12 May How to Deal with Extraordinary Expenses When Selling a Company
In an attempt to project what the future might hold for a business, the buyer looks at many things. One is past performance of the business. Historical income statements provide useful, factual information about income, expense and resulting profit for particular periods of time. Given that the buyer is interested in the future rather than the past, the buyer seeks to understand historical income and expense only as a means for predicting the future. As such, many income and expense entries will need to be removed or modified. One type of expense that may be removed or added back to historical profit is extraordinary expense items.
Because businesses are often valued based on their earnings, the business seller has a natural desire to present the highest historical profit as possible. A great way to do so is “add backs,” and one such type is classifying certain expenses as “extraordinary.” Without a firm definition, this exercise quickly becomes a fishing expedition.
However, the litmus test is what the investor will accept as “extraordinary.” Of course, it is incredibly naive to think that the investor will simply look at the bottom line profit that the seller presents, after recasting, and accept it as fact. In reality, he or she will want to walk carefully through all items that contributed to historical revenue, expenses and profit. When it comes to classifying certain expenses as “extraordinary,” the buyer will ask “Could this ever happen again in the future?” If the answer is yes, then he will reject the add-back.
So, was the loss of a valued employee extraordinary? Well, how often does this occur in business? A large bad debt loss? A large product return? Distributor failed to allow a return of excess inventory? Bad economy?
The Accounting Standard Board says for an event to be considered extraordinary, it must be “infrequent in occurrence” and “unusual in nature.”
Infrequent in occurrence: The event could not reasonably be expected to occur in the foreseeable future.
Unusual in nature: The underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to, ordinary and typical activities of the entity.
In summary, the standards for classification as extraordinary are stringent. The Wall Street Journal recently noted an accounting textbook that quipped, “The only items that could qualify are ‘such items as a single chemist who knew the secret formula for an enterprise’s mixing solution but was eaten by a tiger on a big game hunt, or a plant facility that was smashed by a meteor.'”
By way of example, the accounting standards board ruled that companies affected by the Hurricane Katrina disaster could not classify such expenses as extraordinary. They argued that in the southern region, hurricane damage and disruption expenses meet neither the “unusual in nature” nor the “infrequent” hurdles. Granted, six hurricanes hit the U.S. in 2004 alone.
By contrast, business expenses incurred from the 1980 Mount St. Helen’s eruption were deemed by the Financial Accounting Standards Board (FASB) to qualify for treatment as “extraordinary” based on the fact that it had been 130 years since a volcano had erupted in the U.S.