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Adjusted Net Income Defined By Due Diligence Service

Contributed by Willard Michlin, CPA, CFE

Adjusted net income is sometimes a difficult concept to grasp when buying or selling a business. I give my definition below:

"There is a very specific way that cash flow / adjusted net income is calculated. The following is how it is done. When net income or cash flow is asked for we use the “owners benefit” figure. This is the net profit on the P&L (profit and loss statement) plus the owners benefits added back. The owner’s benefits are added back because everything one single owner gets, regardless of its form is not considered a business expense and is added back as profit. Note: Any cash that the owner receives and doesn’t report is considered an owners benefit and must also be added; it is labeled other income.

Depreciation and Amortization, IRS Taxes, Franchise Taxes, Interest Expense, Donations, Non-Recurring Legal Expenses or Non-essential expenses. Other Expenses, Owners Medical, Life Insurance for Owners, Pension Plan contributions for owner’s family, Non-Essential Salaries, Health insurance (owner’s family portion), Owners vehicle expenses (lease payments, operating expenses, repairs, gas, depreciation and insurance), Magazine subscriptions, Owner’s Travel, Entertainment, Home office expenses and Home telephone expenses. Any other owners benefit that the seller has hidden in some expense account. Real examples include: a) Personal clothing listed as uniforms. b) Family eating out listed under entertainment. c) Children’s education listed under staff training.

Additional clarification on lease payments is as follows: As discussed in the prior paragraph, lease payments made on personal automobiles are not a business expense and are added back. The buyer many times needs to assume a lease payment on leased machinery. If the lease has a $1.00 buy out or any buy out at the end for less than fair market value of the machinery it is called a financing lease. We treat them like a loan payment and add back 100% of the payments and the seller must pay these loans off or the escrow needs to deduct the balance due from buyers cash requirement. We also put these assets on the balance sheet. If the buy-out at the end of the lease, at fair market, on the date of the buy-out, then this is a real lease which is really just a rental agreement. The payments are left as a business expense and are not added back. To find out which kind of lease the seller has will require asking the seller or his accountant."

About The Author: Willard Michlin offers business buyers Due Diligence Services (Second Opinion, Offer Assistance, Final Due Diligence) when they are thinking of making an offer on a business or in the process of investigating a business purchase. Serving all of Southern California. He has written numerous articles on the due diligence process and can be reached direct at 805-428-2063 for more information and an appointment.

Watch for more blog posts / articles from me in the future!

Posted on July 7, 2009 | Email This Blog Post | Print This Blog Post | All Contributions From Willard Michlin, CPA, CFE

Categories: BizBen Blog Contributor, Business Valuation Issues, Buying A Business

Comments:

Caution is always advised when it comes to believing what the seller says about "personal" expenses running through the business. I've seen a lot of situations where the seller claimed the business was paying for his car (but he used it to pick up parts and take customers home while their vehicles were being serviced), or for the laundry (forgetting to mention that cleaning uniforms, table cloths and napkins, towels, shop rags and so forth, are necessary expenses to run the business ), or for accounting services (as if the individual needs a lot of accounting help to do taxes once a year, and just an incidental amount for business, even though there's a CPA producing monthly P&Ls and balance sheets).

Posted by: Steve C.

Fuggedaboudid! That is how they talk in New York (where I'm from) and it means "forget about it!" If a seller claims to make more money than the business shows on the books, you have to ignore that. Go by the principle that any income that isn't shown, does not exist. Anyone who tells you different is either lying or looking to get busted by the I.R.S.

Posted by: Alex Max

Probably you can't assume all personal expenses are not partly business. Maybe it's a good idea to ask the seller what expenses listed in the books you can do without if you buy the business.

Posted by: Lyla L.

How can you find out if there is some income from the business that never gets recorded in the books? I mean the money that might go in the seller's pocket but not actually to the business, even though it is really business income?

Posted by: Ron F.

It should be said that some expenses like automobile are not always just personal for the owner if the vehicle is actually needed in the business. For example, for deliveries or to go and see customers or get some supplies. Another thing is I'm confused about depreciation. A new owner might have a different amount of money used for depreciation, based on what value is on the assets, and so forth. But isn't it necessary to put aside some money to get new equipment when what you are using wears out? Isn't that a real business expense?

Posted by: Leung T.