How Accounting Methods & Entity Type Affect Financial Statement Recasting

There are several accounting methods that will be encountered when recasting financial statements of small businesses, as well as variations on these methods.  This article provides an introduction to the various methods.  The subject’s entity type can also affect the accounting method used for tax returns.  This article also discusses the impact of entity type on tax returns and tax return recasting.  In addition to the accounting methods discussed below, other accounting methods may encountered, including “income tax basis”, “modified cash basis”, or “hybrid basis”.

In income tax basis accounting[1], the financial statements are prepared primarily using financial information as it will appear on the income tax return.  In modified cash basis accounting, long-term assets and liabilities are accrued, while short-term income and expenses are kept on the cash basis. Under a hybrid accounting method[2], companies will use the accrual accounting method to satisfy tax requirements and the cash basis method for all other financial transactions. Accounts receivable (A/R) and accounts payable (A/P) are the only items recorded using the accrual method; A/P transactions relate to inventory, as required by the IRS. Financial transaction like asset purchases, payroll or equity investments are recorded using the cash method, reflecting transactions where cash changes hands.

In this article financial statement recasting, with regard to the income statement, refers primarily to the analysis required to determine the client company’s Seller’s Discretionary Earnings (SDE).  Where SDE is defined as:

“… income before the primary owner’s compensation, other discretionary, non-operating, or non-recurring income or expenses, depreciation, interest, and taxes” –

SDE = Earnings Before Tax + Add-backs

  • Seller’s Discretionary Earnings are pre-tax
  • Seller’s Discretionary Earnings are based on one owner
  • Seller’s Discretionary Earnings must be verifiable
  • Add-backs must be acceptable to Buyer and/or a Lender

If you are recasting financial statements for a client company, and you have questions regarding the details of the accounting method used, with the owner’s approval, meet with the client’s Accountant/CPA to make sure you understand the accounting method.

Accrual Basis Accounting

¨     Accrual Basis Accounting: Revenues are reported in the fiscal period in which they are earned, regardless of when received, and expenses are deducted in the fiscal period in which they are incurred, whether they are paid or not. In other words, using accrual basis accounting, you record both revenues and expenses when they occur.

Cash Basis Accounting

¨     Cash Basis Accounting: Revenues are recorded when cash is actually received and expenses are recorded when they are actually paid (no matter when they were invoiced).

  • Cash basis balance sheets do not include accounts receivable, accounts payable, and accrued expenses

The accrual basis of accounting generally is preferred for income statement and balance sheet recasting because it more accurately matches revenue sources to the expenses incurred during the accounting period.

If the client company uses cash basis accounting, one can make a couple of simple cash-to-accrual adjustments to estimate the revenue and expense if the company had used accrual accounting.

The first adjustment is based on the increase/decrease in the subject’s accounts receivable from the beginning of the year to the end of the year. The amount that accounts receivable increased is added to the cash basis revenues to estimate the accrual basis revenue.  If the accounts receivable balance decreased, the amount of the decrease is subtracted from the cash basis revenue to estimate the accrual basis revenue.


The second adjustment is based on the increase/decrease in the subject’s accounts payable from the beginning of the year to the end of the year. The amount that accounts payable increased is added to the cash basis cost of goods sold to estimate the accrual basis cost of goods sold.  If the accounts payable balance decreased, the amount of the decrease is subtracted from the cash basis revenue to estimate the accrual basis revenue.

Construction-Related Accounting Methods

Construction-related accounting methods can be quite complicated.  Therefore, a detailed discussion of these methods is outside the scope of this article.  However, business brokers and other business consultants involved in pricing and/or selling such companies need to be familiar with these methods.  The following discussion is intended to provide a cursory description of construction related accounting methods and the related terminology.  It is recommended that business brokers / business consultants work closely with their clients and/or their client’s Accountants/CPAs when pricing such businesses to make sure that they correctly interpret the subject’s financial information.

Most construction businesses use two different methods, one for their long-term contracts and one overall method for everything else.  A long-term contact being one that is not completed in the same year it is started.  A short-term contract is one that is started and completed within one tax year.

Construction-related companies can use several different accounting methods[3], including:

¨     Cash Method

¨     Accrual Method

¨     Percentage of Completion Method

¨     Completed Contract Method

In the percentage of completion method, the contractor must allocate direct and indirect costs to contracts in a manner as to recognize revenues and gross profit in the applicable periods of construction, and not only in the period when the construction has been completed, as in the completed contract method. The degree of completion of the construction, i.e., the percentage-of-completion, is typically estimated by dividing the total construction costs incurred to date by the total estimated costs of the contract, or job.

The referenced IRS article, also discusses several variations to these methods.  There are special IRS tax rules3 that determine which accounting method(s) and/or variations of methods must be used for construction companies.   Factors that affect the allowed accounting method(s) include:

¨     The type of contracts the company has,

¨     The company’s contract completion status at the end of the tax year,

¨     The company’s average annual gross receipts

When the percentage of completion method is used, the accounting principle of full disclosure requires the presentation of a work-in-process schedule in the company’s financial statements.  This schedule discloses the details of each contract stage of completion and profitability to date as well as in the current period of reporting.  The work-in-process schedule will not show the backlog of contracted jobs that have not yet started.

Comparison of the subject’s backlog from year-to-year, including those contracts that have not been started, is important information when listing a business.

For more detailed information on accounting for construction contracts see the IRS article referenced above3.


Terms unique to construction industry accounting include:

¨     Retainage – An amount held back (retained) by the customer (or prime contractor if the subject is a subcontractor) from each draw request.  Retainage is typically in the range of 5 to 10%.

¨     Costs and Estimated Earnings in Excess of Billings – The amount by which the contractor has under-billed the customer (or prime contractor if the subject is a subcontractor).

¨     Billings in Excess of Costs and Estimated Earnings – The amount by which the contractor has over-billed the customer (or prime contractor if the subject is a subcontractor).

Impact of Entity Type on Tax Returns

Some of the most common types of entities are listed in the following table along with the applicable IRS form(s) for income tax reporting.


Entity Type

Tax Return


IRS Form 1120S

IRS Form 1120
Sole Proprietorship

IRS Form 1040, Schedule C

IRS Form 1065
Limited Liability Company (LLC)

Any of the Above

The most common expenses considered in financial statement recasting, that are affected by the entity type and/or the tax return, are:

¨     Sec. 179 Deduction/Depreciation – Section 179 allows the taxpayer to expense rather than capitalize certain types of assets up to a given dollar amount each year.  Depending on the type of entity, the Section 179 may be taken as a business deduction in which case it would be an add-back in financial statement recasting; or, as a personal deduction, in which case it would not be an add-back in the recasting.

¨     Charitable Donations – Charitable donations are also handled differently for different entities.  They may be treated as either business deductions or as personal deductions on tax returns depending on the entity type.

¨     Health Insurance – Owner’s health insurance premiums are also handled differently for different business entities.  They may be treated as business deductions, included in owner/officer compensation, or as personal deductions based on several factors including business entity, whether or not the company has a qualified retirement/pension plan that includes a health insurance program.  Due to complexity, the manner in which each different entity handles health insurance / medical expense is not discussed in this article.  Business brokers should be aware, however, that health insurance premiums may or may not be allowable deductions on tax returns.

The following paragraphs discuss how different entities handle the Sec. 179 deduction/depreciation, charitable donations, and health insurance.  The discussion applies only to tax returns.  Owner fringe benefits that are expensed on financial statements are potential add-backs even if they are not legitimate tax return business deductions.

¨     S-Corporation – The S-Corporation is a pass-thru entity, i.e., there are no income taxes at the corporate level.  The profits of the corporation pass thru to shareholders who are taxed at their personal income tax levels.  However, shareholders of S-Corporations have a tax liability on the profits of the company, regardless of whether or not these profits are distributed to the shareholders.

  • Although the IRS frowns on this practice, owners of S-Corporations often take minimal salaries to avoid payment of payroll taxes.
  • S-Corporation tax returns (IRS Form 1120S) treat the Sec. 179 deduction/depreciation and charitable donations as personal deductions (not business deductions).  Therefore, neither of these items is an add-back in the financial statement recasting for S-Corporations.  In the S-corporations tax return (IRS Form 1120S) these and other personal deductions, etc. are listed on Schedule K-1, Shareholder’s Share of Income, Deductions, Credits, etc.  As indicated by the name of Schedule K-1, deductions listed on this schedule are personal deductions not business expenses.
  • S-Corporation tax returns typically include owner’s health insurance expense either in Compensation of Officers (Line 7 of Form 1120S), or it is included as a non-deductible expense on Schedule K-1.  It is then treated as a personal expense on the owner’s individual tax return.

¨     C-Corporation – Unlike S-Corporations, C-Corporations pay income tax.  After-tax profits are distributed to shareholders as dividends.  Shareholders pay personal tax, currently 15%, on dividends from C-Corporations.

  • In order to avoid double taxation, owners of C-Corporations often take large salaries to minimize profit and corporate income tax.  C-Corporation shareholders do not have any tax liability on undistributed profits.
  • C-Corporation tax returns (IRS Form 1120) treat Sec. 179 deductions/ depreciation as a corporate deduction combined with normal depreciation.  Therefore for C-Corporations, Sec.179 depreciation is a potential add-back in income statement recasting.  An exception may be companies that have high annual capital expense. Charitable donations can also be treated as corporate deductions (charitable contributions are limited for C-Corporations to 10% of Taxable Income on Line 28 of IRS Form 1120).  Therefore, C-Corporation charitable donations on Line 19 of IRS Form 1120 are add-backs in the recasting analysis.
  • C-Corporation tax returns also allow owner’s health insurance to be deducted as a business expense.

¨     Sole Proprietorship – Income from a Sole Proprietorship is reported Schedule C (IRS Form 1040) as part of the owner’s personal income tax return.  The sole proprietorship is a pass-thru entity like the S-Corporation in that money made in the business flows through to the individual’s tax return.  The Sole Proprietorship does not provide the liability protection of a corporation (e.g., S Corporation, C-Corporation).  Generally all liability of the business is liability to the business owner.  For a Sole Proprietorship, Section 179 Depreciation is treated as a business deduction included with normal depreciation.  Charitable contributions are treated as personal deductions and are not included on Schedule C.

  • For sole proprietorships, owner’s health insurance expenses are treated as personal expenses – not business expenses.

¨     Partnership – IRS Form 1065 is an information return a Partnership uses to report its income, deductions, gains, losses, etc.  A Partnership does not pay tax on its income but “passes thru” any profits or losses to its partners.  Partners must include partnership items on their tax returns.

  • The partnership uses Schedule K-1 to report each partner’s share of the Partnership’s income, credits, deductions, etc.  All Partnerships must complete Schedule K.  Although the partnership generally is not subject to income tax, partners are liable for tax on their share of the partnership income, whether or not the partnership distributed the income.
  • Like the sole proprietorship, the Partnership is usually a bad choice for a business entity.  Generally all liabilities of a Partnership are liabilities of the partners.  Individuals considering partnerships should look into the more formal entities (i.e., S-Corps., C-Corps., or LLC’s).

¨     Limited Liability Company (LLC) – The federal government does not recognize an LLC as a classification for federal tax purposes, such entities must decide how they want to file their federal returns.  For Federal tax purposes, an LLC business entity must file as a corporation, partnership or sole proprietorship tax return.


There are several accounting methods, and variations of these methods, that may be encountered by business brokers and intermediaries when recasting financial statements.  Recasting tax returns is also affected by the type of entity.  Business brokers and intermediaries should be familiar with the various accounting methods and entity types.  However, due to potential differences from company to company, anyone recasting financial statements should meet with their client’s Accountant/CPA to make sure they understand the details of the accounting method used by the client company.

One thing to remember, whether you are recasting financial statements or tax returns, if an item was not included as a business expense it can’t be added back.

[1] How to Prepare OCBOA (Other Comprehensive Basis of Accounting) Financial Statements,

[2] Hybrid Accounting Methods,

[3] Article on IRS website entitled Accounting for Construction Contracts – Construction Tax Tips,,,id=97986,00.html


Annualizing Income Statements

When listing a business the Seller usually provides the business broker with tax returns for prior years and an interim income statement for the current year.  For small businesses such interim statements are often on a cash basis and are often prepared by management.

Annualizing interim statements without reviewing the result for reasonableness may create problems during due diligence when it becomes obvious that annualized revenue and/or earnings were overstated.

It’s not unusual for interim income statements to show higher profitability than year end-tax returns, or year-end financial statements.  There can be several reasons why this occurs, including:

  1. Business owners, whose financial statements are prepared on a cash basis, in order to reduce income tax liabilities hold checks received at the end of one year depositing them after the first of the following year.  The result is that the Company’s income and earnings are inflated at the beginning of the year.  Interim statements prepared early in the year are inflated more on a percentage basis than those prepared later in the year.  If the business owner holds the same dollar amount of checks at the end of the current year the year-end income will no longer be inflated.
  2. Management-prepared income statements often do not include all expense items.  For example, expenses that are paid by direct-withdrawal from the company’s checking account may not be included in expenses until the firm’s accountant prepares the year-end financial statements.  Interim statements may also include non-operating items under income.  For example, the proceeds from the sale of the owner’s personal luxury automobile or other company assets; or, a cash infusion from the owner may have been included in income rather than being entered on the balance sheet as a loan.  Omission of expense items or inclusion of non-operating income in the subject’s reported revenues inflate the company’s reported profitability.
  3. Interim statements may include annual or semi-annual expenses such as insurance premiums.  Annualizing such items will over-state G&A expenses
  4. The company’s mix of business and/or discretionary expenses may have been reduced increasing the firm’s profitability.  That is, the reduction in expenses may be real.

When considering annualizing an interim income statement, compare the subject’s cost of goods sold (COGS) and total G&A expenses with year-end values for prior years.  If the interim statements do not include expenses such as depreciation, deduct such expenses from prior year statements before making the comparison.  If the expenses as a percent of revenue in the interim statement are significantly different than in prior years discuss this with the Seller or the company’s accountant to find out why.  Are the differences real, or was income inflated or expenses understated / overstated?  Also ask the Seller if the annualized revenues are in agreement with his/her projections and make sure there aren’t any significant non-operating income items included in interim statement revenues.

Certain expenses may be allocated differently from year to year, i.e., included in COGS in some years and in G&A expenses in other years, therefore it may be necessary to compare total expenses (i.e., COGS plus total G&A expenses) in the interim statements with prior years.

To avoid some of the problems associated with annualizing interim income statements, request an interim statement for the same period for the previous year (remember to check both interim statements for the potential problems discussed above).  Using this information, one can present the income statement for the trailing twelve months (as of the date of the interim statements) rather than annualizing a few months.  For example, if:

2008 Year-End Revenues = $700,000

April 30, 2008 Revenues  = $200,000

April 30, 2009 Revenues  =  $250,000

Trailing 12 months revenue   = 2008 Year-End Revenues – April 30, 2008 Revenues + April 30,   2009 Revenues

= $700,000 – $200,000 + $250,000 = $750,000

TTM expenses can be calculated in the same manner.

Remember, if you overstate current year income / profitability it can come back to haunt you if a contract is executed near the end of the year and due diligence shows that year-end revenues / earnings will be significantly lower than your annualized projections.

How Does One Deal with Excess Inventory?

Unlike most comparables sold databases, Bizcomps does not include inventory in the selling price.  This is actually a benefit if the subject has excess inventory.  Since inventory is not included in the selling price the subject’s inventory must be added to the value indication obtained using Bizcomps.  If the subject has excess inventory, this approach will likely overvalue the subject.

For example, assume you are valuing an industrial supply distributor with the following characteristics:

Revenue                               $1,250,000

SDE                                       $185,000

Inventory                                $400,000

In addition assume that the subject has excess inventory of $200,000 included in the inventory value of $400,000.

If one values the subject, using the median price/SDE multiple from the Bizcomps data on the attached table, ignoring the fact that the subject has excess inventory, the value indication is:

Value = (price/SDE multiple x SDE) + Inventory = 2.25 x 185,000 + 400,000

= $816,250

Taking the excess inventory into account, there are two ways to estimate value.

Method 1: Assume that only the normal inventory required to operate the business would be added back in the above equation, and, then add back the estimated market value of the excess inventory.  For the purpose of this example assume that the market value of the excess inventory = 50% of the value of the excess inventory at cost.  The value indication would then be:

Value   = (price/SDE multiple x SDE) + Normal Inventory + Market Value of Excess Inventory.

= 2.25 x 185,000 + 200,000 + 100,000 = $716,250

Method 2: Recalculate the median price/SDE including inventory (SP’/SDE) on the attached table (assuming that the inventory included in the selling price is the subject’s normal inventory).  The value indication in this case would then be:

Value = (SP’/SDE x SDE) + Market Value of Excess Inventory

= 3.25 x 185,000 + 100,000 = $701,250

It should be noted that on the attached table, the coefficient of variation (standard deviation/average) for the SDE multiple including inventory in the selling price (SP’/SDE) is slightly smaller than the coefficient of variation for the multiple that does not include inventory in the selling price (SP/SDE).  This indicates that there is less dispersion for the multiple that includes inventory in the selling price, i.e., there is a better fit to the data for this multiple.

The above example shows that a subject may be overvalued if it has excess inventory and the appraiser and/or broker is not aware of this fact and treats all inventory as if it where normal inventory required for business operations.  Regardless of whether or not the subject’s inventory appears high compared to industry standards, the appraiser and/or broker should ask the owner if the inventory value on the balance is sheet is realistic, whether the subject has excess inventory, including slow moving or obsolete inventory, and, if the owner can provide an estimate of the market value of the normal inventory and/or any excess inventory.

In the particular example given above, the two methods used to address excess inventory gave similar value indications.  This may not always be the case.  The appraiser and/or broker should consider both methods and decide which approach is the most reasonable for the subject.

Methods 1 and 2 discussed above work for the Bizcomps database because this database, while it does not include inventory in the selling price, it does provide the value of the inventory included in the sale.  Other databases that include inventory in the selling price don’t always show the value of the inventory included in the sale.  This makes it more difficult to deal with issues such as excess inventory when using such databases.




Income Statement Recasting

Rent Adjustments for Businesses with Non-Arm’s Length Leases

Valuing a Business with A Non-Arm’s Length Lease)

If a business rents its facility from an independent third party (i.e., arms-length lease), it is typically not necessary to make any adjustments to rent.  An exception can occur if the business has a binding long-term lease with below market rent (positive add-back).

With the exception of certain kinds of special-use or single-use properties, e.g., golf courses, it is necessary to treat the valuation of a business occupying shareholder-owned facility separately from the real estate.  This is also true for any non-arm’s length lease.  To separate the real estate value from the business value it is necessary to remove from the income statements all expenses associated with property ownership and to substitute a market rent for the premises occupied.  If the “market rent” is based on a triple-net lease, the business would also be responsible for insurance, property taxes as well as repairs & maintenance.  One should also remove all real estate-related balance sheet items such as mortgages, accumulated depreciation, etc.

Why are Businesses and Real Estate Valued Separately?

Businesses and real estate are two different types of investments.  The earnings multiple (1/cap rate) for commercial real estate may be on the order of 10 (i.e., value = net operating income/cap rate).  The operating income for a commercial property is related to the fair market rent to that type of facility, in that location, etc.  The fair market rent for a commercial property is independent of ownership.  It is also independent of whether or not the occupying business actually pays rent.

Using the income approach, and assuming a cap rate of 10%, the value of a commercial property with a net operating income (assume it is equal to fair market rent with a triple-net lease) of $100,000 would be $100,000/0.1 = $1,000,000.

If the business has SDE of $400,000 but doesn’t pay rent because the real estate is owned by the business, or the business’ shareholders, the market rent must be subtracted from SDE.  The adjusted SDE is then $300,000.  If the proper earnings multiple for the business is 3.0, the business value is $900,000.

The value of the real estate plus the business is $1,000,000 + $900,000 = $1,900,000.

If you don’t adjust rent (even if the business doesn’t pay rent) to fair market rent, you are in effect counting the rent twice.  You are counting it once as the income produced by the real estate; and, again as part of the business’ discretionary earnings.

If you don’t adjust SDE to account for market rent, you are in effect valuing the business and real estate together (i.e., you are adding their cash flows together).  The total SDE for the property and the real estate is $400,000.  If you use the earnings multiple for the business, the combination would be priced at $1,200,000 ($700,000 low).  If you use the cap rate for the real estate, the combination would be priced at $4,000,000 ($2,100,000 high).

What Discretionary Earnings Should  Be Shown in the Offering Memorandum?

Most misunderstandings arise between the way rent is treated in a business valuation versus the way it is treated in the Offering Memorandum or listing.  In the Offering Memorandum, the total cash flow of $400,000 would be shown if the real estate is included in the sale.  If the real estate is not included, and the Seller will charge market rent of $100,000, the adjusted cash flow of $300,000 would be shown (assuming there are no other expenses the business would have to pay that it is not already paying).  If the real estate is available, the Offering Memorandum should show the business cash flow of $300,000 if the buyer buys only the business.  In addition, there should be an indication of the total cash flow ($400,000) if the Buyer buys the real estate.