Litigation matters often require that the value of specific assets or business be determined. The standards by which such valuations are arrived at can be complicated and sometimes confusing. This article introduces the idea that a calculation of value report—which can rely on limited procedures in certain situations and unlimited procedures in others—meets the requirements of reliability and fitness under the Federal Rules of Evidence (Rule 702) and the “reliable and relevant” test under the Frye standard [Frye v. U.S., 293 F. 1013 (D.C. Cir. 1923)]. It is important to emphasize that the authors believe that this holds true so long as the forensic accountant is free to apply his own approaches and methods to determine a value or range of value.

There are situations in litigation that may not require all of the procedures used in a valuation engagement; thus, a calculation engagement can provide sufficient evidence to be used in an expert opinion submitted to a court or arbiter. Recent court decisions have relied upon a calculation of value in expert testimony. The main issue centers on whether the forensic accountant is free to determine the valuation approach and methods and has access to suitable information to determine value.

Description of Valuation Report Requirements

The AICPA’s Statements on Standards for Valuation Services (VS) section 100, paragraph .21(a) states that a valuation engagement is performed when—

(1) the engagement calls for the valuation analyst to estimate the value of a subject interest, and (2) the valuation analyst estimates the value and is free to apply the valuation approaches and methods he or she deems appropriate in the circumstances. The valuation analyst expresses the results of the valuation as a conclusion of value; the conclusion may be either a single amount or range.

VS 100, paragraph .21(b) states that a calculation engagement is established by an understanding with the client based on the fact that—

(1) the valuation analyst and the client agree on the valuation approaches and methods the valuation analyst will use and the extent of procedures the valuation analyst will perform in the process of calculating the value of a subject interest (these procedures will be more limited than those of a valuation engagement) and (2) the valuation analyst calculates the value in compliance with the agreement. The valuation analyst expresses the results of these procedures as a calculated value. The calculated value is expressed as a range or as a single amount. A calculation engagement does not include all of the procedures required for a valuation engagement.

Paragraph .21(b) indicates that a calculation engagement does not include all of the procedures required for a valuation engagement, but this does not necessarily mean the result is less valid. When the agreement between the valuation analyst and the client restricts the judgment of the analyst, the authors believe the court views the report as unreliable. (Examples of such restrictions could be to limit the analysis to certain books and records or to one valuation method.) Therefore, if a valuation case is headed to court, there are reliability hurdles to clear in order to prevent the report from being excluded. There are two standards used to make this determination: the Frye standard and Rule 702.

Expert Admissibility

The Frye standard resulted from Frye v. U.S. [293 F. 1013 (D.C. Cir. 1923)], wherein the District Court of Columbia rejected the scientific validity of a poly-graph test because it was not widely accepted as a valid technology for detecting lies. In order to apply the Frye standard, a court must decide whether the procedure, technique, or principles in question are generally accepted by a significant percentage of the leading scientists in the relevant field of study.

The Federal Rules of Evidence were adopted for litigation in the federal courts in 1975, more than 50 years after the creation of the Frye standard. In response to Daubert v. Merrell Dow Pharmaceuticals, Inc. [509 U.S. 579 (1993)] and subsequent cases such as Kumho Tire Co. v. Carmichael [526 U.S. 137 (1999)], Rule 702 was amended in 2000. Currently, Federal Rule of Evidence 702 requires that a witness who claims to be an expert based on knowledge, skill, experience, training, or education may testify in the form of an opinion or otherwise if she meets four criteria:

  • The expert’s scientific, technical, or other specialized knowledge will help the trier of fact to understand the evidence to determine a fact in the issue;
  • The testimony is based on sufficient facts or data;
  • The testimony is the product of reliable principles and methods; and
  • The expert has reliably applied the principles and methods to the facts of the case.

In Daubert, trial judges were charged as gatekeepers to exclude unreliable testimony based upon the above criteria. Kumho later refined the gatekeeper function to apply to all expert testimony. Rule 702 is thus often referred to as the Daubert standard.

Several recent court cases have accepted a calculation of value report as admissible in expert testimony. While most courts rely on the Federal Rules of Evidence to evaluate an expert’s opinion, several states use the Frye standard; these are California, Illinois, Maryland, Minnesota, New Jersey, New York, Pennsylvania, and Washington.

Expert Testimony and Valuation

There appears to be significant confusion regarding expert testimony among forensic accountants who provide valuation services for litigation matters across the United States. Some professionals believe that a calculation of value report is well suited when there is a high likelihood that expert testimony will be needed; others believe that a detailed report containing a conclusion of value is required.

Linda B. Trugman, Edward J. Dupke, and Curtis R. Kimball have asserted that while there is no exclusion against testifying to a calculation of value in a litigation matter, forensic accountants should not do so (Valuations vs. Calculations: Advice & Guidance from Professional Standards, Business Valuation Resources Webinar, Jul. 11, 2013). They believe that since a calculated value is lacking in all the procedures included in a valuation engagement, it is not a valuation conclusion and will most likely be difficult to defend when providing expert testimony. Furthermore, they state that “a calculated value will also not likely be acceptable to the IRS or the SEC for the same reasons.”

Calculation and conclusion of value engagements do, however, both estimate value. The primary difference is that a calculation of value can be limited in scope by agreement with the client, whereas a conclusion of value is by nature unrestricted in its approach to value. Therefore, a calculated value is also an opinion of value, contrary to what some believe.

This fact has been misrepresented in litigation and contributes unnecessary confusion to an already adversarial process. It can be argued that the language in VS 100 conveys—in a broad sense—the idea that a valuation expert is restricted in scope whenever he completes a calculation engagement. In practice, however, the authors have found this does not hold true.

When forensic accountants provide expert testimony, it appears that the use of a calculation of value report does, in fact, clear the Daubert/Frye hurdles of reliability, fitness, and relevance. The critical point is that the expert cannot be prevented from applying professional judgment in the selection of valuation approaches and methods (Tom Hilton, “Calculation Reports in Litigation: Are You Cruisin’ for a Bruisin’?” Financial Valuation and Litigation Expert, Feb./Mar. 2013).

Recent court decisions where calculations of value reports were at the center of the court’s findings should be interpreted against this background.

Hipple v. SCIX, LLC

This case [Hipple v. SCIX, LLC, U.S. District Court, E.D. Pennsylvania (2014)] arose out of the alleged fraudulent transfer of the defendant’s assets, and the proceeds of those assets, to the remaining defendants in a post-divorce related matter. The plaintiff’s expert completed a “Calculation of the Value of SCIX” to find a reasonably equivalent value for the “transfer of SCIX’s assets as of October 13, 2010.” The defendant argued that the plaintiff’s expert’s proposed testimony failed both the fitness and reliability restrictions set forth in Daubert because he completed only a limited “calculation of value” rather than a more extensive “opinion of value.” The court rejected the defendant’s argument and concluded that the proposed testimony of the plaintiff’s expert was admissible. It stated that “both a Calculation of Value and Opinion of Value are engagements approved of by the American Institute of Certified Public Accountants.”

The court relied on United States v. Mitchell [365 F.3d 215, 244 (3d Cir.2004)]: “As long as an expert’s scientific testimony rests upon ‘good grounds, based on what is known,’ it should be tested by the adversary process—competing expert testimony and active cross-examination—rather than excluded from jurors’ scrutiny for fear that they will not grasp its complexities or satisfactorily weigh its inadequacies.” The expert relied on a multiple of seller’s discretionary income as grounds, and the valuation agreement was not restricted by the client. It is important to note that while the expert used only one approach to value, it was his own independent estimate of value. Many critics of calculated values question the independence of the expert when using an approach to value agreed to by the client. This does not impede or restrict the expert’s independence if the valuation analyst is free from client-imposed scope limitations. This also applies to non-fraud cases.

Ward v. Ward

This case [Ward v. Ward, 350 Wis. 2d 505 (2013)] involved a luxury pet resort, Pampered Paws, located near Wisconsin Dells, Wisc. The respondent-appellant challenged the circuit court’s division of property and maintenance award following a divorce judgment and reconsideration order. He contended that the valuation of Pampered Paws presented by the petitioner-respondent’s expert failed to make a finding of fair market value for Pampered Paws in circuit court due to the fact that it was only a calculation of value and not a conclusion of fair market value. The appellate court ruled that “circuit courts are not required to accept any one method of valuation over another.” The petitioner-respondent’s expert testified that the calculation of value was the appropriate approach for a business of this type, and the circuit court was persuaded that this methodology produced a reliable indicator of fair market value. The expert used the capitalization of earnings methods with no scope restrictions placed by the client.

In re the Marriage of Curtis D. Martin and Dawn Davis-Martin

The main dispute between the parties in this case [WL 576065 (Iowa) (2015)] was the value of the husband’s interest in Bennett Machine and Fabricating, Inc., a closely held corporation run by his family. The general rule in dissolution cases is that stock should be valued at market value if it can reasonably be ascertained. After performing a de novo review, the appellate court disagreed with the district court’s adoption of the first valuation of Curtis Martin’s stock in Bennett Machine, finding that the valuation was completed for a different purpose and before the redemption of the parents’ stock. On appeal, the court affirmed: “It is illogical to accept a business valuation that does not consider all factors necessary to determine fair market value simply because family members agreed to use it for a completely separate purpose: to sell shares back to the company they own or to each other.”

Based on the court’s analysis, both experts used a calculation of value. The court on appeal agreed with the valuation expert that used an income method and was not restricted in scope by any agreements or client influence.

Merion Capital, LP v. 3M Cogent, Inc.

This matter is a post-trial decision from the Delaware Court of Chancery in an appraisal brought pursuant to 8 Del. C. section 262 and arising out of a merger in which a global technology corporation and its acquisition subsidiary acquired a biometrics technology company [not reported in A.3d (2013)]. The petitioners’ expert used a discounted cash flow (DCF) approach to value the company. The respondent’s expert applied a DCF analysis, a comparable trading analysis, and a comparable transactions analysis, weighting each approach by one-third. It appears that both experts submitted detailed reports, as the petitioners’ expert stated that he believed there were no truly comparable companies or transactions to compare, and, to the extent there were any potentially comparable companies and transactions, he lacked sufficient data from which to make comparisons. The court stated that, generally speaking, “it is preferable to take a more robust approach involving multiple techniques.” Furthermore, the court found that the respondent’s comparable trading and comparable transactions analyses were not reliable and gave no weight to either valuation method. The court did, however, decide upon a fair value using the DCF approach that was much closer to the respondent’s estimate than the petitioners’ expert’s estimate.

The authors note the outstanding reputation of the Delaware Court of Chancery in valuation cases. It is also crucial to note that conclusion of value does not appear in the language of this case; rather the valuation is referred to as a calculation. The DCF was used and referred to as “the Court’s calculation of the valuation of ” the company at issue. Furthermore, both experts used what was referred to as a “fair value calculation.” It appears that no restriction was imposed on the valuation methods used in the report, which were used by both experts.

A Clear Standard

The authors believe that the critical criterion for a valuation expert’s report to be acceptable for litigation purposes is not its format (i.e., whether it is a calculation report or detailed report); instead, it is whether the expert is prevented by the client from presenting an objective, independent methodology.

Based on the above court findings, it seems clear that the report format was not the most important criterion used by the courts in evaluating expert opinions. Instead, the courts focused, correctly, in the authors’ opinion, on whether the experts’ judgment in providing their opinions of value was compromised.

Further support for this point can be found in Surgem, LLC and John Hajjar, M.D., v. Achievmed Inc. and John Seitz [2013 NJ Superior Court, Appellate Division (Oct 16, 2013)]. The court found the calculation of value report prepared by the defendant’s expert insufficient and unreliable to establish the fair value husband’s interest in Surgem, LLC. The defendant’s expert testified that limited procedures were agreed upon with the defendant to develop the report and indicated that the client limited accessibility to information. The expert was restricted, and the court found the report unreliable.

Calculations of value reports have the potential to put forward serviceable information when prepared without scope limitations. The sentiment that a detailed conclusion of value should be the only type of valuation report used for disputes in the deposition and court environment seems misguided. It may therefore be time for regulators to update valuation standards to provide additional levels of valuation reporting.

James A. DiGabriele, PhD/DPS, CPA/ABV/CFF is a professor of accounting in the Department of Accounting Law & Taxation at Montclair State University, Montclair, N.J., as well as the managing director of DiGabriele, McNulty, Campanella & Co. LLC, Fairfield, N.J.
Peter L. Lohrey, PhD, CVA, CDBV is an assistant professor, also in the Department of Accounting & Finance at Montclair State University, as well as the Director of Forensic and Valuation Services at Paritz & Co., P.A., Hackensack, N.J.