The financial statements of privately owned businesses rarely portray the true assets and earnings they generate.  Pro-forma adjustments, often referred to as “add-backs,” are used to adjust a historically reported financial statement for a truer picture of the economic reality of the business.  Add-backs help portray the true value of your business to a potential buyer.

The financial statement of the seller is the primary tool a buyer utilizes to determine the value or price to offer for the business.  In a perfect world, the financial statement accurately portrays the fair market value of assets and the maximum earnings or cash flows the business generated.  Unfortunately, we do not live in a perfect world and the financial statement of a company is often prepared to serve some purpose other than accurately presenting the results of business operations. 

Financial statements of privately held businesses are often prepared on the basis used to report income taxes, the cash basis of accounting or some other comprehensive basis of accounting that serves little purpose in valuation of the business.  These financial statements serve the purpose for which they were intended, but they rarely show the economic reality of the business’s earnings or assets.  Income tax basis financial statements often employ aggressive tax deductions to minimize income taxes.  Cash basis and other comprehensive basis of accounting generally ignore the current value of assets that may have significantly appreciated since they were purchased.

To provide a potential buyer with a clearer picture of earnings and assets, an acquisition professional will make pro-forma adjustments or “add-backs” to historical financial statements.  The type of pro-forma adjustments that are relevant depends on the circumstances unique to each individual business.  The underlying goal is to adjust the historically reported statement to the economic reality of the business by adding or subtracting amounts to individual financial statement components.

Pro-forma adjustments fall into the category of balance sheet adjustments or income statement adjustments.  Balance sheet adjustments are made to adjust assets or liabilities to their current fair market value, or to record an asset for capital items that may have been expensed in the historical financial statements.  Income statement adjustments are made to revenues or expenses to increase or decrease reported earnings to an amount that represents fair market value for the business or to show the business on the same basis that it will be operated by the prospective new owner.

A common income statement adjustment includes adjusting recorded owners’ compensation to reflect a level of compensation that would be appropriate for a non-owner employee performing the same management duties.  Because an owner may elect to pay himself more than market value for his duties or may elect not to take any compensation at all, it is necessary to normalize compensation to a reasonable amount so the true economic profitability of the business is revealed. 

Another income statement adjustment often involves occupancy cost or building rent.  A business that leases its operating facility from its owner may not be paying fair market value rent.  When the business is sold the former owner will require the new owner to pay rent at prevailing fair market value rates.  An adjustment to the historical rent expense for the business is made reflect the earnings of the business as if it had been paying fair market value rent all along.

Some add-backs affect both the income statement and the balance sheet.  For instance, many businesses take advantage of IRS rules allowing businesses to expense up to $104,000 in capital equipment purchases annually.  The affect on the financial statement is to lower earnings by the amount of the equipment written off and to understate the asset balances on the balance sheet.  For business valuation purposes, an adjustment should be made to the historical financial statement to eliminate, the expense associated with the equipment write-off (net of appropriate depreciation), and to increase assets to their true amounts. 

Add-backs are an important tool for adjusting financial statements to show the economic reality of the business, but they are not tools that can alter history.  Add-backs are not appropriate to depict how a business could have performed had the owner taken a different strategic direction or captured an opportunity that was missed.  Add-backs are used to properly depict the earnings and assets of the business as it was actually operated and not how the owner should have or could have operated the business.

The importance of properly identifying add-backs shouldn’t be overlooked.  Businesses are often valued as a multiple of earnings.  A business that is valued at five times earnings but fails to identify a $100,000 add-back would result in a valuation error of $500,000. Your Vercor professional is trained to identify and quantify add-backs that are appropriate to your specific business circumstances.