Valuing Businesses

Prior to SSVS#1, CPAs performing business valuation services were governed only by the AICPA's Code of Professional Conduct and Bylaws and by the industry's strong emphasis on integrity, objectivity and due professional care. Litigation services, which frequently include business valuation, are also subject to the AICPA's Statement on Standards for Consulting Services No. 1 (SSCS), Consulting Services: Definitions and Standards. This document defines consulting services and separates them from attest services, such as issuing an audit report, and also from tax related services, bookkeeping services, and others. Consulting services standards apply to the consulting process and provide guidance to CPAs regarding their relationships with consulting clients, including maintaining objectivity and integrity and being free from conflicts of interest; reaching an understanding with the client regarding the nature of the services to be provided and other relevant considerations; and communications with clients before accepting and during a consulting services engagement. No specific reporting standards apply to consulting engagements ' including litigation services engagements ' but the SSCS does require that the results of a consulting engagement be communicated to the client in some manner (no particular format is specified).

The intellectual basis, supporting information, professional analyses, and audience for an expert opinion rendered in a litigation services engagement is substantially different from the audience for and nature of the opinion given in an attestation engagement where a CPA assesses the fairness of the written assertions of another party and issues a report expressing an opinion about this other party's assertion(s). In a litigation services engagement, which includes expert witness services, the CPA is not subject to the reporting and other requirements applicable to attestation engagements since the CPA's testimony and work is subject to detailed analysis and challenge by other parties to the dispute who have the opportunity to question the CPA and who also have an opportunity to provide input to the fact finding process and participate in the trial or other dispute resolution process. This is commonly referred to as the litigation services exemption.

The Present

In general, SSVS#1 is not intended to be an 'instruction manual,' but rather a listing of 'items to consider' when providing business valuation services. It was written to improve the consistency and quality of business valuation work. SSVS#1 consists of two primary sections specific to business valuation services; namely the Development Standards, paragraphs 21 through 46, and the Reporting Standards, paragraphs 47 through 78. Paragraphs 47 and 50 exempt certain controversy proceedings from the reporting provisions of SSVS#1, whether the matter proceeds to trial or settles. (A controversy proceeding is defined as a matter before a court, an arbitrator, a mediator or other facilitator, or a matter in a governmental or administrative proceeding.) The developmental provisions (paragraphs 21 through 46) of SSVS#1, however, apply to all business valuation engagements, including those performed in connection with expert testimony or other litigation related services.

In addition to the development and reporting standards, SSVS#1 includes two very useful glossaries (Appendix A and B) that define the business valuation terms used in the standard.

The Development Standards define two types of engagements to estimate value ' namely a valuation engagement and a calculation engagement. A valuation engagement requires more procedures than a calculation engagement and results in a conclusion or opinion of value, whereas a calculation engagement provides what is referred to as a calculated value, which does not rise to the level of a conclusion or opinion. In other words, a valuation engagement is a higher level of service than a calculation engagement.

A calculation engagement is akin to the quick and dirty preliminary valuation computations matrimonial attorneys sometimes request in an effort to see if settlement can be reached short of performing all the work necessary to complete a formal business valuation and prepare for a trial. A more in-depth formal business valuation report may also involve numerous forensic accounting and financial investigatory services aimed at discovering unreported income or hidden assets in addition to business valuation services. A key concept separating a valuation engagement from a calculation engagement is that in a valuation engagement the CPA is free to apply the valuation approaches and methods he or she deems appropriate for the circumstances, whereas in a calculation engagement an agreement as to the nature and limited scope of procedures employed is reached with the client.

The development provisions can be further segregated into four subcategories: 1) Analysis of the subject interest (paragraphs 25 ' 30); 2) Consideration and application of appropriate valuation approaches and methods (paragraphs 31-42); 3) Subsequent events (paragraph 43); and 4) Preparing and maintaining appropriate documentation (paragraphs 44-45).

Analysis of the subject interest (i.e., the business, business ownership interest, security or intangible asset being valued) includes, among other things, identifying: 1) the subject interest; 2) the valuation date; 3) the intended use of the valuation; 4) the applicable standard of value; and 5) the relevant assumptions and limiting conditions. Nonfinancial information ' such as the nature, background, and history of the business, the products and services it offers, its organizational structure, management team and key employees, and classes of equity ownership interests and the rights attached thereto ' are also covered in this subcategory as are economic and industry conditions, competition, and business risks.

SSVS#1 states that the valuator should obtain, where applicable and available, financial information for the subject entity. For example, items to gather may include historical financial statements, income tax returns, prospective financial information (i.e., budgets, forecasts, or projections), information regarding the compensation and benefits provided owners, information on key person or officers' life insurance contracts, information regarding contingent or off-balance-sheet assets or liabilities, and information on prior sales of company stock.

The valuation approaches and methods section identifies the three primary valuation approaches and a number of valuation methodologies and provides some very general guidance related thereto. This section calls for the valuation analyst to consider relevant alternatives and select valuation approaches and methods deemed appropriate for the particular engagement. It also lists a menu of items to consider during the valuation process, including (among other things) normalization adjustments, nonrecurring revenue or expense items, capital structure, obsolescence, the remaining useful life of assets, comparable or guideline company transactions and other market data, the dates and relevance of the market data gathered, nonoperating assets, nonoperating liabilities, operating asset excesses or deficiencies and valuation adjustments and discounts, including a discount for lack of control and a discount for lack of marketability or liquidity if applicable.

The subsequent events paragraph states that the valuation analyst should generally only consider circumstances existing at the valuation date and events occurring up to the valuation date. However, in order to keep users informed in the appropriate circumstances, it also makes provision for the optional disclosure of significant subsequent events, in a separate section of the valuation report, where a valuation is meaningful to the intended user beyond the valuation date. The disclosure should state that the information is provided for informational purposes only and does not affect the determination of value as of the specified date of valuation.

The documentation provisions define documentation as the principal record of information obtained and analyzed, procedures performed, valuation approaches and methods considered and used, and the conclusion of value. The quantity, type, and content of documentation are considered matters of the valuation analyst's professional judgment, but may include: information and financial records gathered and analyzed, assumptions and limiting conditions, any restrictions or limitations on the scope of work or data available for analysis, valuation approaches and methods considered and used, information relating to pertinent subsequent events, and other documentation the valuation analyst may consider relevant.

The minimum number of items that a valuation analyst should consider and discuss with the client when performing a calculation engagement (i.e., the lowest level of service described previously) are outlined in paragraph 46 of SSVS#1.

The Future

Although SSVS#1 covers many topics, a number of controversial issues remain and it is possible, if not likely, that the AICPA will promulgate further standards or guidance to address such issues in the future.

For example, SSVS#1 says very little about the use of financial forecasts or projections in a business valuation; however, there are matters in which consideration of financial forecasts or projections, the source of the information and assumptions underlying them, and their overall reasonableness or lack thereof can be a very real concern. While there is an AICPA audit and accounting guide titled Guide for Prospective Financial Information ' which establishes guidelines for the preparation and presentation of financial forecasts and projections ' it also includes a litigation exemption and, accordingly, a wide range of views as to what procedures and formats are acceptable in a litigated matter currently exists among practitioners. Unfortunately, it is not uncommon for some of the forecasts or projections used in litigated matters to be ill-founded predictions that can at best be considered unsupported self-serving creations of fiction. Not even the most inept person would base a real-life decision on such flimsy evidence.

The forecasts or projections used in litigated matters often do not include disclosures of the key variables, relationships, assumptions, and other factors necessary to truly obtain an understanding of the financial model, and frequently do not include a contingent or limiting statement that informs the user that, since prospective information may be affected by many factors both internal and external to the company, the forecast or projection may ultimately prove to be unrepresentative of future conditions and therefore its achievability and reliability cannot be guaranteed. Prospective financial information is necessarily less objective and verifiable than historical financial data, so it is essential that end users understand such inherent limitations.

While I do not expect the AICPA to begin issuing a new business-valuation-related technical standard every time a judgmental issue becomes the topic du jour or every time a controversial estate and gift-tax related court decision is rendered, it is true that the Financial Accounting Standards Board has issued 160 Statements of Financial Accounting Standards (SFAS) ' these statements govern the preparation of financial statements in accordance with generally accepted accounting principles. The first SFAS was issued in December 1973 and the most recent in December 2007. Accordingly it is not much of a stretch to assume that, as the future of business valuation unfurls, additional business-valuation-related standards or other forms of technical guidance will be forthcoming in an effort to respond to the clamoring of AICPA constituents and others when certain matters are spotlighted for attention.

Conclusion

Although standards are sometimes considered both a blessing and a curse, by practitioners and end users alike, as we embark on this new era, I am optimistic that SSVS#1 and its anticipated prodigy will not only improve the quality of business valuation work but will help end users, including attorneys and the courts, to better understand the business valuation process and make better and more informed decisions as time goes by.

Despite the clarity offered by SSVS#1 a number of controversial issues remain and it is likely that additional guidance will be provided by the AICPA in the future. Stay tuned and keep your eyes open.

(Primary sources for the information discussed in this article include the AICPA's Statement on Standards for Valuation Services No. 1, titled: Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset, ' 2007 by the American Institute of Certified Public Accountants, Inc., New York, NY and the AICPA's Statement on Standards for Consulting Services No. 1, Titled: Consulting Services: Definitions and Standards, and Associated Consulting Services Special Reports and Practice Aids.)

Thomas A. Hutson, CPA/ABV, CFP, is a partner at BST Valuation & Litigation Advisors LLC. He is a Certified Public Accountant, Accredited in Business Valuation by the American Institute of Certified Public Accountants, and a Certified Financial Planner.

A question I often receive from attorneys in matrimonial or other litigated matters is whether or not there are any specific standards that a CPA must adhere to when performing a business valuation engagement. Until Jan. 1, 2008, the answer was, effectively, 'No.' As of the beginning of this year, that answer has now changed.

The American Institute of Certified Public Accountants' (AICPA) Statement on Standards for Valuation Services No. 1 (SSVS#1), titled Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset and issued in 2007, applies to business valuation engagements accepted on or after Jan. 1, 2008. Accordingly, the standard will begin to apply to work performed by CPAs in matrimonial cases going forward. (Although a CPA is not required to be a member of the AICPA to maintain his or her license, most CPAs are members of the AICPA, and for purposes of this article all references to a CPA will assume the CPA is a member of the AICPA.)

The Past

Prior to SSVS#1, CPAs performing business valuation services were governed only by the AICPA's Code of Professional Conduct and Bylaws and by the industry's strong emphasis on integrity, objectivity and due professional care. Litigation services, which frequently include business valuation, are also subject to the AICPA's Statement on Standards for Consulting Services No. 1 (SSCS), Consulting Services: Definitions and Standards. This document defines consulting services and separates them from attest services, such as issuing an audit report, and also from tax related services, bookkeeping services, and others. Consulting services standards apply to the consulting process and provide guidance to CPAs regarding their relationships with consulting clients, including maintaining objectivity and integrity and being free from conflicts of interest; reaching an understanding with the client regarding the nature of the services to be provided and other relevant considerations; and communications with clients before accepting and during a consulting services engagement. No specific reporting standards apply to consulting engagements ' including litigation services engagements ' but the SSCS does require that the results of a consulting engagement be communicated to the client in some manner (no particular format is specified).

The intellectual basis, supporting information, professional analyses, and audience for an expert opinion rendered in a litigation services engagement is substantially different from the audience for and nature of the opinion given in an attestation engagement where a CPA assesses the fairness of the written assertions of another party and issues a report expressing an opinion about this other party's assertion(s). In a litigation services engagement, which includes expert witness services, the CPA is not subject to the reporting and other requirements applicable to attestation engagements since the CPA's testimony and work is subject to detailed analysis and challenge by other parties to the dispute who have the opportunity to question the CPA and who also have an opportunity to provide input to the fact finding process and participate in the trial or other dispute resolution process. This is commonly referred to as the litigation services exemption.

The Present

In general, SSVS#1 is not intended to be an 'instruction manual,' but rather a listing of 'items to consider' when providing business valuation services. It was written to improve the consistency and quality of business valuation work. SSVS#1 consists of two primary sections specific to business valuation services; namely the Development Standards, paragraphs 21 through 46, and the Reporting Standards, paragraphs 47 through 78. Paragraphs 47 and 50 exempt certain controversy proceedings from the reporting provisions of SSVS#1, whether the matter proceeds to trial or settles. (A controversy proceeding is defined as a matter before a court, an arbitrator, a mediator or other facilitator, or a matter in a governmental or administrative proceeding.) The developmental provisions (paragraphs 21 through 46) of SSVS#1, however, apply to all business valuation engagements, including those performed in connection with expert testimony or other litigation related services.

In addition to the development and reporting standards, SSVS#1 includes two very useful glossaries (Appendix A and B) that define the business valuation terms used in the standard.

The Development Standards define two types of engagements to estimate value ' namely a valuation engagement and a calculation engagement. A valuation engagement requires more procedures than a calculation engagement and results in a conclusion or opinion of value, whereas a calculation engagement provides what is referred to as a calculated value, which does not rise to the level of a conclusion or opinion. In other words, a valuation engagement is a higher level of service than a calculation engagement.

A calculation engagement is akin to the quick and dirty preliminary valuation computations matrimonial attorneys sometimes request in an effort to see if settlement can be reached short of performing all the work necessary to complete a formal business valuation and prepare for a trial. A more in-depth formal business valuation report may also involve numerous forensic accounting and financial investigatory services aimed at discovering unreported income or hidden assets in addition to business valuation services. A key concept separating a valuation engagement from a calculation engagement is that in a valuation engagement the CPA is free to apply the valuation approaches and methods he or she deems appropriate for the circumstances, whereas in a calculation engagement an agreement as to the nature and limited scope of procedures employed is reached with the client.

The development provisions can be further segregated into four subcategories: 1) Analysis of the subject interest (paragraphs 25 ' 30); 2) Consideration and application of appropriate valuation approaches and methods (paragraphs 31-42); 3) Subsequent events (paragraph 43); and 4) Preparing and maintaining appropriate documentation (paragraphs 44-45).

Analysis of the subject interest (i.e., the business, business ownership interest, security or intangible asset being valued) includes, among other things, identifying: 1) the subject interest; 2) the valuation date; 3) the intended use of the valuation; 4) the applicable standard of value; and 5) the relevant assumptions and limiting conditions. Nonfinancial information ' such as the nature, background, and history of the business, the products and services it offers, its organizational structure, management team and key employees, and classes of equity ownership interests and the rights attached thereto ' are also covered in this subcategory as are economic and industry conditions, competition, and business risks.

SSVS#1 states that the valuator should obtain, where applicable and available, financial information for the subject entity. For example, items to gather may include historical financial statements, income tax returns, prospective financial information (i.e., budgets, forecasts, or projections), information regarding the compensation and benefits provided owners, information on key person or officers' life insurance contracts, information regarding contingent or off-balance-sheet assets or liabilities, and information on prior sales of company stock.

The valuation approaches and methods section identifies the three primary valuation approaches and a number of valuation methodologies and provides some very general guidance related thereto. This section calls for the valuation analyst to consider relevant alternatives and select valuation approaches and methods deemed appropriate for the particular engagement. It also lists a menu of items to consider during the valuation process, including (among other things) normalization adjustments, nonrecurring revenue or expense items, capital structure, obsolescence, the remaining useful life of assets, comparable or guideline company transactions and other market data, the dates and relevance of the market data gathered, nonoperating assets, nonoperating liabilities, operating asset excesses or deficiencies and valuation adjustments and discounts, including a discount for lack of control and a discount for lack of marketability or liquidity if applicable.

The subsequent events paragraph states that the valuation analyst should generally only consider circumstances existing at the valuation date and events occurring up to the valuation date. However, in order to keep users informed in the appropriate circumstances, it also makes provision for the optional disclosure of significant subsequent events, in a separate section of the valuation report, where a valuation is meaningful to the intended user beyond the valuation date. The disclosure should state that the information is provided for informational purposes only and does not affect the determination of value as of the specified date of valuation.

The documentation provisions define documentation as the principal record of information obtained and analyzed, procedures performed, valuation approaches and methods considered and used, and the conclusion of value. The quantity, type, and content of documentation are considered matters of the valuation analyst's professional judgment, but may include: information and financial records gathered and analyzed, assumptions and limiting conditions, any restrictions or limitations on the scope of work or data available for analysis, valuation approaches and methods considered and used, information relating to pertinent subsequent events, and other documentation the valuation analyst may consider relevant.

The minimum number of items that a valuation analyst should consider and discuss with the client when performing a calculation engagement (i.e., the lowest level of service described previously) are outlined in paragraph 46 of SSVS#1.

The Future

Although SSVS#1 covers many topics, a number of controversial issues remain and it is possible, if not likely, that the AICPA will promulgate further standards or guidance to address such issues in the future.

For example, SSVS#1 says very little about the use of financial forecasts or projections in a business valuation; however, there are matters in which consideration of financial forecasts or projections, the source of the information and assumptions underlying them, and their overall reasonableness or lack thereof can be a very real concern. While there is an AICPA audit and accounting guide titled Guide for Prospective Financial Information ' which establishes guidelines for the preparation and presentation of financial forecasts and projections ' it also includes a litigation exemption and, accordingly, a wide range of views as to what procedures and formats are acceptable in a litigated matter currently exists among practitioners. Unfortunately, it is not uncommon for some of the forecasts or projections used in litigated matters to be ill-founded predictions that can at best be considered unsupported self-serving creations of fiction. Not even the most inept person would base a real-life decision on such flimsy evidence.

The forecasts or projections used in litigated matters often do not include disclosures of the key variables, relationships, assumptions, and other factors necessary to truly obtain an understanding of the financial model, and frequently do not include a contingent or limiting statement that informs the user that, since prospective information may be affected by many factors both internal and external to the company, the forecast or projection may ultimately prove to be unrepresentative of future conditions and therefore its achievability and reliability cannot be guaranteed. Prospective financial information is necessarily less objective and verifiable than historical financial data, so it is essential that end users understand such inherent limitations.

While I do not expect the AICPA to begin issuing a new business-valuation-related technical standard every time a judgmental issue becomes the topic du jour or every time a controversial estate and gift-tax related court decision is rendered, it is true that the Financial Accounting Standards Board has issued 160 Statements of Financial Accounting Standards (SFAS) ' these statements govern the preparation of financial statements in accordance with generally accepted accounting principles. The first SFAS was issued in December 1973 and the most recent in December 2007. Accordingly it is not much of a stretch to assume that, as the future of business valuation unfurls, additional business-valuation-related standards or other forms of technical guidance will be forthcoming in an effort to respond to the clamoring of AICPA constituents and others when certain matters are spotlighted for attention.

Conclusion

Although standards are sometimes considered both a blessing and a curse, by practitioners and end users alike, as we embark on this new era, I am optimistic that SSVS#1 and its anticipated prodigy will not only improve the quality of business valuation work but will help end users, including attorneys and the courts, to better understand the business valuation process and make better and more informed decisions as time goes by.

Despite the clarity offered by SSVS#1 a number of controversial issues remain and it is likely that additional guidance will be provided by the AICPA in the future. Stay tuned and keep your eyes open.

(Primary sources for the information discussed in this article include the AICPA's Statement on Standards for Valuation Services No. 1, titled: Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset, ' 2007 by the American Institute of Certified Public Accountants, Inc., New York, NY and the AICPA's Statement on Standards for Consulting Services No. 1, Titled: Consulting Services: Definitions and Standards, and Associated Consulting Services Special Reports and Practice Aids.)

Thomas A. Hutson, CPA/ABV, CFP, is a partner at BST Valuation & Litigation Advisors LLC. He is a Certified Public Accountant, Accredited in Business Valuation by the American Institute of Certified Public Accountants, and a Certified Financial Planner.