What is Normalization?
Financial statements normalization involves adjusting non-recurring expenses or revenues in financial statements or metrics so that they only reflect the usual transactions of a company. Financial statements often contain expenses that do not constitute a company’s normal business operations and that may hurt the company’s earnings. The purpose of normalization is to eliminate such anomalies and provide accurate historical information that enables reliable comparisons and forecasting.
Normalizing adjustments to the financial statements are made for a variety of reasons. If the company is seeking external funding, normalized financial statements provide the investor or lender with a clear picture of the actual expenses, revenues, and cash flow of the company during a particular period. Also, when selling the business, a potential buyer will want to see the normalized statements to gauge whether the business has been profitable overall. When adjusting the financial statements, you should only remove discretionary expenses and one-time gains or expenses that are unrepresentative of normal operating expenses of the business. Here are some examples of normalizing adjustments:
#1 Owner’s Salary and Expenses
In most private companies, the owners have discretion over the amount of salaries and allowances that they draw from the company accounts. Also, the owners may decide to pay their personal expenses through the company accounts. Such expenditures may include travel allowances, internet costs, entertainment, vehicle, fuel, etc. These costs reduce the net revenue of the company. When selling the company, appraisers must add back these expenses to the company earnings.
#2 Rental Expense or Income
A company may decide to pay rent that is above or below the market rate when the company premises are owned by the company or a holding company. Adjusting the rental expense to reflect the prevailing market value will help normalize the financial statements. Also, where the company earns a rental income from its properties that does not constitute a part of the company’s core business operations, this income should be eliminated from the financial statements. Also, any loans related to such properties should be removed from the company’s balance sheet.
#3 Non-recurring Expense or Income
Non-recurring expenses result from abnormal events that are unrelated to the company’s core operations. Mostly, they are one-time gains or losses that are unlikely to reoccur in the future. They may include building renovations, gain or loss on asset disposal, insurance payouts, lawsuits, and sale of company land. One-time incomes should be eliminated from the financial statements, and one-time expenses should be added back to the company’s revenues to reflect the company’s real financial performance during the year.
#4 Extraordinary Events
Extraordinary events refer to unusual gains or losses that materially affect the company’s finances. Also, an event is classified as extraordinary if it is not part of the day-to-day operations of the company. These events may be comprised of material storm damage, regulatory or tax rulings, lawsuits, costs of implementing a new production system, restructuring costs, sale of assets, etc. Such events have a significant impact on a company’s profitability and should be explained separately.
Detailed explanations of extraordinary items appearing in the financial statements should be included in the notes to the annual report, and in the SEC filing 10-K submitted to the US Securities and Exchange Commission.
One-Time Events vs. Extraordinary Events
These events should be treated differently in the financial statements. The one-time/non-recurring items should be recorded under the operating expenses in the income statement, while the extraordinary items should be recorded after the net income figure. The management should provide an additional explanation to these events in the Management Discussions and Analysis.
Learn more about Financial Statement Normalization
Thank you for reading this guide to understanding what normalization is. To keep learning and advancing your career, these CFI resources will be a big help: