Bridging the Gap: Understanding M-1 Adjustments and Their Impact

08/12/2024|Business Valuation CPA|

When estimating  net cash flows to invested capital, we examine schedule M-1 on IRS Form 1120S to reconcile the net income (or loss) per books (i.e., the company’s financial statements) with the income (or loss) per the tax return. The reconciliation helps the IRS understand the differences between what a corporation reports as income for accounting purposes and what it reports for tax purposes.

Possible M-1 Adjustments:

  1. Income Recorded on Books but Not Included on the Tax Return (Line 2):
  2. Expenses Deducted on Books but Not Deducted on the Tax Return (Line 3):
  3. Income Included on the Tax Return but Not Recorded on Books (Line 5):
  4. Expenses Not Deducted on Books but Deducted on the Tax Return (Line 7):

Examples of Common Adjustments:

  • Depreciation: Companies often use different methods for calculating depreciation for tax purposes (like Modified Accelerated Cost Recovery System (MACRS)) compared to financial reporting purposes (e.g., straight-line method). This difference is a common M-1 adjustment.
  • Tax-Exempt Interest: Interest from certain municipal bonds may be recorded as income in the financial statements but is not taxable and, therefore, is adjusted on Schedule M-1.
  • Meals and Entertainment: For tax purposes, only 50% of the cost of meals is deductible, while the entire amount may be deducted on the financial books.
  • Non-Deductible Expenses: Certain expenses like fines, penalties, and life insurance premiums on officers (where the corporation is the beneficiary) are deductible for book purposes but are not deductible for tax purposes.
  • Unrealized Gains and Losses: Gains and losses that are recorded for book purposes but not recognized for tax purposes can lead to adjustments.

The purpose of these adjustments is to ensure that the income reported on the tax return accurately reflects taxable income, even if it differs from what is reported in the company’s financial statements.

Key Points of Correlation:

  1. Accurate Cash Flow Estimation:
  2. Normalization of Earnings:
  3. Tax Considerations in Valuation:
  4. Reflecting True Economic Value:

Practical Application in Valuation:

  • Reconciliation and Adjustments: During the valuation process, it’s essential to review the M-1 adjustments to understand the underlying reasons for differences between book income and taxable income. Adjusting the cash flow projections to reflect these differences ensures that the FCFF model accurately represents the firm’s ability to generate cash flow in the future.
  • Normalization of Financial Statements: Use M-1 adjustments as part of the process to normalize the financial statements, ensuring that the starting point for the FCFF calculation reflects the true operational performance of the business.
  • Projection of Tax Cash Flows: Incorporate the implications of tax-related M-1 adjustments into the cash flow projections, especially in terms of future tax liabilities or benefits, to ensure the valuation reflects the firm’s tax position accurately.

In summary, understanding and appropriately accounting for M-1 adjustments ensures that the FCFF model reflects the true economic value of the firm by accurately projecting future cash flows based on a realistic and normalized understanding of the company’s earnings and tax obligations.Contact us here for your business valuation needs. business appraisal services