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Adjusting Income Statements
Turning Loss Into Profit
Suppose
that a company’s income statement shows that the business lost money -- but you know the company is successful and providing
a good lifestyle for the owner. How can this be? The reported earnings may just need to be normalized. Among the first and
most important steps in the valuation of a business is making adjustments to the income statement -- from Generally Accepted
Accounting Principles or Tax Based Accounting reported earnings to normalized, or adjusted, earnings. Normalized earnings
are generally used as the basis for analyzing a company’s earning performance and to compare that performance to other companies
in the industry. The following case illustrates this point.
Case Study: Mack’s Machines
For valuation purposes,
reported income may require several adjustments to determine the appropriate earnings. While some of the adjustments are clear-cut,
others require an expert’s judgment as to whether they should be made and, if so, in what amount. For instance, Mack’s Machines
manufactures equipment. During the initial document request phase, the valuator learns that on its 1996 financial statement
the company reported an $80,000 loss. During the discovery phase, the expert learns:
• The company uses the last-in,
first-out (LIFO) method to value its inventory. Its LIFO reserve was $400,000 at the beginning of the year and $500,000 at
the end of the year.
• Payments of $15,000 to Mrs. Mack for “bookkeeping” services are included in office salaries
when, in fact, she did not prepare any books or records for the company.
• The company has paid Mr. Mack a significant
bonus each year, primarily to pay out all of the income and to reduce the company’s tax obligation.
• Mr. and Mrs.
Mack received extra benefits, including profit sharing ($28,000) and travel and entertainment ($12,000).
• The company
has a policy of expensing all repair and maintenance items under $2,500. Individual invoices for furniture and equipment totaled
$20,000.
• The estimated economic useful lives of the property and equipment are longer than the tax lives used for
depreciation.
• The company entered into a lease Jan. 1, 1996, with the sole shareholder, Mr. Mack, for its office
and warehouse (20,000 square feet total) at a rate of $2/ft. above the market rate.
As the table shows, several adjustments
were needed to obtain a more accurate picture of the company’s earnings. However, forensic accounting techniques involve more
in-depth analysis and are generally handled under a separate engagement. Contact us for help in understanding adjustments
to income statements and their implications for your business.
Sales $10,000,000
Cost of
Goods Sold 6,825,000
Gross Profit 3,175,000
SG&A Expenses 3,255,000
Net
Loss-Per F/S (80,000)
Adjustments:
To change cost of goods sold to FIFO from LIFO inventory reporting $100,000
To
add back amountspaid to Mrs. Mack 15,000
To adjust Mr. Mack’s salary from actual to reasonable 245,000
To add
back extra perks received by the Macks 57,000
To add back all capitalized items that were expensed 20,000
To
record depreciation to economic cost from actual 75,000
To record rent from actual to market 40,000
Adjusted
Earnings $472,000
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