Recasting Your Books: How, When, and Why
We’ve talked before on this site about the first step in selling your business is business valuation. We have also mentioned that one of the first steps in a business valuation is recasting your books. But what does this mean, how do you do it, when, and why?
The truth about most businesses and business owners is this: they and their accountants do as much as they possibly can for tax reasons to minimize business profitability. The reason is the less money you make, the less you pay Uncle Sam at the end of the year. This makes sense because of the way the tax code has evolved.
There is nothing wrong or immoral about this: why would you pay more taxes than you absolutely have to? The problem is that once it is time to value your business, most small business owners have forgotten how they and their accountants have played with the numbers to make them work best for the IRS.
This means that over time, financial statements show less of the actual value of the business, and make it not look as profitable. What does that mean to your business valuation? It means it could be significantly lower than it should be if you recast your books.
One caveat here: recasting your books does not always have a positive effect on your business value. If you have been paying your spouse or another family member to perform certain tasks at a rate below market value, you might have to include what you would actually pay someone to do those tasks in your recasting. However, for the most part, recasting your books will have a positive effect on your business value.
How do you recast your books?
Every business is different, so for some, there will be more work here than for others. Here are some common items that will be included in recasting.
- Inactive family members on the payroll. Perhaps as part of the deal when you inherited the business from your father, your brother collects a salary but does not actually do any work for the business.
- Vacations and trips that are not directly company related. Maybe you mixed business and pleasure and deducted that resort from your taxes. While that works for the IRS, it does take away from the profit of your business.
- Non-fair market rent paid to you for items the business uses, but you personally own. For example, let’s say you own the building the company uses, but you personally lease it to your business for more than fair market value for a business tax deduction. That rate will be reduced to a fair-market value in recasting.
- Assets on the balance sheet but not required for ongoing operations.
- Your salary that is above fair market value. If you pay yourself a salary, including bonuses, that is above fair market value, it will need to be reduced in your business valuation, to show the true profit of your company.
- Potentially the complete removal of an inactive owner’s salary.
- Duplicate overhead costs eliminated in the case of a new owner.
- Consolidation of multiple locations.
The thing is, this is just a short list. Your accountant can help you with a more complete one, removing anything that is not directly related to the ongoing operations of the business.
Remember, the buyer of your business will be comparing your business to a variety of other opportunities. You want your business to look as desirable as possible. That means making sure they can see the true earning potential of your business, not what you want the IRS to see.
When do you recast your books?
You can recast your books at any time, but it can be a costly process and take a lot of your time. What does that mean about timing? Well, there are essentially only two times when you want to recast your books: those are if you are getting a business valuation because:
- You are looking for financing or investors in your business.
- You are either considering selling your business or actively listing it for sale with a business broker.
In either case, you want to show what you are truly making for a profit to either a lender, potential investor, or a buyer. You could recast your books just out of curiosity, but there is seldom a legitimate reason to do so.
Why recast your books?
We have touched on this point in the introduction and the portion on when to recast your books, but it bears repeating one more time.
Your current cash flow and other financial statements probably do not accurately reflect the real value of your business. Your profits are tied up in things that are not essential to the everyday operation of the business, but that offer you tax savings over the long run.
Recasting provides an economic view of the company as though it were run by management dedicated to maximizing profitability. This means that instead of tax savings, your books with be concentrated on showing the maximum profit possible.
This can set your business apart, allowing the buyer who is comparing it to other opportunities to do so with a real picture of the potential of your business to make them money. After all, that is why you went into business, and it is why someone would want to buy your business as well.
Are you ready to sell your business or just looking for a business valuation? Rogerson business services can help, and we would love to talk with you about how. Feel free to contact us for a brief consultation and to get the process moving forward.