“Normalizing” reconciliations to the income statement and balance sheet is necessary when comparing diverse borrowers. A thorough knowledge of accounting helps lenders prepare dissimilar customers’ financial statements for apples-to-apples comparisons and to aid in underwriting decisions. Here’s a basic explanation of this accounting tactic.
Varied accounting methods
Even within the broad confines of 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.
Some small firms, 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 — such as expanded Section 179 and bonus depreciation deductions — may temporarily defer income taxes. So, consider the tax implications when reconciling different tax accounting methods.
Solo events
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 incurred 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.
Related-party transactions and unusual perquisites
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.
An eye on the balance sheet
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.
Make informed decisions
Loan customers are diverse. They use different accounting methods, have different risk perceptions, operate in different locations and so on. But making normalizing reconciliations to financial statements lets you compare borrowers in the same or different industries to one another — or to themselves over time — to get a better understanding of a borrower’s past and future earning power.
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