Introduction

Discover the intricate world of business valuation, where normalizing expenses unveils the true value of companies, ensuring fairness and accuracy in financial assessments.

Business valuation involves assessing the worth of a company, and a crucial aspect of this process is normalizing expenses on financial statements. Normalizing expenses is essential as it helps in presenting a more accurate and fair representation of the company’s financial health and performance. This practice involves adjusting expenses that are either non-recurring, non-operational, or not reflective of the company’s ongoing operations to provide a clearer picture to potential investors, buyers, or stakeholders.

Why Normalizing Expenses?

Normalizing expenses is necessary for several reasons:

Accuracy: It ensures that the financial statements reflect the true operational costs of the business, excluding one-time or non-operational expenses.

Comparability: Normalizing allows for better comparison with industry standards and benchmarks, aiding in assessing the company’s performance relative to its peers.

Transparency: It provides transparency to stakeholders by removing distortions caused by irregular expenses, enabling them to make informed decisions.

Valuation: Normalized financials are crucial for business valuation purposes, as they provide a more realistic basis for determining the company’s worth.

Controlling vs. Non-Controlling Interest

In business valuation, distinguishing between controlling and non-controlling interest is vital, as it impacts how expenses are normalized and how the company’s value is determined.

Non-Controlling Interest Normalization

Non-controlling interest normalization entries are made to account for the fact that in a potential sale scenario, the assumption is often that the company will be sold entirely, and only a controlling shareholder can facilitate such a sale. However, to arrive at a Fair Market Value (FMV), it’s necessary to consider the expenses associated with non-controlling interests.

Normalizing Entries for both Controlling and Non-Controlling Interests

When a business valuation is performed, normalizing entries should be made for both the Generally Accepted Accounting Principles adjustments and the controlling and non-controlling.

Some of the typical controlling normalizing entries are:

Wages at Market Rates (W-2 Salary)

Payroll Taxes (both FICA & Medicare)

Perquisites:

  • 401K
  • Defined Benefit Plan
  • Country Club
  • Excess Vacations
  • Household expenses
  • Children school expenses
  • Insurance (Non-Compete)
  • Insurance (Life for Owner & etc.)
  • Insurance (Personal Auto)
  • Vehicles (company cars) etc.

Rent (to market rates if property owned by owner) ages at Market Rates (W-2 Salary)

Some of the typical non-controlling normalizing entries are:

Capital Gains and Losses

Contributions (this is taken on the Owner’s personal return)

Extraordinary one-time (non-recurring occurrence) Items

  • Employee Lawsuit for wrongful termination
  • Product Liability
  • Contingent Liability Lawsuit
  • One-time miscellaneous expense
  • Recognized installment sale
  • Restructuring charges
  • Research for a patent, trademark, etc.
  • Preparation of a letter of intent

Prepayments on a cash basis of accounting

Excess Attorney’s & Accounting Fees to defend an IRS audit

  • Any litigation like wrongful termination
  • Merger & Acquisition research

Miscellaneous Income (maybe)

  • Non-Recurring income

Miscellaneous Expenses (maybe)

  • Non-Recurring expense

Discontinued Operations

  • Both the revenue and corresponding expenses

Excess Bonus and Accelerated Depreciation

  • Consider the useful life of the asset

In some cases Amortization (Goodwill)

Salary paid to an individual who doesn’t work in the business as well as the related payroll taxes and perquisites, if any

  • Related Party consideration

Rent expense if different from market rates

Personal expenses paid by management that are non-operating by nature (i.e.; expenses for a second home, vacation trips, non-titled assets such as a speed boat, etc.)

LIFO inventory in the Balance Sheet

  • Restate to FIFO the beginning and ending inventory within the income statement (cost of goods sold)

Travel per-diem rates in excess of IRS safe-harbor rates for lodging, and meals and incidentals

GAAP (generally accepted accounting principles) Adjustments

  • Deferred taxes receivable
  • Deferred taxes payable
  • Prepaid Expenses (possibly because it will end up in Retained Earnings
  • Prepaid Revenue (possibly because it will end up in Retained Earnings
  • Other Tax Entries

The normalizing entries should be made irrespective on their impact on the performance of the company.

Assumption of Resale and Controlling Shareholder

The assumption of resale implies that the company will be sold as a whole entity, irrespective of the percentage of ownership. However, since non-controlling shareholders lack control over the sale process, their expenses must be normalized to accurately reflect the company’s FMV.

Importance of Non-Controlling Interest Normalization

Equity Value: Normalizing non-controlling interests ensures that the equity value attributed to them is fair and reflective of their actual contributions and expenses.

Investor Perspective: Potential investors or buyers need normalized financials to assess the company’s value comprehensively, considering all ownership interests.

Legal and Accounting Compliance: Non-controlling interest normalization also aligns with legal and accounting standards, promoting transparency and accuracy in financial reporting.

Conclusion

In conclusion, the determination of value, especially in litigation contexts, requires a rigorous and comprehensive approach to ensure accuracy and reliability.  Normalizing expenses serve specific purpose for controlling and non-controlling stakeholder’s interests.  It should be a meticulous analysis to determine the appropriate ongoing operations of a company.  Therefore, practitioners must carefully assess the appropriateness of both controlling and non-controlling stakeholder’s interests

Are you seeking expert business valuation services to strengthen your case and provide compelling evidence in litigation?  Look no further. As a seasoned business valuation expert with a deep understanding of the complexities involved in determining fair market value, I offer comprehensive solutions tailored to your specific legal needs.

I have earned a Master’s Degree in Business Valuations and apply those skills to my everyday business valuations.

Richard Claywell has been valuing closely held companies since 1985.  He has earned two of the highest designations in the business valuation field, the Certified Business Appraiser (“CBA”) and Accredited Senior Appraiser (“ASA”). Richard is a Certified Public Accountant, has a Master’s in Business Valuation (MBV), and holds ASA, CBA, ABV, ICVS, CVA, MAFF, CFD, ABAR, CVGA, and ICVS-A credentials.

I hold the Master Analyst in Financial Forensics and the Certified in Fraud Deterrence.  I have taught forensic accounting/fraud courses in the United States, China, and Taiwan.

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