The main objective of adjustments on financial statements is to determine the true earning power of the entity in the past. Doing this requires elimination of all nonrecurring items and those that have no permanent influence on the future earning power. As a result, past earnings are made comparable with projected earnings, and the forecasts can be corroborated by the use of plausibility checks. The final result is a reliable basis for the entity’s valuation.
This post reveals 10 type of systematic adjustments on financial statements. Enjoy!
Items That Applicable for Adjustment
With respect to adjustments, there are two questions:
- Is the item nonrecurring?
- Is it related to discontinued operations or assets not essential to operations?
Unless the answer to either question is yes, adjustments are necessary; otherwise, the respective amount needs to be eliminated in the same way assets, liabilities, revenues, and expenses have to be separated into those that are essential and nonessential. Items that are immaterial do not have to be analyzed, eliminated, or adjusted; the normal materiality limit is about 1% of net income after tax. Examples of nonrecurring items are presented next.
Non-recurring Items that Cause Valuation Changes
- Profits and losses resulting from changes in asset values related to mergers
- Impairment losses related to goodwill, fixed or intangible assets
- Payments that have been made on receivables and other items previously written off
- Unrealized profits and losses from changes in fair values of financial instruments and hedging transactions
- Actuarial gains and losses related to pension plans
- Earnings from the reversal of a provision
- Reversal of an asset impairment loss
- Profits and losses stemming from changes in deferred taxes due to modifications in tax laws, regulations, rates, or losses carried forward
Other Nonrecurring Items
- Sales and profits caused by extraordinary events at other companies (a strike at competitor)
- Proceeds from government grants
- Profits and losses resulting from asset disposals
- Nonrecurring earnings from subsidiaries (tax recoveries, distribution of reserves)
- Profits and losses related to mergers or acquisitions
- Extraordinary losses from defective products and warranties (only material amounts)
- Gains or losses from litigation, strikes, settlements of claims
The 10 Systematic Adjustments
From time to time, entities make basic changes to their financial reporting, such as adopting IFRS. In such cases, to ensure comparability, adjustments have to be made, although allocating such amounts to different past years, normally based on sales or EBIT, may be somewhat arbitrary.
Here are 10 types of adjustment commonly made:
1. Changes in accounting principles – There can be fundamental variations between many national accounting standards and IFRS. When analyzing financial statements, one of the basic questions is: Which accounting standards were applied? Differences can arise from recognition of realized or unrealized profits, use of fair value, items that result in profits or losses, or changes in equity. Some national accounting standards prescribe that no retrospective adjustments are to be made; IFRS, however, requires them.
2. Changes in valuation practices – Changes in valuation practices include profits and losses caused by changes in methods of:
- Cost calculations (cost of goods)
- Inventory measurement ( average cost, including overhead and depreciation elements, which may be zero)
- Depreciation techniques (straight line, declining balance, sinking fund)
- Impairment testing (fair value less costs to sell, value in use)
Note: Generally, this information is found in the notes to the financial statements.
3. Changes in accounting policies – Dealing with this item is one of the most difficult parts of financial statement analyses, as there is a wide range of possible, acceptable changes in accounting policies. Information comes primarily from interviews with management and notes to the financial statements. Changes in accounting policies fall into three categories:
- Estimates: The probability of an event or contingency, the result of litigation or an uncertain liability, the useful life of an asset
- Valuation methods: Amortized historic cost, fair values, value in use
- Alternative treatments of controlled entities. Full consolidation, pro rata inclusion
Any of those items and procedures can result in an increase or decrease in profit, which will vary in amounts and materiality. Likely triggers are:
- Replacement of key personnel (chief executive or financial officer, management in general)
- Contemplated initial public offering
- Intended sale of the entity
- Reorganization of an operation
Regular modifications of basic business strategy should be treated as ordinary items with no elimination being required. However, their effects must be taken into account in the analyses of sustainable profits.
4. Singular events – Singular events cover the losses (occasionally gains) caused by:
- Office or plant moves
- Natural disasters (floods, avalanches etc.)
- Asset disposals
- Property sales
- Recalls due to product defects
- Extraordinary warranties
Usually, their effects are seen directly in the financial statements since some of the costs (net of any insurance proceeds) will be charged to normal expenses (rent, advertising, interest), with the balances generally being posted to “other income” or “other operating expenses.”
Unless the notes to the financial statements or some internal report contains the pertinent information, only questioning senior management followed by fundamental analyses of income or expense accounts will indicate their existence. Indicators are unexpected increases in certain expenses or individual postings of unusual amounts. Frequently both are offset by claimed extraordinary increases in earnings.
5. Related parties – The profits of small and medium-size businesses may be strongly influenced by related-party transactions; therefore, they have to be very critically analyzed.
Areas of concern are:
- Employment arrangements
- Dual-purpose assets
- Personal benefits
In many cases, family members are employed whose remuneration may be too high (very common) or too low (not unusual) in relation to the services they provide. Some entities even “employ” family members who get paid little or nothing for their activities. When such a firm is sold, those unpaid functions have to be evaluated and an imputed cost deducted.
It is common for family firms to have dual-purpose assets that may be used for business or private purposes (e.g., cars, real estate, investments). Contracts covering employment or related to the use of such assets may contain conditions that are not at arm’s length. In that situation, full adjustment has to be made to assets, liabilities, revenues, and expenses.
Interest payments on loans due to or by family members may not be in accordance with market rates. A common situation is to withdraw bonuses, pay the personal tax, and lend the balance back to the entity without interest; in all cases, the agreed-on interest rate needs to be adjusted to market.
Certain types of expenses give opportunities for personal benefits; they include travel, entertainment, legal, and tax advisory services. It is always essential to separate business from private use; the latter has to be eliminated completely.
Another frequent practice, on purchasing a business, is to strip out any real estate and lease it back at a fixed rental, which may be above the market rate for similar properties. Also, leases covering other assets, such as equipment, may contain unusual conditions that could affect their useful lives or values.
6. Minority shareholders – Minority shareholders in general merely have a minor influence on business activities. Unlike a controlling interest, they can affect business strategy and policy only within a very narrow range. Therefore, when valuing a minority position, no adjustment should be made to profits for transactions with related parties; the relative positions of the shareholders may have an impact on the value conclusion; therefore, the structure needs to be assessed as part of the process.
7. Group relationships – Several levels of effects from group entities have to be taken into account. Transfer prices in particular should be analyzed very carefully to ensure they are in line with the market; these issues can refer to a wide range of goods, services, loans, leases, license agreements, and the like. Benefits from group synergies (more advantageous purchasing, lower borrowing costs), which may no longer exist once an entity is sold, are rarely considered; their absence may adversely affect profits once the firm becomes a stand-alone entity.
Firms forming part of a controlled group are usually part of a complex logistic and financial system. There are investments, sale-leaseback agreements, and other contracts that often are not at market rates. Odd effects, such as unexpected goodwill, and major changes in the structure may sometimes result from a first-time consolidation, inclusion of formerly nonconsolidated subsidiaries (particularly those financing customer purchases), or changes in consolidation procedures.
8. Discontinued operations – As defined in IFRS 5, Noncurrent Assets Held for Sale and Discontinued Operations, a discontinued operation is a component of an entity that represents a separate major line of business or geographical area of operations, and either (a) has been disposed of, or (b) is classified as held for sale. To qualify for this status, the sale must be part of a single coordinated plan to dispose of the separate major line of business or geographical area of operations. The category also includes any subsidiary acquired exclusively for future disposal. Profits and losses from such operations may be treated as part of the regular results or as nonrecurring items, depending on the individual situation.
9. Taxes – The results of special tax-driven items or transactions generally have to be analyzed critically; all tax-based values should be adjusted.
10. Presentation of facts – Differences in timing can affect many items; for example, announced increases in tax rates may lead to bringing forward investments. Critical economic situations often result in postponing required repairs or replacement of machines and lead to reducing expenses for marketing, research, and training. Such events directly affect liquidity, balance sheet structure, and profit of the entity not only at the time of the decision but also in following years. Therefore, adjustments should be looked at in the context of at least a five year analysis to discover these long-term effects.