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November 2016 Tip of the Month

Abo Cipolla Financial Forensics Shows How to Turn Loss into Profit

Suppose that a company’s income statement shows that the business lost money -- but you know the company is successful and providing a good lifestyle for the owner. How can this be? The reported earnings may just need to be normalized. Among the first and most important steps in the valuation of a business is making adjustments to the income statement -- from Generally Accepted Accounting Principles (we do know that some refer to such as Generally Accepted Abo Principles) or Tax Based Accounting reported earnings to normalized, or adjusted, earnings. Normalized earnings are generally used as the basis for analyzing a company’s earnings performance and to compare that performance to other companies in the industry. The following case illustrates this point.

Case Study: Trump Wall Construction, Inc.

For valuation purposes, reported income may require several adjustments to determine the appropriate earnings. While some of the adjustments are clear-cut, others require an expert’s judgment as to whether they should be made and, if so, in what amount. For instance, Trump Wall Construction, Inc. builds pre-fab walls. During the initial document request phase, Abo Cipolla Financial Forensics, as valuator, learns that on its 2015 financial statement the company reported an $80,000 loss. During the discovery phase, Abo Cipolla learns:

  • Payments of $15,000 to Mrs. Trump for “bookkeeping” services are included as salaries when, in fact, she did not prepare any books or records for the company.
  • The company has paid Mr. Trump a significant bonus each year, primarily to pay out all of the income and to reduce the company’s tax obligation.
  • Mr. and Mrs. Trump received extra benefits, including profit sharing ($28,000) and travel and entertainment ($12,000).
  • The company has a policy of expensing furniture and equipment items under $2,500. Individual invoices for such fixed assets totaled $20,000.
  • The estimated economic useful lives of the property and equipment are longer than the tax lives used for depreciation.
  • The company entered into a lease Jan. 1, 2015, with the sole shareholder, Mr. Trump, for its office and warehouse (20,000 square feet total) at a rate of $2/ft. above the market rate.

As the table shows, several adjustments were needed to obtain a more accurate picture of the company’s earnings. However, forensic accounting techniques involve more in-depth analysis and are generally handled under a separate engagement.  Contact Abo Cipolla Financial Forensics for help in understanding adjustments to income statements and their implications for your business.