Normalization of Income: Where Business Valuation Meets Forensic Accounting

Normalization of Income: Where Business Valuation Meets Forensic Accounting

At the Legal Intelligencer blog, Terry Silver explains that since buyers and sellers often have differing ideas of a business’ true fair market value, normalization is usually a required part of any M&A deal:

The valuation of virtually every closely held business requires normalization adjustments. Although these adjustments may be made to either the balance sheet or the income statement, the most common normalization adjustments are imposed upon the income statement. The International Glossary of Business Valuations Terms defines “Normalized Earnings” as “the economic benefits adjusted for non-recurring, non-economic, or other unusual items to eliminate anomalies and/or facilitate comparisons.”

As closely held businesses are controlled by one or just a few individuals, the valuation analyst should consider whether the economic benefits being paid to its owners are above, below or at market levels. Sometimes the analyst can easily identify which items require normalization and at other times the analyst is left to his or her own devices to identify the income normalization issues.

The International Glossary of Business Valuations Terms defines “Fair Market Value” as “the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open an unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.” Both the hypothetical buyer and seller base their respective value estimates on the anticipation of the entity’s true economic income. Normalization may be required to adjust to the true economic income.

Examples of common items that are normalized in the valuation of a closely held business are:

• Related party rent
• Prerequisites such as insurances, automobile, employee benefits, etc.
• Items that would normally be considered personal, but are nonetheless paid for through the business
• Owner and related party compensation