Business valuations – Not for the faint of heart
Business valuations can be risky business for CPAs, especially for those who do not specialize in valuations. This is particularly true when a tax or consulting engagement expands into a business valuation at the client's insistence.
Unlike planned valuations by a specialist, a CPA may perform the valuation without a proper analysis of the risks involved. To complicate matters, clients and third parties may further expand the engagement by using the valuation for multiple purposes.
CPAs perform valuations of companies for many reasons. The methodology used and the resulting value often depends on the reason for the valuation. For instance, the value of a company for estate or gift tax purposes may be different from its value for a sale or buyout.
While findings typically are not transferable, as discovered by Adele Accountant, clients sometimes have difficulty understanding this concept.
Adele prepared an annual valuation for the employee stock ownership plan of Bickering Inc., her client. Adele did not usually perform valuations, but she agreed to the request of her long-term tax client as a courtesy.
When a shareholder dispute erupted – with no buy-sell agreement in place – two of the three shareholders, Buck and Dough, looked to Adele's valuation to determine the value of the company. According to Adele's report, the company's value had declined steadily in recent years.
Buck and Dough used Adele's valuation as leverage to negotiate a lower purchase price for the shares owned by Solvent, the third shareholder.
Solvent sued Adele, claiming that her valuation had weakened his negotiating position. Although Solvent was unable to establish that her valuation caused Solvent any damages, Adele still incurred substantial defense costs.
Adele's case contains common elements found in many business valuation claims: (1) The CPA does not routinely perform business valuations, but agrees to expand the initial engagement to include the valuation at the client's request; (2) the valuation is used for purposes beyond the scope of engagement; and (3) the claimant alleges an under or overvaluation of the business, affecting the dollars received or paid.
Two of the best ways to avoid business valuation claims are to screen clients carefully and to use customized engagement letters.
1. Carefully screen clients.
A good client for a tax engagement may not be an acceptable risk for a business valuation. As part of the client interview, the CPA should determine the specific purpose of the valuation, i.e., who will rely on the report. Potential conflicts of interest, present or future, should be analyzed. These may arise between business owners or between spouses in a family business for which the CPA has provided services to both spouses in the past.
The industry type and size also have a bearing on the risk. Some industries are more difficult to value than others. For example, because of the intangible nature of their assets, claims for disputed valuations are more likely to arise from valuations of service businesses than from valuations of manufacturing or retail businesses.
2. Use customized engagement letters.
Business valuations often arise from other types of engagements and may need customized engagement letters. In addition to the standard provisions, the engagement letter for a valuation should identify the client, narrowly define the intended purpose of the valuation and specifically identify the intended users of the report.
The letter should note the inherent weaknesses of the valuation process and emphasize that the valuation is not transferable. It also should state that the valuation is valid only for the stated purpose and only as of a specific date.
As a final protection against third parties, the valuation report itself should contain similar provisions, including,
- The identities of the intended recipients
- The purpose for the valuation
- A statement that valuation is an inexact science
- A statement that the report is valid as of a specific date and that the value will change over time
- A statement that the valuation is based on information provided to the CPA that is assumed to be accurate but has not been verified
Adele learned one last thing: Business valuations are not as simple as they appear. CPAs should obtain formal training in business valuations before accepting any such engagement.
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