Normalized Financial Statements Definition
The non-recurring expenses and revenues of a company are adjusted to get a real picture of the company’s financial performance. This adjusted financial statement is known as the “normalized financial statement”.
The financial statement of a company often includes expenses and revenues that are not part of its regular business operations, those non-operating assets or liabilities and all other anomalies are removed from the statement by normalizing it. A normalized financial statement allows a reliable and even comparison.
A Little More on What are Normalized Financial Statements
Normalization of financial statement is often done during fundraising from external sources. The investors may want a normalized financial statement to get the actual picture of the company’s finance including usual cash flow, revenue, and expenses. Similarly, a potential buyer wants a normalized financial statement to estimate the profitability of the business. All the discretionary expenses, one-time earning or loss are removed from the financial statement for normalizing it. A normalized statement reflects on the usual transaction of a company.
Following are some of the examples of how to normalize a financial statement.
Adjusting for the owner’s salary and expenses
In private companies, generally, the owners decide their own salary and allowances. They withdraw that amount from the company’s account. The allowances may include travel allowance, internet, and phone bill, fuel and vehicle cost, entertainment cost etc. The net revenue of the company gets reduced by these expenditures. While normalizing the financial statement all these expenses must be added back to the company’s earning.
Adjusting for the Rental Expenses and Earnings
If a company is operated from the rental property, the rental expense needs to be adjusted according to the market price. Often the companies pay a rent that is higher or lower than the market value. The expense is adjusted for removing this discrepancy. Also, if a company earns any money from its rented-out properties that are not a part of its core business operation, the whole amount needs to be eliminated from the financial statement. Any loans related to such properties are also to be eliminated from the statement.
Removing Non-recurring Expenses and Earnings
A company may earn a revenue from selling a land or an asset in a year. All such non-recurring earnings should be removed from the normalized statement. Similarly, any one-time expense like renovation, loss from disposing of an asset, insurance payout etc. is to be added back to the company’s revenue to get an actual picture of the company’s financial performance.
Eliminating Expenses of Extraordinary Events
A company may have to pay for extraordinary events such as material storm damage, lawsuits, regulatory ruling etc. These expenses need to be added back to the company’s revenue while normalizing a financial statement.
Removing Discretionary Expenses
The owner of a company may pay an untimely bonus or may organize a trip for its employees at his or her own discretion. These expenses are not directly related to the company’s usual operational cost. These expenses should be adjusted in a normalized statement.
References for Normalized Financial Statements
Academic Research on Normalized Financial Statements
- · Financial performance analysis for construction industry, Kangari, R., Farid, F., & Elgharib, H. M. (1992). Journal of Construction Engineering and Management, 118(2), 349-361. This article discusses the quantitative model based on the financial ratios alongside the assessment to the financial performance and the rating of a construction company and the chances of its survival in business. The following financial rates are used to develop models in analyzing the company; total liabilities against the net worth, current ratio, returns on total assets, return on net worth, total assets to revenues, and the revenues against the net working capital. These model also considers the characteristics of different trades in the construction industry and the effect in the company size. The model is developed for six different groups which are listed herein: operative builders, electrical works, general contractors, plumbing, heating, and air conditioning, and other specialty trades.
- · Detecting falsified financial statements: a comparative study using multicriteria analysis and multivariate statistical techniques, Spathis, C., Doumpos, M., & Zopounidis, C. (2002). European Accounting Review, 11(3), 509-535. This article discusses extensively on the innovative classification methodology that can be used in detecting firms that issue falsified financial statements (FFS) and any identification of the factors related to FFS.
- · Applying FMCDM to evaluate financial performance of domestic airlines in Taiwan, Wang, Y. J. (2008). Expert Systems with Applications, 34(3), 1837-1845. This article, discussed the hypothesis being carried out, using the grey relation analysis to cluster financial ratios and to help in finding representative indicators. After which a fuzzy multi-criteria decision making (FMCDM) method was then applied to evaluate the financial performance of the airline. Lastly, empirical research on the financial performance of three domestic airline company in Taiwan is meticulously illustrated.
- · The effect of experience with different sized clients on auditor evaluations of fraudulent financial reporting indicators, Hackenbrack, K. (1993). Auditing, 12(1), 99. It is very significant to examine these fraud risks indicators, to know if they are indeed very helpful in the investigation reported as misconduct and any fraudulent cases in Malaysia. The outcome may be beneficial to researchers, by helping them develop a new fraud risk indicator that looks into the actual instances of fraud in Malaysia
- · Financial statement fraud detection: An analysis of statistical and machine learning algorithms, Perols, J. (2011). Auditing: A Journal of Practice & Theory, 30(2), 19-50. This research paper compares and contrasts the performance of six popular statistical and machine learning models used in detecting fraud in financial statements under different assumptions and misclassification costs against the figure of fraud firms against the nonfraud firms. These results led to research of fraud in financial statements and has proven to be useful for practitioners and regulators to improve fraud risks models.
- · Application of TOPSIS technique for financial performance evaluation of technology firms in Istanbul stock exchange market, Bulgurcu, B. K. (2012). Procedia-Social and Behavioral Sciences, 62, 1033-1040. This article aims to propose a multi-criteria decision-making model to compare and contrast the financial performance of thirteen different Technology firms trading in the Istanbul stock exchange market.
- · Evaluating accounting information systems that support multiple GAAP reporting using normalized systems theory, Vanhoof, E., Huysmans, P., Aerts, W., & Verelst, J. (2014, May). In Enterprise Engineering Working Conference (pp. 76-90). Springer, Cham. This article made use of a mixed approach method comprising of design science, using a case study research to evaluate the structure of Accounting Information System (AIS) that reports in multiple General Accepted Accounting Principles (GAAP), making use of the Normalised Systems Theory (NST). The application of the NST in accounting demonstrates its relevance in a non-software specific domain. However, this is the first evaluation carried out on AIS as regards evolvability.
- · A note on cash flow and classification patterns of financial ratios, Gombola, M. J., & Ketz, J. E. (1983). Accounting Review, 105-114. This study revealed the cash flow computer by adjusting the net income in all deferrals and accruals. The best fit definition leads to the classification schemes in which cash flow ratios from a factor separate and distant from other factors of return ratios
- · Dividend policy and financial distress: An empirical investigation of troubled NYSE firms, DeAngelo, H., & DeAngelo, L. (1990). The Journal of Finance, 45(5), 1415-1431. This article revealed the dividend policy amendments of 80 NYSE firms to protracted financial distress as a piece of evidence against multiple losses incurred during the 1980-1985 fiscal year.
- · US reinsurance prices, financial quality, and global capacity, Weiss, M. A., & Chung, J. H. (2004). Journal of Risk and Insurance, 71(3), 437-467. The complexity of property-liability insurance has led to many economic hypothesis and analysis birthing several theories yet; not a single theory can explain its totality. The significant discovery in this research was the capacity variables that were broken down by the considerable region of the world.
- Government‐wide financial statements and credit risk, Johnson, C. L., Kioko, S. N., & Hildreth, W. B. (2012). Public Budgeting & Finance, 32(1), 80-104. Recently the state government has been issuing well detailed financial reports in alignment with the statement No — 34 of the Government Accounting Standards Board. There is likelihood to generate a well detailed and consistent set of government financial information.