Adjusting Financial Statements: A Complete Guide

by Jacob Orosz (President of Morgan & Westfield)

Executive Summary

Adjusting your profit and loss statements is a vital step in preparing your business for sale. Properly adjusted financials can streamline due diligence, enhance your credibility, and potentially maximize value. Adjusting your financial statements involves making numerous adjustments to calculate your business’s adjusted earnings (i.e., SDE or EBITDA), which will form the basis of your valuation.

• SDE (Seller’s Discretionary Earnings) is the most common metric for valuing businesses with annual revenue between $500,000 and $1 million.
• EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is the most common metric used for valuing businesses with $1 million to $5 million in annual revenue.

Common Adjustments to P&L Statements

Common adjustments to financial statements include:

• All owners’ salaries and perks 
• Expenses or income that aren’t expected to recur or continue after the sale
• Personal expenses not related to the business, such as personal auto, insurance, child care, medical, and travel expenses
• Depreciation
• Amortization
• Interest payments on any business loans
• Investment or other non-operating expenses or income
• Other one-time or non-recurring expenses

Tips for Making Adjustments to Financials

• Be Thorough: All adjustments should be verifiable. The more detail and reasoning you provide for adjustments, the smoother the sale process will be. Please note that you should not make adjustments to any items older than two years.
• Be Conservative: Be conservative when making adjustments. The fewer adjustments, the cleaner your financials will look. Eliminate any adjustments less than 0.5% to 1.0% of your SDE or EBITDA, and ideally, eliminate all adjustments before selling your business.
• Minimize the Number of Adjustments: When a buyer first looks at your P&L, the total number of adjustments is one of many factors they’ll consider when evaluating your business as a potential acquisition. If your P&L is clean, with minimal adjustments, they’ll likely assume due diligence will be faster and less expensive.

How To Produce a Detailed List of Adjustments

• Export a General Ledger: Export a general ledger (called a “Profit and Loss Detail” report in QuickBooks) from your accounting software to an editable spreadsheet. Do not export to a PDF or print it.
• Highlight Each Adjustment: Mark each adjustment by highlighting the entire row.
• Make Notes: Create a column where you can write notes or details about each adjustment.

Introduction

Like most business owners, you likely operate your business in a manner to reduce taxes. You may have given yourself or family members perks and other benefits or deducted other expenses through your business – all to decrease taxable earnings. 

These practices are all well and good, but when it comes time to sell, your financials must be “normalized” or “adjusted” before your business can be valued. Adjusting your financials involves making numerous adjustments to your profit and loss statements to determine your adjusted earnings (i.e., SDE or EBITDA). This is one of the most important steps in preparing your business for sale, as adjusted earnings are the foundation of any business valuation, and the level of adjusted earnings will determine your most likely exit paths.

Adjusting Financial Statements: An Overview

Making adjustments to your financial statements involves removing owner-specific perks, benefits, and expenses. This process is necessary to show potential buyers your business’s available cash flow.

Adjusting the financials allows you to compare your business with other businesses using seller’s discretionary earnings (SDE) or earnings before interest, tax, depreciation, and amortization (EBITDA).

• SDE is the most common metric used by buyers, business brokers, and other professionals for valuing companies with annual revenue of less than $5 million.
• EBITDA is the most common metric used for valuing businesses with more than $5 million in annual revenue.

Buyers compare potential acquisitions using SDE or EBITDA. By comparing the SDE or EBITDA of one company with another, buyers can easily understand a business’s value based on its actual profit rather than its taxable income. This provides a more accurate comparison between target companies.

Types of Adjustments

The following are descriptions of the different types of adjustments.

Discretionary expenses: Expenses that benefit you and not your business or employees. For example, expenses related to your personal vehicle, insurance, or country club membership. 

Extraordinary or non-recurring revenue and expenses: Exceptional expenses are unlikely to recur and are documented as extraordinary – for example, costs associated with a natural disaster or litigation.

Non-operating revenue and expenses: Expenses or revenue unrelated to your business operations. For example, interest earned on investments, income from the sale of non-operating equipment, or insurance settlements.

Sample Adjustments to Financials

Adjustments That Are Generally Allowable

The following is a sample list of adjustments that generally are allowable and can be adjusted.

• Amortization: All amortization.
• Auto: Any personal automotive expenses, payments, fuel, insurance, and repairs for non-business purposes.
• Barter Fees: Any barter-related expenses.
• Child Care: Payments for child care.
• Continuing Education: Any education expenses not related to your business.
• Cost of Goods: Expenses for any purchases unrelated to your business (e.g., remodeling expenses for your home).
• Depreciation: All depreciation.
• Entertainment: All personal entertainment and related expenses in which a client, customer, or employee was not present.
• Insurance: Any personal insurance expenses, such as health, auto, dental, and life insurance.
• Interest: All interest.
• Legal: Any personal or one-time legal fees (e.g., settling a lawsuit).
• Meals: Any personal meal expenses in which a client, customer, or employee was not present.
• Medical: Any personal medical expenses.
• Memberships: Any fees for memberships that don’t relate to your business, such as networking events.
• One-Time Expenses: Any significant, one-time expenses in your business, such as start-up expenses, build-outs, repairs, or expenses related to building a new website.
• Owner’s Salary: Your W-2 or 1099 income, including your payroll taxes and any payroll taxes paid by your company – but not your draws or distributions, unless they appear on your P&L statements. Only salary in the form of W-2 or 1099 income should be added back. Note: This means added back when calculating SDE or normalized to market rates when calculating EBITDA.
• Payroll: Salaries paid to family members who don’t work in the business. This includes any payroll taxes attributed to your salary or family members who are not active in your business. 
• Repairs: Any repairs for your home or other personal property.
• Supplies: Groceries or other supplies used for personal purposes.
• Taxes: All personal and corporate income taxes.
• Travel: All expenses related to personal travel.
• Any other expenses that benefited you personally and not the business.

Any adjustments you make should be verifiable, thorough, and accurate. The more detail you provide, the smoother your sale will go.

Adjustments That Are Not Generally Allowable

The following is a sample list of adjustments that generally are not allowable and can’t be adjusted.

• Advertising: Marketing and advertising campaigns always involve risk, so the cost can’t be removed because the campaign didn’t bring in any business or was unsuccessful. If you want to sell your business soon, stick to low-risk campaigns.
• Cash Income: Getting paid when you sell your business for unreported cash income is now nearly impossible unless you own a small, cash-based business. If you want to sell your business soon, begin reporting all income.
• Payroll: Overpaid employees’ salaries shouldn’t be removed but can be identified as an expense that could be reduced post-closing. If you want to get paid for this value-add, implement the change before the closing to eliminate the risk of implementation for the buyer.

Adjustments That Might be Allowable

The following is a sample list of adjustments that might be allowable and could be adjusted, or that can be partially adjusted.

• Bad Debt: Any bad debt (i.e., accounts receivable) considered excessive based on previous years. If your business had bad debt in the past, it likely will again. This should be adjusted based on prior years by deducting an even amount each year, creating a reserve for bad debt, or by spreading a sizable bad debt expense over several years.
• Charitable Contributions: Owners often make charitable contributions with the expectation of receiving business in return. For example, a business owner might sponsor a local sports team to attract local customers, but the results of this exposure are difficult to measure. You can adjust any contributions unrelated to your business, or that didn’t lead to exposure, such as a private donation to your church, but leave in any that did or could have.
• Continuing Education: Some educational expenses are discretionary but shouldn’t be removed just because they were optional. These expenses should be removed only if they’re personal and unrelated to your business, such as your golf instructor lessons (unless you happen to own a golf-related business).
• Dues and Subscriptions: Only personal memberships that didn’t benefit your business, such as country club dues, can be removed. But, this must be 100% personal in nature. If you golfed with potential customers, leave it in. If you golfed with your grandma, adjust it unless she was helping you close a deal.
• Entertainment and Meals: Dining with clients is an effective way to build relationships. This expense shouldn’t be removed just because it was optional. If you want to sell your business in the near future, eliminate any discretionary entertainment or meal expenses. Otherwise, only adjust those that were 100% personal in nature.
• Memberships: Membership fees in country clubs and other optional groups should be identified and adjusted, although any savvy buyer will question whether the business benefits from such memberships. These fees can be adjusted if it was 100% personal and your business received no exposure, or you weren’t golfing with clients, customers, or employees.
• Retirement contributions: Any retirement contributions for yourself or your family should be adjusted. Don’t remove fees related to maintaining retirement plans that benefit your employees.
• Travel expenses: Any expenses solely related to personal or nonessential travel can be adjusted. Any nonessential or excessive business travel should be identified and partially adjusted. If your trip to the Bahamas was 100% personal, then adjust it. If the trip was for a 2-day conference and you spent a few extra days snorkeling, then partially adjust this expense.

Expenses That Should be Normalized to Market Rates

The following is a list of expenses that should be normalized to market rates:

• Rent: If you own the property your business is housed in, the rent should be adjusted to current market rates. In other words, your business should pay your real estate entity the current market rate to rent the property.
• Payroll: Salaries for working family members should be adjusted to current market rates (i.e., based on their replacement cost in the market). Salaries for any family members not working in your business should be added back.

How To Produce a List of Adjustments

The easiest way to prepare a list of your adjustments is to follow these steps:

1. Export a General Ledger: If you’re using QuickBooks, the ledger is called the “Profit and Loss Detail report.” This report lists every transaction for each account on your P&L statement. Be sure to export your general ledger to an editable spreadsheet. Do not export it to a PDF or take a picture or screenshot of your P&L.
2. Highlight Each Adjustment: Mark each adjustment by highlighting (e.g., in yellow) the entire row. This will create a highly organized, detailed report available for buyers when they perform due diligence. This report will also allow buyers to tie your adjustments directly to your profit and loss statements and accounting software. 
3. Make Notes on Adjustments: Create a column where you write notes of what the adjustment in that line is for (e.g., health insurance for myself and my spouse). Please note that you should not make adjustments to any items older than two years.

Sample General Ledger with Adjustments – Your report should look something like this. Adjustments are highlighted in yellow:

Tips for Making Adjustments

Tip #1: Be Thorough

Keep all adjustments concise and verifiable. 

The more thoroughly you document each adjustment, the better. If you’re inaccurate with one adjustment, buyers will question the credibility of everything you say from that point on. 

The more documentation you have to back up each adjustment, the quicker the due diligence process will be.

Tip #2: Be Conservative

Be conservative when making adjustments to your financials. 

If you’re conservative here, the buyer will assume you’ve been conservative elsewhere and may verify fewer of your representations during due diligence. On the other hand, if your adjustments are aggressive, the buyer may perform more thorough due diligence as a result.

For example, if you made $50,000 in charitable contributions to your school, but you received some direct exposure for your business, then it’s best to not adjust this expense, even though it may have been optional or discretionary. Or, if you ran an advertising campaign that wasn’t successful, it’s best not to adjust this since failed advertising is still a business expense, even though it wasn’t successful.

Value is a function of risk. The lower the risk, the higher the value. A buyer who’s dealing with a conservative seller will view the transaction as less risky and may pay a higher multiple than they would pay to an aggressive seller.

If the buyer has any reason to question the adjustments you’ve made, they may include more thorough representations and warranties in the purchase agreement to protect themselves from anything they don’t discover during due diligence. If your representations later prove to be untrue, they’ll come back to bite you even after the closing. 

Tip #3: Minimize the Number of Adjustments

The fewer the adjustments when selling your business, the cleaner your financials will look. 

When a buyer first looks at your P&L, the total number of adjustments is one of many factors they’ll consider when evaluating your business as a potential acquisition. If your P&L is clean, with minimal adjustments, they’ll likely assume due diligence will be faster and less expensive.

Step back and look at your profit and loss (P&L) statement. How many total adjustments do you have? Don’t look at the total in dollars (for example, $936,950 in adjustments) but rather at the total volume (e.g., 14 adjustments in the most recent year). The fewer adjustments, the better. Eliminate any adjustments less than 0.5% to 1.0% of your SDE or EBITDA, and ideally, eliminate all adjustments before selling your business. For example, if your EBITDA is $1 million, don’t make any adjustments unless they exceed $5,000 to $10,000. Smaller adjustments make your “adjusted P&L” look busier and don’t impact the valuation enough to justify them. 

Note that the size of the adjustments as a percentage of SDE or EBITDA, and the impact on the multiple, will be the same, regardless of the multiple. So, removing an adjustment that is 0.5% of your EBITDA will impact the valuation by 0.5%. The reverse is also true. You would only need to receive a 0.5% higher multiple to offset an adjustment you didn’t make that is 0.5% of your SDE or EBITDA. Instead of a 5.0 multiple, you would need to receive a 5.025 multiple. 

Tip #4: Don’t Adjust Items Older Than Two Years

Only significant expenses older than two years should be adjusted.

Buyers are primarily interested in the recent performance of the business to understand its current and future earning potential, so older data becomes less relevant. Adjusting older financials is also less likely to have a significant impact on the overall valuation, as small changes from years ago are often diluted by more recent numbers.

Tip #5: Match Every Adjustment to a Line Item on Your P&L

Every adjustment should correspond to a specific line item on your P&L statements. 

Refer to the particular line item or account name (e.g., automotive expense) and the year on your profit and loss statements when noting the adjustment. For example, if you have three separate accounts for auto expenses (e.g., fuel, insurance, and maintenance), break up your adjustments into these three separate accounts. Do not lump them all into one item called “automotive” as the buyer will have a difficult time tying your adjustment to the actual expense on your P&L.

Tip #6: Only Adjust What’s On Your P&L 

The expenses being removed must appear on your P&L statements to be adjusted. 

A common error is to adjust an item that doesn’t appear on your profit and loss statements but only appears on the balance sheet, such as an owner’s distribution or draw. The expense being removed must appear on your P&L statements in order to be adjusted. If the item doesn’t appear on your P&L, it doesn’t need to be adjusted because it isn’t there. Each adjustment must be tied to a specific line item on your profit and loss statements. 

Tip #7: Ensure Adjustments Don’t Exceed What’s on Your P&L

Adjustments can’t exceed the actual amount of an expense. 

For example, an adjustment cannot be $50,000 if the expense is only $20,000. You can only deduct what appears on your P&L – not more. 

If you act cautiously in your adjustments, buyers will see you as low risk, may perform lighter due diligence, and will likely pay a higher multiple for your business. 

Conclusion

Trading efficiently in the eyes of the taxman and in the eyes of your potential acquirer can be two entirely different things. 

Closing that gap fairly and demonstrably is a key phase in properly valuing your business and preparing it for sale. But the process of adjusting your financials isn’t always simple – you must pay careful attention to the guidelines above to determine which benefits can be adjusted and which can’t. 

In life, as in business: proceed with cautious optimism and act early. Neutralize potential discrepancies before they arise, and you’ll be another step closer to the right sale price for your business. 

FAQs

Why do you need my adjustments? Most businesses are valued based on a multiple of their adjusted earnings (i.e., SDE or EBITDA), so we must calculate your adjusted earnings before we value your business.   

What’s the difference between adjusting an expense and normalizing it? Adjusting an expense involves identifying the expense and adding it back to net income when calculating the adjusted earnings of a business. Normalizing expenses may involve adjusting the expenses up or down to current market rates, which also affects the adjusted earnings. Common items that are normalized include rent and owner’s salaries.   

Who will see my adjusted financials? Nearly every buyer who is interested in your business and signs a non-disclosure agreement (NDA) will request to access your adjusted financials.

Why are some adjustments not allowable? Adjustments that are often not permitted are those for expenses that were discretionary and benefited your business, as well as those that are difficult to verify. Examples include meals for employees, country club dues, or charitable contributions, all of which could have benefited your business to some extent. An expense can’t be adjusted just because it was optional.

How aggressive should I be in adjusting my financials? Be conservative because most buyers will verify the adjustments you make. The fewer the adjustments, the quicker due diligence may be. If you aren’t sure about an adjustment, keep it in your back pocket to use in later negotiations if you need it.

How will buyers verify my adjustments? Most buyers will ask for documents to prove that the expense was personal, such as receipts or invoices. For example, if you deduct purchases made on Amazon for personal use, then the buyer may ask for the invoices so they can see what the purchases were for. Or if you deduct auto-related expenses, they may ask you for receipts, invoices, or a mileage log.

Why should the adjustment names be the same as the names in my P&L statement? You must be able to tie your adjustment to the specific expense line item that the adjustment belongs to in your P&L. It’s common for clients to send us an adjustment amount that exceeds the amount of the expense, which it should not. For example, some clients send us an adjustment titled “Auto” for $50,000 when the actual auto expense on their P&L statement is only $20,000. Tying the adjustment to the actual line item on the P&L helps us identify these discrepancies.

Why can’t my adjustment exceed the amount on my P&L? You can’t adjust an expense that doesn’t appear on your profit and loss statement. In other words, you can’t remove something that isn’t there.

Why do I need to match adjustments to a specific line item on my P&L? It’s cleanest to identify any adjustments directly next to the line item that contains the expense on your P&L, which simplifies the process of verifying the expense for the buyer. For example, we encounter many owners who believe they’re deducting numerous personal auto expenses through their business, but these expenses are often capitalized on the balance sheet and don’t appear as an expense on the P&L, or only appear as an expense on their federal income tax returns.

What if I want to adjust an expenses that isn’t on my P&L? You can’t adjust (e.g., remove) an expense unless it appears as an expense on the P&L. For example, many business owners deduct auto and meal expenses through their business, however, these expenses sometimes only appear on their federal income tax returns and not their financial statements. If the expense doesn’t appear on your financial statements, then you can’t adjust it.   

How many adjustments can I make? You can adjust as many expenses as are legitimate, however, the fewer line items you adjust, the better, as your adjusted P&L will appear cleaner and will require less work for the buyer to verify your adjusted earnings.

Can I partially adjust an expense? Yes, any expense can be partially adjusted. For example, maybe 50% of your auto or meal expenses were personal and 50% were for the business. In this case, only 50% of the expense should be adjusted.

Can my draws be adjusted? No, because a draw should not appear as an expense on your profit and loss statement (it only appears on your balance sheet). Only expenses that appear on your P&L should be adjusted.   

Should I make any adjustments to inventory or cost of goods sold (COGS)? You can adjust any expenses that are personal and do not benefit the business, such as inventory you used solely for personal purposes (e.g., lumber for remodeling your home).

Can I adjust bad debt? Bad debt should ideally be adjusted or normalized for each year based on deducting a reserve for bad debt.

What’s the easiest way to produce a list of adjustments? The easiest way is to export your general ledger (called a P&L Detail in QuickBooks) to a spreadsheet and then highlight each potential expense that can be adjusted.

How do I export a general ledger (GL) or “Profit & Loss (P&L) Detail”? This varies based on accounting software but is a common request, and current instructions are likely online for your accounting software. If you’re unsure, you can Google how (e.g., how to export a general ledger in [Name of Accounting Software You Use]) or ask your accountant.

What if I only have hard copies of my P&Ls or general ledger? Ask your accountant for an editable spreadsheet (it’s easy to produce), or export a spreadsheet if you have access to your accounting software. Working from a spreadsheet is much cleaner than from a PDF.

Should I ask my accountant or CPA to help me produce a list of adjustments? You may ask your external accountant, however, your accountant must be familiar with the perks and other personal expenses you write off through your business. Most external accountants are unlikely to have this level of familiarity with your business. Internal bookkeepers, accountants, or controllers are generally more familiar with your financials and are likely more capable of helping you.

What’s the role of my accountant in the process? You may ask your accountant to export your financial statements and general ledger to a spreadsheet. If your accountant has more knowledge about your business, then you may also ask them to help you identify potential adjustments.