Case Study: Normalization Adjustments and the COVID-19 Pandemic

February 21, 2022

By: Damien Strohmier, Senior Manager, CPA, CCIFP

Normalization adjustments are those adjustments to EBITDA that remove non-recurring income and/or expenses related to one-time or extraordinary events in order to present a company’s earnings or performance in a normal operating year.

The COVID-19 pandemic is one example of an event that may seem extraordinary or non-recurring, but requires judgment to truly determine what should be considered in the adjustment there are many things related to the COVID-19 pandemic that may continue to occur in future years.

Below, we walk through an example of a COVID-19 adjustment on a quality of earnings (QoE) engagement performed for a construction company.

COVID-19 Adjustment of Quality of Earnings (QoE)

The company presented within their draft quality of earnings table separate adjustments totaling approximately $2,000,000. One of the adjustments addressed removal of the benefits derived from credits and forgiven loans offered under the CARES Act, another related to a shutdown period during 2020, and the final adjustment reflected the ongoing impacts to profitability of jobs.

The first of these adjustments is straight forward. The company was awarded credits and other funds offered through the CARES Act that were intended to help stabilize the economy and keep workers on payroll during the pandemic. These adjustments certainly meet the criteria of non-recurring and in this example, were an appropriate reduction of approximately $750,000 to the adjusted EBITDA.

The second adjustment dealing with the actual shutdown period included an addback of approximately $1,250,000. The support for the adjustment was a study of the lost production hours during the shutdown period. The addback was inclusive of the gross profit that would have been recognized had laborers worked these hours and made the company’s operating results during the shutdown period, consistent to historical periods, with actual adjustments based on the availability of backlog and actual work schedules, as compared to historical periods.

There is a lot to consider related to this adjustment. Is the methodology correct? Does it really produce an accurate representation of what gross profit was missing from that time frame? This will be revisited later in the article, but you can spend a lot of time trying to prove the methodology and amounts, but that time may be wasted if there is not a big picture assessment of what the ending adjusted EBITDA is, and if that is realistic for the company’s ongoing performance.

The third adjustment covering the profitability impacts of the COVID-19 pandemic is where a majority of our discussion time with management was spent. This adjustment was based on time studies performed by an association of the company’s primary trade and was intended to reflect the estimated impact of the COVID-19 pandemic on the operating results in both 2020 and 2021.

The first consideration for this adjustment is whether we truly see a change in the operations on jobs moving forward, and whether the profitability impact is really non-recurring. Rather than engaging into a debate about the ongoing impacts of the pandemic, our team looked at the overall adjusted EBITDA which was now well above historical performance.

Working further with management, we were provided a separate report of actual downtime reported and COVID-19-related costs that had been captured in their accounting system. The downtime was representative of health checks and unique traffic flow that had to be followed on job sites.

What is non-recurring about these costs? The fact that they weren’t included in the bid on the jobs. The company’s profitability was impacted because they did not include in their original estimates the impact from these unforeseen hours. Moving forward, there would be two changes: inclusion of these items in estimates, and fewer mandated restrictions to follow.

Now we had an appropriate basis for an adjustment and determined final adjusted EBITDA should exclude the adjustment related to the time study, and instead, should include an adjustment based on the accumulation of costs due to downtime and other pandemic-related costs.

The end result was an adjusted EBITDA below the company’s historical results. Just as we challenged the initial presentation of adjusted EBITDA that was greater than the company’s historical results, we had to support the “why” surrounding being below historical averages. We approached this with two new considerations:

1) are we missing anything else that should be added back related to COVID, and

2) is there any other reason why this period did not perform as well?

The latter consideration held our answer, as the company had fade on jobs that negatively impacted the current period. Was that due to COVID-19? An argument could be made that there was some impact, but knowing we already have an adjustment tied to actual costs incurred by the company, and looking at the company’s historical estimating performance, we knew that some element of fade on contracts was also prevalent in historical years. We were comfortable with presenting the draft adjusted EBITDA from our report, but also receptive if management could identify other jobs where COVID-19 costs were not reported in their time system.

Getting out of the details to see the big picture is the purpose of what we aimed to demonstrate related to this situation. The professionals involved in the transaction had to conclude what the most appropriate add-back would be to produce a normalized EBITDA complementary of the company’s past and expected ongoing performance, such that the bank financing the transaction could be comfortable the debt service would be met.