Financial statements of the business that are adjusted to reflect the actual financial benefits of business ownership.
What It Means
Most small businesses are managed to minimize taxable income. Thus, it is often necessary to make adjustments to the reported financial statements in order to express the actual cash flow benefits available for the owner. Adjusting the business financial statements facilitates its comparison to the industry standard ratios.
Here are some Balance Sheet items that may require adjustment:
- Accounts receivable. Review an accounts receivable aging report and remove uncollectible accounts, taking them as a bad debt expense.
- Inventory that is not good and sellable. Inventory that has become damaged or obsolete should be adjusted out.
- Prepaid expenses should be adjusted out if they do not remain with the buyer after the business purchase.
- Cash and cash equivalents are typically retained by the seller. Adjust the balance sheet to have the amount of cash required for running the business.
- Remove any amounts due from shareholders as assets or due shareholders as liabilities.
- Book value of assets. If you plan on an asset purchase, you may wish to adjust or “step up” these to their fair market value. This will give you tax advantages due to a higher basis for asset depreciation.
- Real estate owned by the business needs to be removed if it is not part of the business purchase.
- Carefully review such intangible assets as business goodwill to determine if they should be adjusted.
- Accounts payable. Determine if some liabilities have been accumulated without being paid. If so, they must be added to the balance sheet.
Some items on the Profit and Loss Statement that may require adjustment are:
- Adjust cost of goods to historic averages. It is possible that the business has been using lower cost inventory that may not continue in the future.
- Adjust owner’s salary to a market rate.
- Review and adjust salaries of family members to market rates, if they work in the business.
- Review and adjust depreciation expense consistent with the expected useful life of the underlying assets.
- Adjust the business rent to a fair market rate. If the business owns its real estate premises, include a fair market rent as a business expense.
- Adjust expenses that are incurred at owner’s discretion. Examples are some travel and entertainment, vehicles, memberships, bonus payouts and others.
- Factor out any one-time expenses that are unlikely to occur in the future.
In the professional business appraisal literature the process of recasting the financials is often referred as reconstruction or normalization.