As CPAs continue to expand into providing financial and other advisory services, one area of interest is business valuation services. The author explains how business valuation factors into financial reporting, tax compliance, and litigation. He details the applicable legal and professional guidance and explains the valuation process in each practice area.
Valuation services are a growing component of many accounting firms’ business offerings. There are good reasons why a CPA firm might want to explore starting a valuation practice; for example, the field offers the potential for increased profits and compensation. This article provides CPAs with a general overview of valuation services related to financial reporting, tax compliance, and litigation. Knowing where certain valuation services complement a firm’s strengths is essential for establishing a strong and sustainable valuation practice.
Navigating the complex financial reporting process is a challenge for many companies. In the United States, companies prepare financial statements in accordance with Generally Accepted Accounting Principles (GAAP), which often drive the need for valuations related to financial reporting. GAAP pronouncements typically state the type of assets and liabilities that need to be valued, as well as the timing and the standard to be used. The Accounting Standards Codification (ASC), maintained by FASB, is the single current source of GAAP. The following are some of the most frequent valuation engagements performed for financial reporting purposes.
Fair value measurement.
ASC Topic 820, “Fair Value Measurement,” enhances disclosures and establishes a framework for measuring fair value on a consistent and comparable basis. Topic 820 is a broad, principles-based standard that applies to all entities, transactions, and instruments that require fair value measurement. It applies to financial and nonfinancial assets and liabilities measured at fair value, except those relating to stock compensation and other share-based payment transactions. Fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” The primary difference between fair value and fair market value is that fair value does not take into consideration discounts for lack of marketability or lack of control.
Assets and liabilities recorded at fair value regularly on a company’s balance sheet, such as investment holdings, are categorized based on the level of judgment associated with the inputs used to measure their fair values. Topic 820 establishes a three-tier hierarchy of inputs used to determine fair value measurements as follows:
- Level 1: Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities
- Level 2: Inputs are observable, unadjusted quoted prices in active markets for similar assets or liabilities
- Level 3: Unobservable inputs.
A company that has investments in marketable securities such as publicly traded stock would classify those assets under Level 1 and use quoted share prices in the market place to determine the fair value of their holdings. A private equity fund that has investments in privately held companies would classify those investments in Level 3 and value them for reporting purposes using such valuation methods as discounted cash flows or guideline company transactions. The fair value hierarchy is enclosed in the notes to the financial statements.
ASC Topic 718, “Compensation—Stock Compensation,” and ASC 505-50 provide guidance on how to account for transactions in which an entity exchanges its equity for goods or services. Topic 718, which applies to both public and nonpublic companies, requires companies that award their employees equity-based compensation to record the fair value of those awards in their financial statements. This applies to all stock options, restricted stock, stock appreciation rights, and other equity instruments used to compensate employees for their service. ASC 505-50 addressed equity-based payments to nonemployees; with the adoption of ASU 2018-07, which amended Topic 718 to cover nonemployees, entities will generally apply the same guidance to both employee and nonemployee equity-based awards.
Topic 718 measures the equity-based compensation expense to employees at the “fair value–based method” of the award on the date of grant, less any consideration paid by the employee. Employee stock options are generally not tradable in the public markets and thus have features that differ from those of publicly traded options. Topic 718 recommends that, when applying the fair value method, companies use an option pricing model when valuing an equity award. Valuation advisors typically use the Black-Scholes, binomial, and Monte Carlo models to determine the fair value of employee stock options.
In certain situations, the definition of fair value under Topic 718 is slightly different from the definition of fair value measurement in Topic 820. Even though the fair value concepts in both codifications are closely aligned, for practical reasons, FASB decided to exclude Topic 718 pronouncements from Topic 820 in their entirety.
The valuation of equity-based compensation awarded by nonpublic companies can be more complicated than for public companies, as privately held companies often have capital structures involving multiple classes of stock. Valuation specialists must first determine the enterprise value of the nonpublic company, then allocate that value to all the different equity securities. Enterprise value is allocated based on each security’s liquidation preference, derived from its rights. The option pricing model is a commonly used method for allocating value to multiple classes of securities in its capital structure.
Once the fair value of the equity award is determined, the expense is recognized ratably over the vesting period of the award in operating expenses in the income statement.
Companies that grant equity-based compensation often engage independent valuation advisors to analyze their underlying assumptions and develop option pricing models based on those assumptions. Even when working with valuation advisors, it is essential for management to understand the valuation methodology and ensure the assumptions used in the model comply with the requirements of Topic 718.
Determining the fair value of acquired assets and liabilities requires valuation advisors to use significant judgment and estimates, including in the selection of valuation methods.
Mergers and acquisitions.
The results of business combinations are reported in consolidated financial statements under ASC Topic 805, “Business Combinations.” Topic 805 applies to all transactions or other events in which an entity obtains control of one or more businesses; it requires business combinations to be accounted for using the acquisition method and outlines specific criteria for recording intangible assets.
According to Topic 805, the purchase price, which is the sum of the consideration paid, is allocated to all the identifiable assets and liabilities of the acquired business at their acquisition date fair values. The standard of value is generally fair value for business combinations; however, certain assets such as equity-based payments and employee benefits require other valuation measurements. The excess of the purchase price over the amount allocated to the assets and liabilities, if any, is recorded as goodwill. In the rare case where an acquirer makes a bargain purchase, the acquirer records a gain instead of goodwill.
Determining the fair value of acquired assets and liabilities requires valuation advisors to use significant judgment and estimates, including in the selection of valuation methods. Although most assets and liabilities may need some form of adjustment, areas that require careful analysis include contingent consideration, intangible assets, and goodwill.
Certain mergers and acquisitions include provisions under which the acquirer is obligated to purchase additional interests in a subsidiary contingent on future performance or upon satisfying other conditions specified in the purchase agreement. These provisions are reported as contingent consideration in the consolidated financial statements at fair value.
Intangible assets include trademarks, trade names, customer lists, licenses, trade secrets, and patented technology. Many intangible assets, such as customer lists, trade secrets, and software, lack physical substance. The challenge for valuation advisors is to identify and value these intangible assets separately from goodwill. An intangible asset acquired in a merger or acquisition is recognized independently from goodwill if that asset arises from contractual obligations or other legal rights, or if it can be sold, transferred, licensed, rented, or exchanged.
Goodwill is the excess of the cost of the acquired company over the fair values assigned to the assets and liabilities assumed. It can be thought of as amounts that do not qualify as identifiable intangible assets. Elements contained within goodwill can include the value of expected synergies of the business combination, the importance of the going-concern aspect of the existing business, and the assembled workforce.
The fair value of an intangible asset is determined using valuation methods such as the income, market, and cost approaches and recorded as long-term assets in the consolidated financial statements. For example, intangible assets in which it is possible to isolate discrete income streams are often valued using the multiple excess earnings method (MPEEM) under the income approach. This method is typically employed when valuing such intangibles as customer relationships. MPEEM measures the present value of the future earnings generated over the remaining life of the asset. Other valuation approaches include the relief from royalty rate method for trade names and the replacement cost method for software.
The tax valuation needs of an entity, whether public or private, are driven primarily by tax compliance, deferral, or minimization. These driving forces are the result of regulations promulgated by the Internal Revenue Code (IRC), Treasury Regulations, revenue rulings, Internal Revenue Bulletins, judicial proceedings, and other authoritative sources. Regardless of which is the primary factor, independent and objective valuation services are needed to ensure that entities do not suffer unfavorable tax repercussions.
Estate and gift tax valuation.
One of the most common engagements for tax purposes is the determination of the value of a business or business interest for estate or gift tax purposes. The federal government levies estate and gift taxes on the transfer of all property, real or personal, tangible or intangible, from one person or entity to another. Estate valuation is essential because it determines whether, and to what extent, the estate owes taxes. Appraisals are also necessary when a person or entity transfers property through a gift. Valuations for gift tax matters fall under most of the same regulations as valuations for estate tax purposes.
The IRC, Treasury Regulations, and revenue rulings define guidelines for estate and gift tax valuations. IRC section 2031 provides general guidance on the appraisal of nonpublic companies and their valuation dates for estate and gift taxes. Section 2031(a) defines the scope of what property is subject to estate tax, as well as the applicable valuation date, while section 2031(b) states that the value of similar publicly traded guideline company stock should be considered as a proxy for the value of a privately held company for estate tax purposes. IRC section 2512 relates specifically to the valuation of gifts and defines the valuation date for gift taxes as the date of the contribution. Other IRC sections also have estate and gift tax implications.
Valuations for gift tax matters fall under most of the same regulations as valuations for estate tax purposes.
Treasury Regulations are the IRS’s interpretations of the IRC and provide guidance on valuation issues for estate and gift tax determination. For example, Treasury Regulations section 20.2031-1 defines the standard of value for estate tax purposes as fair market value. The corresponding pronouncements for gift tax valuations are outlined in Treasury Regulations section 25.2512-1. Treasury Regulations section 301.6501 provides for a three-year statute of limitations beyond which the IRS cannot challenge a tax return, provided that the gifts are adequately disclosed. One of the requirements for adequate disclosure is that the donor submit a valuation of the transferred property prepared by a qualified independent appraiser.
Revenue rulings are administrative rulings by the IRS that apply the law to factual situations not requiring a specific change to the Treasury Regulations. A revenue ruling can be relied upon as precedent by all taxpayers. Although several revenue rulings relate to valuation, Revenue Ruling 59-60 is the single most important ruling relating to appraisals for estate and gift tax matters. Revenue Ruling 59-60 relates primarily to appraisals performed for privately held companies for tax purposes. The ruling provides guidelines on the approaches to valuation, capitalization rates, and risk factors to be considered when valuing a business or business interest. Because of its wide acceptance by the courts, valuation professionals, and users of valuation information, Revenue Ruling 59-60 is often cited as a relevant source for many other types of valuations.
Nonqualified deferred compensation.
IRC section 409A regulates nonqualified deferred compensation (NQDC) plans and establishes rules related to the timing of elections and distributions. “NQDC plan” is a general description for any arrangement that defers the payment of a portion of an employee’s compensation to a future date. NQDC plans have different restrictions, tax implications, and reporting requirements than qualified retirement plans such as pension and 401(k) plans.
NQDC plans must satisfy certain conditions to remain compliant with section 409A rules. If a plan fails to meet these conditions, all compensation that was deferred under the plan must be recognized as gross income, and a 20% tax penalty is imposed on the amount of deferred compensation recognized. Accrued interest may also apply in certain circumstances. As a result, the penalty for noncompliant plans can be very costly for both employee and employer.
The more familiar types of NQDC plan include stock options, stock appreciation rights, and other equity-based compensation awarded to executives and key employees. These equity award arrangements are exempt from the adverse tax implication in section 409A if certain conditions are fulfilled. NQDC plans are generally not allowed to change their deferral elections during the year.
Section 409A does not typically apply to incentive stock options and stock appreciation rights if they are granted at fair market value; however, if a company issues options to an employee at an exercise price below the fair market value of the underlying security on the date of grant, section 409A will apply. The underlying security in most cases for options is the common stock of the company. Therefore, the valuation of the common stock is critical.
For publicly traded companies, regulations require that the valuation of such stock be based on the contemporaneous prices established in the securities market. The valuation of privately held companies is significantly more complicated under section 409A. Setting a fair market value for privately held stock is necessary for determining the exercise price of the equity awards. The AICPA publication Valuation of Privately-held-Company Equity Securities Issued as Compensation (2013, http://bit.ly/2qgWIPN) provides guidance on how to value the equity of nonpublic companies. The practice aid offers specific instruction on the selection of methodologies to be used for equity valuation and allocation. Some of the more common methods of valuation are the option pricing method, the current value method, and the probability-weighted expected return method.
Considering that nonpublic company valuations are subjective and often based on estimates, the regulations provide for a safe-harbor valuation. For purposes of section 409A, the IRS must accept a safe-harbor valuation unless it can demonstrate that the appraisal is grossly unreasonable. The IRC provides three criteria to qualify for the safe-harbor valuation, one of which is securing an independent appraisal.
Litigation engagements often focus on damage claims and economic loss suffered by the plaintiff. In these types of engagements, valuation advisors are asked to determine the decline in value of a plaintiff’s business or determine the loss in profits. As litigation engagements often end up in court, it is essential that valuation advisors are independent of the parties to the lawsuit for expert witness credibility. Typical examples of litigation engagements include shareholder disputes, divorce, bankruptcy, and breach of contract.
Understanding how each jurisdiction defines the standard of value is critical in determining the valuation method that will be performed and the discounts and premiums that may apply.
All states have dissenting shareholder statutes. Shareholder disputes typically arise under two different types of case: dissenting shareholder actions and minority oppression actions. A dissenting shareholder action begins when a minority shareholder believes that the actions of the company will trigger an adverse effect on its interests. A trigger event can include a merger, reverse stock merger, or sale or disposition of assets. In dissent actions, the most common remedy is for the company to purchase the dissenter’s shares at fair value; a less common remedy is the rescission of the transaction.
Shareholder oppression actions are generally triggered when a minority share-holder in a nonpublic company seeks a remedy against the majority shareholder. In oppression suits, the minority shareholder needs to demonstrate that the majority shareholder abused its authority as an officer or is guilty of fraud, mismanagement, oppression, or similar misconduct. The standard remedy in most courts requires the company to purchase the oppressed shareholder’s shares at fair value. Although rare, liquidation of the company is another available remedy, with the proceeds distributed to all of the shareholders.
State statutes and judicial precedent set the standards for this area of valuation. In both dissenting shareholder and oppressed shareholder cases, the standard of value is generally fair value in most states; however, the courts have shown that the definition of fair value is open to judicial interpretation. Understanding how each jurisdiction defines the standard of value is critical in determining the valuation method that will be performed and the discounts and premiums that may apply.
Although shareholder dispute laws are state driven, the Model Business Corporation Act attempts to standardize fair value. The act defines fair value as the value of the corporation’s shares determined immediately before the effectuation of the corporate action to which the shareholder objects, using customary and current valuation concepts and techniques generally employed for similar businesses, and without discounting for lack of marketability or minority status except where appropriate. Most states have adopted the act’s definition of fair value.
The standard of value in New York is defined by case law as fair value in both shareholder oppression and dissenting shareholder actions. Fair value in New York does not allow the application of discounts for lack of control but does allow the consideration of a discount for lack of marketability. Friedman v. Beway Realty Corp. [614 N.Y.S.2d 133 (N.Y. App. Div. 1994)], which solidified the interpretation of fair value in New York, established the rationale for disallowing discounts for lack of control. The court rejected such discounts to protect minority shareholders from receiving unfair value for their shares when the controlling shareholders engage in adverse or oppressive actions. The court also ruled, however, that discounts for lack of marketability should be considered, leaving their future use to the sole discretion of the courts. Recent court cases have demonstrated that there is no uniform standard for applying a discount for lack of marketability; rather, such discounts appear to be applied on a case-by-case basis.
The definition of fair value and the valuation methodologies used for shareholder disputes are determined at the state level. It is essential that valuation advisors work with attorneys to become knowledgeable about the statutes and case law in the jurisdiction where the lawsuit will take place, to ensure that they use the correct methodology and the court accepts the valuation.
Valuation is a critical component of divorce proceedings, especially when a business or business interest is involved. Many of the valuation issues in divorce cases arise when there is a business owner spouse. In these cases, the business is often the primary source for transferring economic value from the business owner spouse to the non–business owner spouse.
Valuations related to divorce are entirely state-specific and depend on the facts and circumstances of each case. The standard of value can affect normal valuation procedures and often determines whether premiums or discounts can be applied. Fair value has been the primary standard used in litigation matters involving a marital dissolution; however, many state statutes contain the terms “fair value” or “fair market value,” which are often interpreted differently across jurisdictions and may differ from traditional definitions established in the IRC or GAAP. Therefore, it is critical for valuation advisors to understand what standard of value applies in the jurisdiction in which the case is being decided. In practice, valuation advisors work with attorneys to interpret the meaning of fair value; failure to identify and apply the correct valuation standard can result in the valuation being amended or excluded, resulting in a costly outcome for the client.
One of the key areas for valuation in a divorce involving a business owner spouse is goodwill. Goodwill for the owner of a business can include any intangible value attributable to name, reputation, customer loyalty, and other similar factors not separately identifiable. How much, if any, goodwill to include in a divorce valuation often has a material impact on the total value of the marital estate.
Valuation is a critical component of divorce proceedings, especially when a business or business interest is involved.
Whether or not goodwill is included in divorce cases depends on the particular jurisdiction. In addition, many states differentiate between enterprise goodwill, which is includable in the marital estate, and personal goodwill, which is less often included. Enterprise goodwill is that which is attributable to the business, while personal goodwill relates to the ability, skills, and experience of the owner and is considered difficult to transfer to other individuals. Court decisions dealing with this issue have demonstrated that how to divide goodwill is entirely dependent on the facts of each case.
The courts in New York generally recognize both enterprise and personal goodwill as includable in the marital estate. In O’Brien v. O’Brien [66 NY2d 576 (1985)], the court held that a professional license was marital property subject to equitable distribution, based on the “enhanced earning capacity” of the license. Subsequent courts used this ruling as a rationale in recognizing both professional and personal goodwill as marital property subject to distribution in a divorce.
There are no standard valuation methodologies to separate personal goodwill from enterprise goodwill; however, some techniques have worked in certain situations. One such method is analyzing the factors that pertain to goodwill and then allocating those factors between enterprise and personal goodwill. Some of the factors specific to personal goodwill are the owner’s age, earning power, reputation, and knowledge; noncompete agreements; and duration of the practice. These factors are then contrasted with the marketability of the company, type of customers, sources of new customers, workforce, and competition.
In addition to the valuation of businesses, valuation advisors provide critical services for divorce proceedings, such as critiquing reports of opposing experts, assisting counsel with depositions, assisting with the development of case strategy, and providing expert witness testimony.
Knowing the Landscape
A thorough understanding of business valuation services requires careful analysis of the applicable rules, laws, and regulations. Whether looking to add a business valuation service line or entering an engagement where business valuation plays a key role, CPAs should familiarize themselves with all of the above to ensure that the assets in question are properly valued and accounted for in the financial statements.