Normalization of Income: Where Business Valuation Meets Forensic Accounting, Part 1

By Terry Silver
Special to The Legal

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

Business owners sometimes compensate themselves with the remaining profit left over after the payment of all other business expenses. The analyst must determine whether that compensation is at market level. Fair market value requires that the future cash flow be burdened with the market level compensation instead of the actual compensation that was designed to soak up any remaining profits. There are databases that assist in identifying market level compensation by reference to industry, location and employee demographic attributes (age, responsibility, experience, accreditation, etc.) The analyst normalizes the owner’s compensation actually paid to a level consistent with their peers.

Entities often lease real property, machinery and equipment from related parties. The rents set by the owner(s) may be above or below the market rental. Any excessive or bargain rents paid between affiliates require normalization. Owners sometimes manipulate the entity’s earnings by diverting revenue, enhancing expenses or fabricating journal entries. Because the identification of true economic income is so vital to valuation, the analyst may find it necessary to go to more extreme steps, for example, a forensic examination. A forensic examination includes the interviewing of management and employees, obtaining information from other third parties, and the use of data mining software. More on that in my next posting.

Terry Silver is a Certified Public Accountant, Certified Valuation Analyst and certified in financial forensics, for Citrin Cooperman, an accounting, tax and business consulting firm in Philadelphia, where he is a partner with more than 33 years of experience as an accountant and auditor. He focuses his practice on business valuation and financial forensic services, expert testimony and matrimonial actions. He can be reached at tsilver@citrincooperman.com or (215) 545-4800.

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