Betty, owner of Bait and Bake, started her morning with a fishing trip before opening the Café.   She and her three sons, Jimmydale, Timmydale, and Rod, frequently borrowed their neighbor Grippy Lee’s boat and would fish for the cafe.  It was a busy outing, each pulling in three (3) fish.

It seems obvious they caught 12 fish—three each for a total of four family members. But, “12” was not always the answer the family gave to the question, “How many fish today?”  Surprisingly, they reported 6, 9, 10, and 12—and no one seemed to bat an eye as if all the numbers made perfect sense. 

Their reports were made to the following people:

At first glance, the conflicting reports might seem like the final lesson in Betty’s Masterclass in Winning One-Upmanship rather than sportsmanship. Yet Jimmydale, Timmydale, and Rod did not flinch when hearing various answers—and for good reason. A closer look reveals that all the numbers were true and accurate, each tailored to the audience and the purpose of the conversation. Betty and her boys weren’t telling tales; they were sharing exactly the right version of the story for the listener.

The Game Warden.  First, they saw the game warden.  Betty reported six (6) fish. Jimmydale is 14 years old and considered an adult under local fishing laws and must report his catch in the household count.  At 12 and 10 years old, Timmydale and Rod do not need to report any of their fish.

The Chef.  In Bait and Bake’s kitchen, Betty told Great Scott, her chef, they caught 9. Although the family reeled in 12 fish, Betty thought two (2) were too small for consumption and returned them to the water. One (1) fish was given to Grippy Lee in gratitude for loaning the boat. For Great Scott, the important number was how many fish the restaurant could serve, making 9 the most accurate answer for the kitchen.

The Press.  Betty maintains a small blog where she shares charming stories about sustainability and life in her country town. Today, she writes that her family brings home 10 fish from their morning trip. For her blog audience, the focus isn’t on how many fish are reeled in, but on what is taken from the lake. Fish that are returned, whether due to size or sustainability, are simply not part of the count—reflecting the community’s shared values of conservation, responsible fishing, and harmony with nature.

Family friends.  Rod proudly brags to friends that the family caught 12 fish. In the local area, it’s common for people to count how many fish they reeled into the boat, regardless of catch and release. For many sportsmen, the real focus is on the activity itself—whether the fish are biting and how often they get a nibble. In this context, 12 was an accurate number to report to fellow sports enthusiasts.

What seemed like a straightforward count of fish quickly turned into multiple answers—each tailored to a specific purpose, much like financial reporting.

A Nibble on the Line: Betty’s Next Big Catch

Betty’s blog has become her true passion, and she’s beginning to think it may soon be time to focus on it full-time. Meanwhile, Bait and Bake is attracting interest from none other than Grippy Lee, who approaches Betty about his interest in the business and asks to see her financials. When Betty reviews her records, she notices something curious: her financial statements show a profit, but her tax returns are without profit.  

Most business owners might panic when their tax returns and internal financials tell such different stories, but Betty is not fazed. Her experience fishing has taught her that the same event can be honestly and accurately reported differently, depending on the purpose. She also recalls hearing that, in the case of selling a business, many owners seek a valuation, which often includes the preparation of adjusted or economic financials.

Types of Financial Reports

Financial statements are integral to understanding and conveying the story of a business, tailored to meet the needs of various audiences. Just as Betty carefully selects the right fish count to report depending on her audience—be it the game warden, the chef, or her fishing buddies—each type of financial document serves a unique purpose and offers different insights. This ensures that each party, from internal management to external investors or lenders, has the relevant, accurate, and complete information to make informed decisions.

Internal Financials – Tailored to the Owner’s Operational Needs

Internal financials are designed to help business owners manage day-to-day operations and evaluate strategies. While they follow Generally Accepted Accounting Principles (GAAP) for consistency and reliability, they also reflect the owner’s unique goals and priorities.

• Example: Betty includes the $2,000 country club membership in her internal financials to assess whether networking has increased revenue.
• Benefit: These reports allow Betty to track trends, set budgets, and make decisions specific to her business operations, even if some expenses wouldn’t be deductible for tax purposes or deemed necessary by investors.

Because Betty owns the business, these internal financials are customized to be useful specifically to her. They reflect her unique management style and priorities, even incorporating discretionary choices that may not align with those of an external investor or a non-owner manager.

Tax Returns – Focused on Compliance and Minimizing Tax Liability

Tax returns serve the government’s need for financial data to calculate and collect taxes. Prepared under the Internal Revenue Code (IRC), they prioritize compliance and focus on minimizing taxable income.

• Example: Betty’s country club membership is excluded from her tax return because such expenses are not deductible under tax laws.
• Tax returns may omit certain expenses or follow different timing rules for reporting income and deductions, creating disparities with internal financials.

iii. Adjusted or Economic Financials – Third Party

Adjusted or economic financials are tailored for external stakeholders, such as investors or valuation analysts, to present an economic view of profitability. These reports adjust internal or tax-based statements to reflect what the business might look like under typical, independent management.  The adjustments are termed “normalizing adjustments” or “norms”.

An adjusted financial perspective asks an essential question: What would a third-party, objective investor who is not involved in the day-to-day operations of the business do? Unlike an owner-manager, who may focus on personal goals such as community engagement or discretionary spending, a third-party investor is likely to prioritize profitability, operational efficiency, and return on investment.

• Example: Betty’s $2,000 country club membership would likely not be an expense occurring in a business run by an outside investor.

• Similarly, Betty takes a $50,000 year-end bonus.  This would likely be excluded because an independent investor would prioritize retaining profits for reinvestment or dividends, rather than discretionary payouts.

By eliminating owner-specific discretionary decisions, adjusted financials provide an objective view of the business’s true earning potential. These adjustments align the financials with industry norms, ensuring that they offer a clear and unbiased picture of ongoing profitability and cash flow. For potential investors, this perspective is critical in assessing the sustainability and value of a business like Bait and Bake.

Connecting Financial Reporting to the Fishing 

Just as Betty’s family reported different fish counts depending on their audience, financial reporting also varies based on its purpose and intended user. Each type of financial report—internal, tax, or adjusted—tells its own story about the same business activity, reflecting specific standards and goals.

For example:

• The Chef’s Count (Internal Financials): 9 Fish.  Focused on what’s available to serve, this is akin to internal financials, which helps the owner understand operational efficiency.
• The Game Warden’s Count (Tax Returns): 6 Fish.  Tied to legal reporting requirements, this is similar to tax returns, which prioritize compliance with regulations.
• The Adjusted Count (Economic – investor perspective): 10 Fish.  Stripped of personal decisions, such as giving away a fish, this reflects economic financials tailored for external parties to evaluate true profitability.  This count adds back the fish Betty gave to Grippy Lee.

Financial reports, like fish counts, are shaped by the needs of their audience. Understanding this distinction is key for interpreting the financial health and value of a business. 

Key Transactions at the Bait and Bake

To understand how different financial reporting methods interpret the same events, let’s examine Betty’s notable transactions at Bait and Bake.

1. Refrigerators and Oven: Betty invests in two industrial refrigerators and a state-of-the-art convection oven for $80,000. “I made it with my starter oven as long as I could,” she jokes, “but the light bulb in my E-Z Bake Oven struggled to cook one biscuit an hour.” As for the refrigerators, she explains, “You can’t store fish and bread pudding in the same fridge unless you want your dessert to be paired with tarter sauce.”
2. Rent to Brother.  Betty pays $48,000 in rent to her brother for the parking lot, which she reluctantly describes as “a reverse family discount. He swore he wouldn’t raise the rent again, but I think I saw him building a tollbooth.”
3. Betty’s pay. Betty takes a $150,000 salary and rewards herself with a $50,000 year-end bonus. “I think I should get the leftovers in profit,” she says, “the same way I eat the leftover bread pudding and fish for dinner.” While Betty feels she deserves the reward for managing the business, she’s less certain about the tax consequences of taking such a hefty bonus—“but I’m sure my accountant will tell me eventually!”
4. Country Club Membership.  Betty spends $2,000 on a country club membership, reasoning that once golfers exhaust the country club audience, they can head to Bait and Bake to retell their tales for a matinee audience. “If I can pivot one conversation about a birdie into an order for fish and chips,” she laughs, “it’s money well spent.”

To understand how different financial reporting methods interpret Betty’s transactions, the following chart provides a detailed explanation of how each item is treated under Internal Financials, Tax Returns, and Economic/Adjusted Financials. These treatments demonstrate the distinct goals and priorities of each method, tailored to their respective audiences.

While the first chart explains the treatment of each item, the next chart summarizes the impact to profit. This quantification illustrates how the differing treatments affect Betty’s overall expenses, profit, and profitability.

The second chart highlights how Betty’s profitability varies depending on the reporting method, demonstrating the significant impact of discretionary items and differing standards. With these differences in mind, one can examine how adjusted financials provide a clearer perspective for potential investors and valuation analysts, emphasizing normalization adjustments and their significant role in economic financial statements.

The Investor’s Priorities

Adjusted financials, also known as economic financial statements, offer a unique lens through which potential investors or valuation analysts evaluate a business. For Betty, these financials provide an opportunity to present Bait and Bake as a viable, profitable investment, free from the influence of personal decisions or discretionary spending. Unlike internal financials, which reflect the owner-manager’s priorities, or tax returns, which focus on compliance and minimizing liabilities, adjusted financials prioritize an objective, normalized view of profitability and cash flow. For example:

• Profit vs. Bonus: Owner-managers often take year-end bonuses as a way to extract profits from the business. While this is perfectly valid for internal or tax purposes, adjusted financials reallocate such bonuses to reflect fair market compensation for a non-owner manager, ensuring the remaining profits align with investor expectations for dividends.
• Fair Market Adjustments: Adjusted financials also normalize expenses like rent. In Betty’s case, the $48,000 paid to her brother for the parking lot is reduced to $18,000, aligning with fair market rates.

Normalization Adjustments

Normalization adjustments are at the heart of adjusted financials. These adjustments reframe financial statements to reflect what a business’s performance would look like under typical, independent management. Key categories of adjustments include:

• Owner Compensation: Adjusting salaries and bonuses to reflect fair market rates for a non-owner manager.
• Personal Expenses: Removing discretionary items such as personal use of company resources or non-essential memberships (e.g., Betty’s $2,000 country club fee).
• Depreciation Methods: Standardizing depreciation (e.g., using straight-line) to align with industry norms and remove distortions from accelerated methods.

The Importance of Adjusted Financials

Adjusted financials bridge the gap between operational realities and investor expectations. By focusing on normalized profitability, these financial statements help potential investors evaluate:

1. Sustainability: Is the business generating consistent, recurring profits?
2. Operational Efficiency: How does the business compare to others in the industry?
3. Return on Investment: What level of dividends or reinvestment can be supported?

In Betty’s case, adjusted financials reframe her decisions from a third-party perspective. While giving Grippy Lee a fish or paying herself a substantial bonus may seem reasonable from her point of view, these discretionary actions would likely be reconsidered under investor-style management, where the goal is to maximize operational efficiency and profitability.

Third-Party Preparation of Adjusted Financials
Adjusted financials are often prepared by independent third parties, such as valuation analysts or financial consultants, to ensure objectivity and accuracy. This independence is critical, as it removes potential biases that could arise from self-prepared reports. A third-party preparer evaluates the business with fresh eyes, free from any personal connection or management influence, ensuring that the adjustments reflect standard industry practices and an unbiased representation of the company’s economic performance. For Betty, having the adjusted financials prepared by an independent analyst provides potential buyers like Grippy Lee with the confidence that the Bait and Bake’s earning potential has been evaluated impartially.

Conclusion

The adjusted financials provide investors with a standardized, unbiased view of a business’s true earning potential. For Betty, these reports help ensure that potential buyers like Grippy Lee see Bait and Bake’s value clearly, without the influence of personal decisions or discretionary spending. By incorporating independently prepared and thoroughly researched adjustments, the reports give Grippy Lee the confidence that the financials reflect a fair and objective assessment of the café’s profitability. Betty knows it’s time to reel in the deal and find her net—because if she waits too long, Grippy Lee might spit the hook in search of better bait.