Many of us probably remember Harvey Dent, aka “Two-Face,” from our childhoods as one of Batman’s arch enemies. He looked like a normal guy from one perspective, but from the other side, he was a bizarre-looking villain. While normalizing adjustments in business valuation may not be quite as exciting as watching Batman battle Two-Face, they bear a similarity to this comic book character.
The results of many companies as reported in financial statements or tax returns do not always reflect economic reality. Therefore, normalizing adjustments are required when business valuations are performed to present a company’s income statements and balance sheets at their true economic levels, without distortion from accounting rules or the owners’ operational preferences. A company’s value can look completely different after normalizing adjustments have been made – it is almost like spinning Two-Face around to look at one side as opposed to the other.
For example, an owner may be taking a very large salary in an effort to reduce taxable income and income taxes, effectively eliminating any net income. When employing an earnings-based approach in valuing such a company, a normalizing adjustment would likely be necessary to adjust owner’s compensation downward to an appropriate fair market value, effectively raising net income and the resultant value of the company.
It is important to note that normalizing adjustments can both increase, or decrease, net income. Another common normalizing adjustment occurs when a related party rents property to the company being valued at a monthly cost lower than the property’s fair market rental value. In this case, the valuation expert would increase the company’s rent expense to fair market value, effectively reducing net income and lowering the company’s value.
While valuation experts are trained to identify normalizing adjustments through trend analysis and management inquiry, business owners and advisors can make the valuation process run more smoothly by bringing potential adjustments to the attention of their valuation expert. It is ultimately up to the valuation expert’s judgment as to what normalizing adjustments are appropriate for a given company, but when a business owner is prepared to answer questions regarding potential adjustments, it can lead to a more efficient valuation engagement.
Looking for business valuation assistance in Cleveland or Akron? Contact our Business Valuation Services at 440-449-6800 for more information.