by Scott Balfour
You know it and I know it. Tax returns don’t tell the whole story as to what is going on in a business.
Most financial statements and tax returns, when prepared, are often constructed with the intention to minimize the tax burden. Paying less in taxes is a goal of most business owners. This is why the books need to be recast to give an accurate picture of what’s going on in the business. Skimming is the non-reporting of income and is illegal and ill-advised.
Recasting of the books entails making adjustments for those entries which are allowed by the IRS for tax purposes, yet aren’t part of the operating expenses of the business. In small businesses, there are also discretionary expenses that are the judgment of the business owner. These expenses in the same type of business could vary from one business owner to another. The goal is to recast the books to show a clearer representation of what is going on in the business on an even platform. This is done to provide a starting point, so whoever views the recasting can see what’s going without these tax considerations or discretionary decisions. This provides a platform for the reader to make decisions or projections as to what is important to them. Let’s get into some examples:
- Depreciation – is the timely writing off of hard assets and equipment for tax purposes. Many people refer to these as paper entries for there is no cash or check that was written for depreciation expense. Beyond that, one owner might want to accelerate depreciation to get a quicker more immediate tax benefit where another owner may choose to do it over an extended period of time. Both practices are permitted by the IRS, so the best practice is to set this at zero.
- Amortization – is very similar to depreciation. It reflects soft assets, but is treated the same way.
- Interest Expense – Some owners may run the business with no debt, where others will highly leverage it. Setting the interest to zero allows for a platform that doesn’t reflect what the current owner has done (history) and gives a basis for the future owner to plug in the numbers they think are appropriate given their individual business styles and ability (future).
- Owner’s Compensation – in a small business the owner sets his own pay rate. Obviously, different owners could have different views as to what an appropriate rate is given their skills, abilities, and risk. So once again, this is usually set at zero, allowing a platform for viewers to adjust for their use.
- Rent – Unless a building is designed for a specific use, say an oil refinery, it is best to look at it as if it were rented. The books would be recast to show fair market rent as an expense and be removed from the balance sheet assets if owned by the business. It would then be treated as a separate entity for valuation purposes, financing purposes, and the like. Alternatively, if on the book at original cost less depreciation, it should be stated at the current value of the real estate. Often in small businesses, the owner owns 100% of the stock in the business in one entity, say an S-Corp., and the real estate in their personal name. Because of this, the books may either show no rent, rent equal to the mortgage payment, an arbitrary plug number they initially allocated that may have to stay constant year after year, or rent substantially above-market rent as a way to take cash out of the business without having to pay social security, employment tax or dividends on it. Regardless of the approach and/or motivations of the current owner can you see why representing it at the fair market rent makes a whole lot more sense?
- Discretionary Expenses – Sometimes other discretionary expenses are not as clear as in the above examples that need recasting. Because of this, it’s important not only to recognize the adjustment, but also the thinking and documentation behind them. This is called due diligence. This can range from a simple review of what is provided with some questions answered by the seller, to in-depth forensic accounting, depending on the complexity of the business and relevant factors. Below are some random examples Auto expense: One owner may expense his high-end Mercedes; another may expense a part of the family caravan. The company does make deliveries so maybe it should be adjusted to an Econovan, or perhaps a specialized delivery van. Some owners may expense and depreciate the vehicle while others may lease it and others take mileage. All of these may be legally permitted by the IRS, yet the resulting number varies widely for each. This clearly shows why an expense needs to be looked at and considered because a recast number tells a clearer story. Other examples include: A palatial furnished office vs. modest office. Business trip: The difference between Motel 6 and the Marriott. Travel: First Class vs. Coach air-fare. Wages may have family employees; some are overpaid, others underpaid and some not paid at all. Wages need to be recast to reflect market value for the hours and skills needed for those jobs. The list can go on and on. The goal is clarity.
Boring! Agreed. But let’s answer why it is important. Running a business reflects on the quality of one’s life. More waking hours are put into running most businesses than spent with the family. Most family’s lifestyles are a function as to the financial success of the business. A business is often the single top asset or liability of an owner. Not knowing what is ‘really going on is not good for the owner, purchaser, banker, investors, vendors, financial planner, advisors, or anyone else that relies on the financial condition of the business as reviewed by looking at the tax returns.
Today transparency is the name of the game. Reality is the best view. Recasting brings reality to financial reporting if done right and properly understood.
In my world of Business Brokerage, recast statements help sellers determine the asking price for their business or other financial planning needs. Recasting helps purchasers to identify ‘what’s really going on in the business to assist them in their projections and determining a price that works for them. Recasting helps advisors do their job, be it financing, business planning, and forecasting, bonding, insuring, valuing, estate work, etc.