Normalizing Financials in Business Valuation

Using Forensic Accounting Skills to Your Advantage

When valuing a business, one essential step in the process is to review and analyze the subject company’s historical financial information. This information allows a business valuator to analyze the company’s past performance and pinpoint trends in the business to forecast its future performance. The author in this article shares his opinion regarding items that a business valuator may encounter in an engagement that merit normalization.

When valuing a business, one essential step in the process is to review and analyze the subject company’s historical financial information. This information allows a business valuator to analyze the company’s past performance, identify where it stands compared to others in its industry, and pinpoint trends in the business to forecast its future performance, which is vital to determining the company’s value.

However, for most closely held businesses, certain aspects of their historical financials may need to be adjusted to capture their true economic well-being. These adjustments are called normalization adjustments and are intended to remove the items from a subject company’s financials that a willing buyer would not take into consideration when assessing the income or cash flow of the company on a go-forward basis.[1]^,[2]

Some items that would require normalization adjustments include nonrecurring income or expenses and owner’s discretionary expenses, such as owner’s compensation and perquisites. These items may not be reflective of the subject company’s true economic performance and more reflective of the decisions made by the previous management or owner. Therefore, a willing buyer of the business may not expect these items to affect the business in the future.

Not all business valuators are forensic accountants, but when they are, they have the analytical skills to effectively identify normalization adjustments required when valuing a business. In this article, I will share investigative techniques and analyses that are often used by forensic accountants that are very beneficial in the normalization process of a business valuation.

Identifying Owner’s Discretionary Items

Very often, forensic accountants are engaged in shareholder or partnership disputes in which one party claims misappropriation of assets or breach of fiduciary duty by another party. For example, I was engaged in a partnership dispute in which the plaintiff claimed the defendant had misappropriated their business’s assets by using company funds to pay for their family’s personal expenses.

When involved in such a matter, I analyzed the company’s financial data, such as its financial statements, tax returns, general ledgers, and banks statements, and identified instances of such behavior. Closely held businesses often have cash outflows such as personal expenses and loans to shareholders. Such expenditures are not always claimable offenses, especially if a business is owned by one person, and he or she can spend company funds at their discretion. However, when assessing the outlook of a business through valuation, a willing buyer should be aware of such items because they do not reflect accurately to how the business performs economically. These items are called the owner’s discretionary expenses.

Therefore, like forensic accountants, business valuators should perform investigative techniques to identify and ultimately adjust these items to normalize the business’s financials.

One common type of owner’s discretionary expense is meals and entertainment. Generally, these expenses should be expected by a business. It is a form of business development. However, very often, certain meals and entertainment expenses may not have anything to do with the business at all. A review and analysis of a subject company’s general ledgers and bank statements can help identify such expenses. A business valuator may find several business meals and ultimately assess them as reasonable meals and entertainment expense. However, if unusual entertainment expenses with large dollar amounts are identified, a business valuator may consider these outside the scope of the business and ultimately a normalization adjustment.

For example, through my own analysis of a New York real estate company, I have identified large payments to an African exploration company, totaling over $10,000. Just as a forensic accountant involved in a shareholder dispute may identify this kind of expense as misappropriation of assets, a business valuator should consider this as a normalization adjustment.

Another example of an owner’s discretionary expense is automobile expense. Many businesses need trucks or vans to transport their goods or supplies. These expenses can be deemed reasonable and not adjusted out. However, if there are car payments related to nonbusiness vehicles, those should be considered for normalization.

In my own work, I identified in a company’s general ledger monthly car payments. These items were earmarked as “auto expenses.” However, when I reviewed the company’s bank statements and cancelled checks and found out these payments were to “Porsche Payment Center”, I knew these car payments were clearly not business related.

A third type of owner’s discretionary expense is compensation to family members. In a closely held family business, it is not uncommon to see an owner’s spouse or children included in the payroll. However, it is possible that these family members did not perform any services for the business.

When gaining an understanding of a subject company’s business, it is important to know its operational needs, such as how many employees are required to run the business on a regular basis. If a business valuator reviews a company’s general ledger and payroll data and identify paychecks to family members, he or she should further investigate to determine whether services were provided by these individuals. Interviews with management or the owner should be conducted to find out. If no services were provided by the family member, his or her compensation should be a normalization adjustment. If services were provided, a business valuator should assess whether the amount of compensation for their services is deemed reasonable.

Identifying Non-recurring Items

Just as the owner’s discretionary expenses would be considered normalization adjustments for a subject company, non-recurring income and expenses should be adjusted as well.

These items should not be expected by a willing buyer of the business to continue to affect the subject company going forward. Therefore, it should be taken out of the company’s economic prospective performance.

When trying to identify non-recurring income items, a business valuator should review the company’s general ledgers and accounts receivable subledgers to analyze a full listing of cash receipts by customer. This data will show trends of customer payments. This analysis would show how often certain customers pay and how much customers typically pay. Observing these trends would allow a business valuator to identify customer receipts that deviate from the rest. The same analytical procedure can be performed for non-recurring expense items by analyzing both the general ledgers and the accounts payable subledgers of the business.

Once unusual items are identified through these analyses, inquiry with management or the owner should be conducted to clarify the nature of these items. Once it is confirmed that these items are non-recurring, these should be considered normalization adjustments.

Similar investigative analyses are performed by forensic accountants to identify unusual, questionable, and suspicious transactions at a company. Very often, a client that suspects fraud at their company would hire forensic accountants to perform such an investigation. The client may be aware of suspicious and questionable activity but cannot analyze large data sets and pinpoint anomalies themselves. Performing trend analyses over a company’s general ledger and subledger data not only can be useful in a fraud investigation, but also it may be useful in normalizing historical financials for business valuation purposes.

Using Forensic Accounting Skills to Your Advantage

The examples mentioned above are only a few of many normalization adjustments that one should consider when valuing a business. Normalizing financials require skillsets in analyzing financial information and digging deeper into these datasets to identify what needs to be adjusted. Forensic accountants have the investigative skills to pinpoint these items. These skills can be very useful when determining the economic performance and outlook of a subject company in a business valuation engagement.

[1] Gary Trugman, BVR Understanding Business Valuation, Portland OR, Business Valuation Resources, LLC, 2022. Pg. 198.

[2] Depending on the nature of the business valuation engagement, adjustments to a subject company’s financial statements may not be appropriate. For example, if a business valuator is determining the value of a minority interest of a business, normalization adjustments may not be made because a minority interest may not be able to affect a change in a company’s economic position.

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Andre Castillo, MBA, CPA, ABV, CFF, CFE, is a Senior Manager located in our New York City office, who has been serving clients since 2016. He is a national expert in forensic accounting, litigation consulting, economic damages calculations, business valuations, and fraud investigations. From 2022 to 2023, he provided financial and forensic domain expertise as an advisor to Hudson Labs (formerly Bedrock AI), a financial research software company. Prior to joining CBIZ, Mr. Castillo started his career at KPMG, LLP, where he provided audit services to publicly traded companies in the sports and entertainment industry and the consumer products industry. As an auditor, he spearheaded the assessments for his clients’ adoptions of new accounting standards, such as ASC Topic 606.

Mr. Castillo can be contacted at (212) 790-5921 or by e-mail to Andreroland.castillo@cbiz.com.