Don’t compare apples to oranges

Don’t compare apples to oranges

Abstract: Borrowers’ accounting practices can vary widely. An accounting tool called “normalizing” can help adjust income statements and balance sheets to compensate for companies’ different accounting methods. Failing to normalize financial statements may result in faulty lending decisions. This article uses some examples to illustrate how normalizing works and the difference it can make in helping a lender who is evaluating a borrower accurately compare its practices to those of a competitor or to industry benchmarks.

Don’t compare apples to oranges
Evaluate borrowers accurately by normalizing financial statements

In evaluating their borrowers, lenders need to use all the tools at their disposal — including an accounting tactic called “normalizing.” Normalizing involves adjustments to income statements and balance sheets to compensate for companies’ differing accounting methods. Because borrowers’ accounting practices vary widely, comparing them without adjusting their financial statements is like comparing apples to oranges. Ultimately, failing to normalize financial statements may result in faulty lending decisions.

No two are alike

Even within the broad confines of Generally Accepted Accounting Principles (GAAP), it’s rare for two companies to follow exactly the same accounting practices. When you compare a borrower’s practices to those of a competitor or to industry benchmarks, it’s important to understand how they report transactions.
A small firm, for example, might report earnings when cash is received (cash basis accounting), but its competitor might record a sale when it sends out the invoice (accrual basis accounting). Differences in inventory reporting, pension reserves, depreciation methods and cost capitalization vs. expensing policies also are common.
Additionally, some tax accounting practices — expanded Section 179 and bonus depreciation deductions, for example — may temporarily defer income taxes. So, consider the tax implications when reconciling different tax accounting methods.

Past vs. future

Lenders need to distinguish between historic performance results that represent potential ongoing earning power and those historic results that don’t. If a one-time revenue (or expense) or gain (or loss) will temporarily distort the company’s future earnings potential, you would add back expenses and losses (or subtract the revenues and gains) if they’re not expected to recur.
If a borrower’s plant was devastated by a hurricane or a borrower experienced a $1 million equipment theft, for instance, you’d add back the extraordinary losses to get a clearer picture of normal operating performance. Or if the borrower won a $5 million lawsuit, you’d subtract the gain. Other nonrecurring items might include discontinued lines or expenses incurred in an acquisition.
But go beyond just adjusting these charges. One-time charges — insurance claims and fraud losses are examples — could shed light on future risk factors. Ask about the nature of these charges and any preventive measures the borrower has taken or will be taking to minimize the risk of recurrence.

At arm’s length

Some closely held business owners are paid based on the company’s cash flow or the owner’s personal needs, not on the market value of services they provide. Many closely held businesses also employ family members, conduct business with affiliates and extend loans to company insiders.
Because of this, you, as the lender, should identify all related-party transactions and inquire whether they occur at “arm’s length.” Also consider reconciling for unusual perquisites provided to insiders, such as season tickets to sporting events, college tuition or company vehicles.

On an equal basis

While most normalizing reconciliations are made to the income statement, many flow through to the balance sheet, which is often the lender’s starting point in determining collateral values.
Suppose one manufacturer uses eight-year useful lives for its equipment, but another uses six-year useful lives for the same items. To create an equal basis of comparison, you might reconcile the first company’s earnings downward to reflect its slower depreciation technique. In addition, the net book value of its equipment should be lowered to reflect its relatively inadequate depreciation deductions. These lender-made normalizing adjustments effectively make the first borrower appear less attractive than initially shown on its financial statements when compared to the second borrower.

See your borrowers as they are

Obviously, you need to evaluate each borrower based on its individual circumstances. But in assessing your borrowers’ performances and potential for future growth, you also need to be able to engage in comparisons — whether between industries or over time. To that end, normalizing reconciliations to financial statements can help you see borrowers’ financial situations more clearly, leading to better lending decisions.
© 2016