WFU Law School
Law & Valuation
5.5 Common Errors

5.5.1 Normalize Financials

The initial stage of any valuation should include the normalizing of the balance sheet and profit and loss statement. Some questions to ask in normalizing earnings would be:

  • Have the accounts receivable been appropriately discounted?
  • Has the work in process been accounted for and appropriately valued?
  • Was the inventory value based on LIFO or FIFO?
  • If the lease rate is different from the current market rate, has that difference been valued?
  • Has there been an appropriate deduction for reasonable owner's compensation?
  • Have non-recurring expenses been deleted?
  • Have the perquisites been added back to earnings? (For example, family members on the payroll, life insurance, disability insurance, personal legal and accounting expenses, company automobile, personal credit cards, country club membership, etc.)
  • Are there loans or debts to shareholders?
  • Are there any unrecorded liabilities?
  • Should there be an adjustment to after-tax earnings?
  • Do the financial statements conform to GAAP?
  • Is the accounting on a cash basis or accrual basis?

The balance sheet must also be normalized by considering some of the following:

  • Do the underlying assets , such as real estate or equipment, need to be appraised?
  • Is the depreciation appropriate? For example, if you use accelerated depreciation, then the value of those assets will be minimized in comparison to the straight line depreciation method. Should depreciation be added back in?
  • Are some of the assets not necessary to the operation of the business? For example, a vacation home, an airplane or a luxury automobile?
  • Should LIFO be converted to FIFO in determining the cost of goods sold?
 
5.5 Common Errors

©2003 Professor Alan R. Palmiter

This page was last updated on: August 4, 2003