AICPA), and the National Association of Certified Valuation Analysts (NACVA) professional standards.
This unique combination of skills and experience provides an invaluable resource for all your business valuation and planning needs.
Reach out to our team today for a consultation. We are eager to help you reach your business goals.