When it comes to tax time, privately held companies want to show as little profit as possible. However, when it's time to borrow money or sell the business, they want to show just the opposite. Lenders and prospective acquirers want to see a strong bottom line. The best way to present this is by normalizing, or recasting, the profit and loss statement. The adjustments to the profit and loss statement are usually termed "add backs", because expenses are added back to increase the company's profit.
Add backs are typically one-time, non-recurring or discretionary expenses for business. For example, legal fees for litigation, a new roof, tooling for a new product, non-market rate rent or salary expense, just to name a few examples. By adjusting these expenses, a buyer is presented with a clearer picture of the company's normalized profits and can potentially justify a higher valuation.
Buyers will take a hard look at the add backs to confirm they are reasonable and to gain confidence in the sustainable earnings of a company. It is important to realize that there is really no such thing as a pure one-time expense, as every year will produce other "one-time" expenses. If a company goes overboard in claiming add backs, it will undermine the credibility of their presentation.
Recast earnings are a legitimate way of showing the normalized earnings of a privately held company. But remember - excess or unreasonable add backs will not be acceptable to buyers, lenders, or business appraisers.
Buyers place the highest confidence on non-adjusted profits, so reducing add backs and maximizing profits is recommended for 2-3 years prior to a sale.
Normalized Financial Statements - Statements that have been adjusted for items not representative of the normal operations of the business. Normalizing statements could include adjustments for a non-recurring event, such as attorney fees expended in litigation or costs of moving to a new location, or non-market rate costs such as rent or owner's compensation and benefits.