Understanding Financial Statement Normalization: A Comprehensive Guide

Financial statementsThree Financial StatementsThe three financial statements are the income statement, the balance sheet, and the statement of cash flows. These three core statements are normalization involves adjusting non-recurring expenses or revenues in financial statements or metrics so that they only reflect the usual transactions of a company. Financial statements often contain expenses that do not constitute a company’s normal business operations and that may hurt the company’s earningsNet IncomeNet Income is a key line item, not only in the income statement, but in all three core financial statements. While it is arrived at through. The purpose of normalization is to eliminate such anomalies and provide accurate historical information that enables reliable comparisons and forecasting.

Normalization Adjustments

Normalizing adjustments to the financial statements are made for a variety of reasons. If the company is seeking external funding, normalized financial statements provide the investor or lender with a clear picture of the actual expenses, revenues,Revenue StreamsRevenue Streams are the various sources from which a business earns money from the sale of goods or provision of services. The types of and cash flowValuationFree valuation guides to learn the most important concepts at your own pace. These articles will teach you business valuation best practices and how to value a company using comparable company analysis, discounted cash flow (DCF) modeling, and precedent transactions, as used in investment banking, equity research, of the company during a particular period. Also, when selling the business, a potential buyer will want to see the normalized statements to gauge whether the business has been profitable overall. When adjusting the financial statements, you should only remove discretionary expenses and one-time gains or expenses that are unrepresentative of normal operating expenses of the business. Here are some examples of normalizing adjustments:

#1 Owner’s Salary and Expenses

In most private companies, the owners have discretion over the amount of salaries and allowances that they draw from the company accounts. Also, the owners may decide to pay their personal expenses through the company accounts. Such expenditures may include travel allowances, internet costs, entertainment, vehicle, fuel, etc. These costs reduce the net revenue of the company. When selling the company, appraisers must add back these expenses to the company earnings.

#2 Rental Expense or Income

A company may decide to pay rent that is above or below the market rate when the company premises are owned by the company or a holding company. Adjusting the rental expense to reflect the prevailing market value will help normalize the financial statements. Also, where the company earns a rental income from its properties that does not constitute a part of the company’s core business operations, this income should be eliminated from the financial statements. Also, any loans related to such properties should be removed from the company’s balance sheet.

#3 Non-recurring Expense or Income

Non-recurring expenses result from abnormal events that are unrelated to the company’s core operations. Mostly, they are one-time gains or losses that are unlikely to reoccur in the future. They may include building renovations, gain or loss on asset disposal, insurance payouts, lawsuits, and sale of company land. One-time incomes should be eliminated from the financial statements, and one-time expenses should be added back to the company’s revenues to reflect the company’s real financial performance during the year.

#4 Extraordinary Events

Extraordinary events refer to unusual gains or losses that materially affect the company’s finances. Also, an event is classified as extraordinary if it is not part of the day-to-day operations of the company. These events may be comprised of material storm damage, regulatory or tax rulings, lawsuits, costs of implementing a new production system, restructuring costs, sale of assets, etc. Such events have a significant impact on a company’s profitability and should be explained separately.

Detailed explanations of extraordinary items appearing in the financial statements should be included in the notes to the annual report, and in the SEC filing 10-K submitted to the US Securities and Exchange Commission.

One-Time Events vs. Extraordinary Events

These events should be treated differently in the financial statements. The one-time/non-recurring items should be recorded under the operating expenses in the income statement, while the extraordinary items should be recorded after the net income figure. The management should provide an additional explanation to these events in the Management Discussions and AnalysisWhat is MD&A?The Management Discussions and Analysis (MD&A) is a section of the annual report or SEC filing 10-K that provides an overview of how the company performed in the prior period, its current financial condition, and management's future projections..

Learn more about Financial Statement Normalization

Thank you for reading this guide to understanding what normalization is.  To keep learning and advancing your career, these CFI resources will be a big help:

• Three Statement ModelThree Financial StatementsThe three financial statements are the income statement, the balance sheet, and the statement of cash flows. These three core statements are
• Balance SheetBalance SheetThe balance sheet is one of the three fundamental financial statements. The financial statements are key to both financial modeling and accounting.
• Income StatementIncome StatementThe Income Statement is one of a company's core financial statements that shows their profit and loss over a period of time. The profit or
• Cash Flow StatementCash Flow Statement​A cash flow Statement contains information on how much cash a company generated and used during a given period.
• Debt ScheduleDebt ScheduleA debt schedule lays out all of the debt a business has in a schedule based on its maturity and interest rate. In financial modeling, interest expense flows