Beware of 'Calculations' of Business Value

Recent cases highlight how dangerous experts can be when they report that their finding of business value is based on a “calculation.” This wording has special meaning, implying a quick, cheap set of procedures that is tantalizing, especially for clients and attorneys struggling with placing a cash-equivalent value on an intangible asset, such as equity in a privately held business. Calculations are usually based on assumptions of the client (or perhaps the attorney), not on the independent judgment of the appraiser. But danger lurks in the darkness of ignorance, for these simplified “valuation” procedures are too often a crippled form of analysis without complete judgment that mistakenly conveys the assurance of a formal opinion expected of an expert.

Cases in Point

In In the Marriage of Hagar (2010 WL 4807559, Iowa App., Nov. 24, 2010), the appellate court addressed the husband's interest in a small chain of family owned dry cleaning stores. In the trial court, the family CPA estimated that the businesses were worth anywhere from $71,000 to a negative $120,000. His calculation report cited “industry rules of thumb” and indicated that his conclusions did not require the same professional judgment as a complete valuation analysis. After the trial court valued the businesses based in large part on the CPA's figures, the wife appealed. The appellate court agreed with the error, finding “we do not use [the CPA's] calculations because he admittedly did not use judgment.”

A second recent case is In re Marriage of Cantarella, 2011 WL 86284, Ca. App. 4 Dist., Jan. 11, 2011. This case is unpublished, but is referenced in Business Valuation Update, March 2011, pp. 40-41. In this second case, the parties tried to “do it themselves,” but saw the wife appeal four months after settlement with a CPA's “preliminary valuation” that came with a caveat that it was incomplete. The appeals court held that because the parties could not establish a clear alternative value for the business, the trial court did not err in adopting the parties' agreement.

What Is a 'Calculation' of Value?

The term “calculation analysis” has been recently popularized by many CPAs doing valuation work because of the 2007 release of American Institute of Certified Public Accountants (AICPA) business valuation standards ' Statement on Standards for a Valuation Services No. 1, Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset, referred to as “SSVS1.” These forms of “crippled” analyses have been authorized by other professional associations before 2007. For example, historical standards of the Institute of Business Appraisers refer to a “preliminary report” as a form of analysis. Business Valuation Standards of the American Society of Appraisers refer to a “calculation” and a “limited procedure opinion” and a “full scope opinion.” Although membership in these appraisal organizations is relatively small, perhaps 7,000 members, AICPA membership numbers more than 130,000. All CPAs who perform analytical services related to business valuation ' whether they are accredited in business valuation (“ABV”) by the AICPA or not ' must follow SSVS-1.

Hence, CPAs (or non-CPA members of CPA firms who are doing valuation work) must now describe their services as either a “calculation engagement” or a “valuation engagement.” The latter service is widely regarded as synonymous with an appraisal opinion suitable for matrimonial litigation, even though no wording in SSVS-1 references the terms “appraisal” or “opinion.

An engagement for estimating the value of a business, business ownership interest, security, or intangible asset is identified in SSVS-1 as being either a valuation engagement or a calculation engagement. When performing a valuation engagement, the CPA estimates the value of a subject interest based on the valuation methodologies the practitioner has selected as being appropriate in the circumstance. A valuation engagement results in a conclusion of value. In contrast, a calculation engagement does not include all of the procedures required for a valuation engagement, and the valuation methodology is determined by the client, with possible input from the valuation analyst. Unlike a valuation engagement, a calculation engagement results in a calculation of value. Whether it is a valuation or calculation engagement, the resulting value may be either a single amount or a range. In both engagements a report will be issued. The type of reporting, summary or a detailed version is a secondary decision open for both forms of service.

In a calculation engagement, the client and CPA will agree on the valuation assumptions, approaches and methodologies to be used. The procedures required in a calculation engagement are more limited than those required in a valuation engagement. Essentially, many of the common elements necessary for a professional opinion are required for a “calculation engagement,” such as defining the standard of value, premise of value, purpose and intended use, control characteristics, and degree of marketability. A calculation engagement differs from a valuation engagement because it allows valuation approaches and methods agreed upon with the client. The distinguishing language seen in a calculation report states that: 1) a calculation engagement does not include all of the procedures required for a valuation engagement; and 2) had a valuation engagement been performed, the results may have been different. In other words, in a calculation engagement, a CPA is allowed to perform a limited analysis based on incomplete work with restricted judgment. The inclusion of this language in any report will clarify any doubt the CPA is performing.

Dangers for Matrimonial Attorneys

If you intend to rely on a “calculated value” from an expert, ensure that your client understands the limitations of this method. Many attorneys have their clients sign a written statement acknowledging their approval of the limited scope of work. Appraisers are required to do likewise, usually with the attorney as the engagement authority (“client”). Unfortunately, it is unclear whether it is the attorney's responsibility to educate the clients as to the procedures employed. The attorney may have to rely on the expert to convey these distinctions, including the differences in fees, and what procedures would not be employed that could lead to different results. Inevitably, the question will arise as to what extra effort will be necessary to turn a “calculation” into a “valuation.”

If the business is complex with likely substantial value that could affect either spouse, embarking on a calculation venture probably is not the best option. It might be more prudent to proceed to the full-scope appraisal or analysis. It may be difficult to argue that settlement negotiations were conducted in good faith if value from a “calculation” changes after further work is performed. The errors involved in misstating value based on incomplete work are hard to undo and will cause problems with knowledgeable opposing counsel who are likely to explore the differences and reasoning in excruciating detail.

Often, a calculation analysis is offered by an expert who simply does not want to put in the effort of a full-scope analysis, and charge for the proper time it will take; or it is required by a client who does not want to pay more. In our experience in the Midwest, too often an unsophisticated appraiser or accountant will offer to do a calculation for a smaller business where limited funds are available. Philosophically, there is some “protection” for the analyst since the statement “' had a valuation engagement been performed, the results may have been different” suggests that the value conclusion is simply preliminary.

Sometimes both attorneys will retain “dueling appraisers” and ask both for a calculation in hopes of establishing the settlement range. Again, danger lurks for the unsuspecting professionals because both analysts' calculations could miss similar important elements relating to marital asset value, yielding both estimates as too high or too low. Keep in mind that different assumptions and procedures will be agreed upon. Also, smaller businesses often have poorer quality accounting and unusual asset mixes, presenting complexity that a quick calculation analysis cannot address. Adjustments may be necessary for accruals, non-recurring events, unrecorded assets and liabilities (such as note obligations between the owners and the corporation), quality of equipment, whether the business has excess equipment or excess “other” assets. These types of adjustments are required in a full-scope appraisal or valuation analysis, but too often are ignored or otherwise sidestepped in a calculation. Needless to say, they could they be material. These types of adjustments to initial tax filings or compiled/internal results affect levels of net assets, true leverage, pattern of growth, and quality of earnings ' all of which affect marital asset value. Simple calculations typically also ignore the depth of economic and industry conditions that affect value as of a certain date, particularly with the severity of the recent economic recession.

Recommendations

Matrimonial attorneys should recognize that any business valuation appraiser or accountant who is retained and instructed to perform a “calculation of value” is offering a preliminary value estimate based on crude tools. Fee quotes should be less, and turnaround time should also be quicker than a full “valuation analysis.”

There is a place for calculation engagements. As a consulting service, such analysis could be important as input for the attorney in the development of theory of the case. Calculation assignments are also useful where a specific issue needs to be addressed, such as researching a range of multiples for similar businesses that have been bought and sold. In situations where knowledgeable clients (who approve a calculation service) have a reasonable expectation of appropriate value that must be confirmed, a calculation analysis also has a place. In an asset-rich business without significant abnormalities, a calculation could be effective if marital equity is a smaller non-controlling interest and the attorney has a desire to gauge if pro-rata book value is a reasonable value. (In this last situation, additional entity goodwill will often be somewhat counter-balanced by a discount for lack of control, although not necessarily equally.) Matrimonial attorneys need to be wary when presented with a “calculation” of business value. Dangers exist for the unprepared!

Rob Schlegel, a member of this newsletter's Board of Editors, is an Accredited Senior Appraiser in Business Valuation by the American Society of Appraisers, and also holds the Master Certified Business Appraiser designation from the Institute of Business Appraisers. John Kotlarczyk is a Certified Public Accountant who is also Accredited in Business Valuation (ABV) and is Certified in Financial Forensics (CFF). Both are Principals in the Indianapolis, IN, office of Houlihan Valuation Advisors.

Recent cases highlight how dangerous experts can be when they report that their finding of business value is based on a “calculation.” This wording has special meaning, implying a quick, cheap set of procedures that is tantalizing, especially for clients and attorneys struggling with placing a cash-equivalent value on an intangible asset, such as equity in a privately held business. Calculations are usually based on assumptions of the client (or perhaps the attorney), not on the independent judgment of the appraiser. But danger lurks in the darkness of ignorance, for these simplified “valuation” procedures are too often a crippled form of analysis without complete judgment that mistakenly conveys the assurance of a formal opinion expected of an expert.

Cases in Point

In In the Marriage of Hagar (2010 WL 4807559, Iowa App., Nov. 24, 2010), the appellate court addressed the husband's interest in a small chain of family owned dry cleaning stores. In the trial court, the family CPA estimated that the businesses were worth anywhere from $71,000 to a negative $120,000. His calculation report cited “industry rules of thumb” and indicated that his conclusions did not require the same professional judgment as a complete valuation analysis. After the trial court valued the businesses based in large part on the CPA's figures, the wife appealed. The appellate court agreed with the error, finding “we do not use [the CPA's] calculations because he admittedly did not use judgment.”

A second recent case is In re Marriage of Cantarella, 2011 WL 86284, Ca. App. 4 Dist., Jan. 11, 2011. This case is unpublished, but is referenced in Business Valuation Update, March 2011, pp. 40-41. In this second case, the parties tried to “do it themselves,” but saw the wife appeal four months after settlement with a CPA's “preliminary valuation” that came with a caveat that it was incomplete. The appeals court held that because the parties could not establish a clear alternative value for the business, the trial court did not err in adopting the parties' agreement.

What Is a 'Calculation' of Value?

The term “calculation analysis” has been recently popularized by many CPAs doing valuation work because of the 2007 release of American Institute of Certified Public Accountants (AICPA) business valuation standards ' Statement on Standards for a Valuation Services No. 1, Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset, referred to as “SSVS1.” These forms of “crippled” analyses have been authorized by other professional associations before 2007. For example, historical standards of the Institute of Business Appraisers refer to a “preliminary report” as a form of analysis. Business Valuation Standards of the American Society of Appraisers refer to a “calculation” and a “limited procedure opinion” and a “full scope opinion.” Although membership in these appraisal organizations is relatively small, perhaps 7,000 members, AICPA membership numbers more than 130,000. All CPAs who perform analytical services related to business valuation ' whether they are accredited in business valuation (“ABV”) by the AICPA or not ' must follow SSVS-1.

Hence, CPAs (or non-CPA members of CPA firms who are doing valuation work) must now describe their services as either a “calculation engagement” or a “valuation engagement.” The latter service is widely regarded as synonymous with an appraisal opinion suitable for matrimonial litigation, even though no wording in SSVS-1 references the terms “appraisal” or “opinion.

An engagement for estimating the value of a business, business ownership interest, security, or intangible asset is identified in SSVS-1 as being either a valuation engagement or a calculation engagement. When performing a valuation engagement, the CPA estimates the value of a subject interest based on the valuation methodologies the practitioner has selected as being appropriate in the circumstance. A valuation engagement results in a conclusion of value. In contrast, a calculation engagement does not include all of the procedures required for a valuation engagement, and the valuation methodology is determined by the client, with possible input from the valuation analyst. Unlike a valuation engagement, a calculation engagement results in a calculation of value. Whether it is a valuation or calculation engagement, the resulting value may be either a single amount or a range. In both engagements a report will be issued. The type of reporting, summary or a detailed version is a secondary decision open for both forms of service.

In a calculation engagement, the client and CPA will agree on the valuation assumptions, approaches and methodologies to be used. The procedures required in a calculation engagement are more limited than those required in a valuation engagement. Essentially, many of the common elements necessary for a professional opinion are required for a “calculation engagement,” such as defining the standard of value, premise of value, purpose and intended use, control characteristics, and degree of marketability. A calculation engagement differs from a valuation engagement because it allows valuation approaches and methods agreed upon with the client. The distinguishing language seen in a calculation report states that: 1) a calculation engagement does not include all of the procedures required for a valuation engagement; and 2) had a valuation engagement been performed, the results may have been different. In other words, in a calculation engagement, a CPA is allowed to perform a limited analysis based on incomplete work with restricted judgment. The inclusion of this language in any report will clarify any doubt the CPA is performing.

Dangers for Matrimonial Attorneys

If you intend to rely on a “calculated value” from an expert, ensure that your client understands the limitations of this method. Many attorneys have their clients sign a written statement acknowledging their approval of the limited scope of work. Appraisers are required to do likewise, usually with the attorney as the engagement authority (“client”). Unfortunately, it is unclear whether it is the attorney's responsibility to educate the clients as to the procedures employed. The attorney may have to rely on the expert to convey these distinctions, including the differences in fees, and what procedures would not be employed that could lead to different results. Inevitably, the question will arise as to what extra effort will be necessary to turn a “calculation” into a “valuation.”

If the business is complex with likely substantial value that could affect either spouse, embarking on a calculation venture probably is not the best option. It might be more prudent to proceed to the full-scope appraisal or analysis. It may be difficult to argue that settlement negotiations were conducted in good faith if value from a “calculation” changes after further work is performed. The errors involved in misstating value based on incomplete work are hard to undo and will cause problems with knowledgeable opposing counsel who are likely to explore the differences and reasoning in excruciating detail.

Often, a calculation analysis is offered by an expert who simply does not want to put in the effort of a full-scope analysis, and charge for the proper time it will take; or it is required by a client who does not want to pay more. In our experience in the Midwest, too often an unsophisticated appraiser or accountant will offer to do a calculation for a smaller business where limited funds are available. Philosophically, there is some “protection” for the analyst since the statement “' had a valuation engagement been performed, the results may have been different” suggests that the value conclusion is simply preliminary.

Sometimes both attorneys will retain “dueling appraisers” and ask both for a calculation in hopes of establishing the settlement range. Again, danger lurks for the unsuspecting professionals because both analysts' calculations could miss similar important elements relating to marital asset value, yielding both estimates as too high or too low. Keep in mind that different assumptions and procedures will be agreed upon. Also, smaller businesses often have poorer quality accounting and unusual asset mixes, presenting complexity that a quick calculation analysis cannot address. Adjustments may be necessary for accruals, non-recurring events, unrecorded assets and liabilities (such as note obligations between the owners and the corporation), quality of equipment, whether the business has excess equipment or excess “other” assets. These types of adjustments are required in a full-scope appraisal or valuation analysis, but too often are ignored or otherwise sidestepped in a calculation. Needless to say, they could they be material. These types of adjustments to initial tax filings or compiled/internal results affect levels of net assets, true leverage, pattern of growth, and quality of earnings ' all of which affect marital asset value. Simple calculations typically also ignore the depth of economic and industry conditions that affect value as of a certain date, particularly with the severity of the recent economic recession.

Recommendations

Matrimonial attorneys should recognize that any business valuation appraiser or accountant who is retained and instructed to perform a “calculation of value” is offering a preliminary value estimate based on crude tools. Fee quotes should be less, and turnaround time should also be quicker than a full “valuation analysis.”

There is a place for calculation engagements. As a consulting service, such analysis could be important as input for the attorney in the development of theory of the case. Calculation assignments are also useful where a specific issue needs to be addressed, such as researching a range of multiples for similar businesses that have been bought and sold. In situations where knowledgeable clients (who approve a calculation service) have a reasonable expectation of appropriate value that must be confirmed, a calculation analysis also has a place. In an asset-rich business without significant abnormalities, a calculation could be effective if marital equity is a smaller non-controlling interest and the attorney has a desire to gauge if pro-rata book value is a reasonable value. (In this last situation, additional entity goodwill will often be somewhat counter-balanced by a discount for lack of control, although not necessarily equally.) Matrimonial attorneys need to be wary when presented with a “calculation” of business value. Dangers exist for the unprepared!

Rob Schlegel, a member of this newsletter's Board of Editors, is an Accredited Senior Appraiser in Business Valuation by the American Society of Appraisers, and also holds the Master Certified Business Appraiser designation from the Institute of Business Appraisers. John Kotlarczyk is a Certified Public Accountant who is also Accredited in Business Valuation (ABV) and is Certified in Financial Forensics (CFF). Both are Principals in the Indianapolis, IN, office of Houlihan Valuation Advisors.