“Recasting” the Financial Statements

In most cases, financial statements of privately held companies are designed to minimize taxable income in any given year. There may be nonrecurring or nonoperating expenses that would not be considered ordinary business expenses. It is possible to ''recast'' financial statements to show the true historical income to give a more accurate picture of future performance, which directly affects value.

When recasting income statements, you will find that most adjustments fall into one of the following categories:

• Nonrecurring items, such as unusual bad debt or litigation expenses, or the effects· of a discontinued operation.

• Related party transactions or other transactions not representing arms-length or market value. This category frequently involves officer compensation and other discretionary expenses that may be higher than industry norms for unrelated management employees.

• Adjustments to eliminate income or losses from nonoperating assets, including dividends from securities, interest income and gains and losses on their sale.

• Differences due to the accounting treatment of certain transactions, including inventory costing and capitalization policies·.

The balance sheet should also be adjusted for nonoperating assets or items the buyer might consider undesirable. Examples might include loans to or from employees, excess equipment, cash value of life insurance policies or marketable securities.

If the business owns real estate, the seller may want to place the asset in a separate corporation and enter into a lease with the buyer at market rent.

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