Financial statements normalization involves adjusting non-recurring expenses or revenues so that it only reflects the usual transactions of a company. Financial statements often contain expenses that do not constitute the normal business operations and may hurt the company’s earnings. The purpose of normalization is to eliminate such anomalies and remain with the 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 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 all along. When adjusting the financial statements, you should only remove discretionary expenses and one-time gains or expenses that are unrepresentative of the business. Here are examples of normalizing adjustments:
In most private companies, the owners have the 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.
A company may decide to pay rent that is above or below the market rate, where 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 and does not constitute a part of the company 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.
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 occur in the future. They may include building renovations, gain or loss on asset disposal, insurance payouts, lawsuits and sale of company land. These 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.
Investors rely on the information contained in financial statements to decide whether or not they will invest in a company. Therefore, there has to be a transparent disclosure of all revenues and expenses incurred by the company. Generally accepted accounting principles (GAAP) guide firms in the preparation of financial statements and the disclosure of one-time and extraordinary events.
Analysts rely on the financial statements in predicting the future performance of a company. Hence, making the necessary disclosures of unusual and infrequent transactions will help them make informed decisions. An essential part of the analysis is to understand categories that are classified as non-recurring items and extraordinary items to determine their effects on the company’s reported revenues.
One-time items refer to entries that appear in the company’s financial statements and are unlikely to re-occur in the future. They mostly result from unpredictable events that are not expected to persist and are not part of the company’s day to day operations. Also, they may occur due to changes in accounting principles and discontinued operations. Some companies include gains and losses from non-recurring events to hide the losses incurred from normal business operations.
Details of non-recurring items should be included in the footnotes section of an income statement and in the Management Discussions and Analysis (MD & A) section of SEC 10-K filing or annual report. Analysts should segregate the non-recurring items so that the resulting revenue presents the real picture of the regular business activities of a company.
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 comprise 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 SEC filing 10-K submitted to the US Securities and Exchange Commission.
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 net income figure. The management should provide more explanation to these events in the Management Discussions and Analysis.