Business valuation errors can be costly to you and your clients: Here’s how to avoid them. Whether it’s an error in the valuation of Snapchat parent Snap or an error in the valuation of a mom-and-pop restaurant up for sale, a mistake in valuing a business can be costly — to the buyers, the sellers, and the valuation and accounting professionals involved.
As business appraisers and many accounting professionals know, valuing businesses is a complicated process. That complexity — along with the costliness of errors — is among the reasons accountants and others performing business valuations spend hours to earn professional accreditations. Those factors are also behind the development of professional business valuation standards by the AICPA and other organizations.
Ultimately, however, reducing professional liability related to valuations starts with the accountant or valuation professional having an understanding of the business being valued and the purpose for the valuation, according to Jim Alerding, a former member of both the AICPA Business Valuation Committee and the AICPA Business Valuation Standards Writing Task Force. Ongoing attention to detail throughout the valuation process also plays an important role.
“There is a minefield of potential errors and biases and rigging in the valuation process,” Alerding said recently during a Sageworks webinar providing tips for spotting errors and avoiding them when performing your own work. Errors or “rigging” of valuations can occur in each of the standard approaches to business valuation: the asset approach, the market approach, and the income approach, Alerding explained during the webinar, “Common Errors (and Sometimes Rigging) in Valuations.”
“The best way of finding errors or riggings is to look to the process — the process of actually completing the valuation and reporting on it,” said Alerding, who is an inductee into the AICPA Business Valuation Hall of Fame and the author of several books on valuation. Valuation reports generally provide a good roadmap for reviewing valuations, but in some cases it may be necessary to review the work papers as well, he added.
Alerding noted that within the asset approach for valuations, several methods can be used, and he touched on some of the potential errors that can occur when using each of those methods. For example, one problem that can arise when using the net asset method of the asset approach is that a practitioner may fail to identify all of the assets — tangible and intangible. Another issue might be that appraisers helping determine the value of real estate or machinery and equipment type assets could be using any of up to six different standards of value:
- Reproduction cost new
- Replacement cost new
- Fair market value
- Fair market value in continued use
- Orderly liquidation value
- Forced liquidation value.
The standard that the appraiser selects might not be appropriate for the purpose of the valuation, he said. Consider a milk-processing plant that has most of its machinery and equipment built into the walls of the plant, making it very difficult to remove the machinery and equipment. Even if the equipment can be removed, he said, “You basically have scrap value.”
“So as a result, if you’re looking at the fair market value on a going-concern basis, your assets that are built in [to the plant] are going to be a much different value than if you were looking at scrap value or trying to move it” out of the plant as a result of a liquidation or other event, he pointed out.
Using incorrect methods for valuing intangible assets is another situation that can lead to errors when using the asset approach, he noted. Furthermore, “Determining the value of goodwill is extremely difficult in a net asset method, so if you believe there is goodwill in the business you may have to give a second thought to using the net asset method approach.”
When using the market approach, common errors include using too few or too many guideline companies for the guideline-company method. Another common problem is using public companies that aren’t sufficiently comparable to the company being appraised, so it’s important to consider the size and specific industry of comparables, he emphasized.
Just as it is important to normalize the financial statements of a company being valued, Alerding said that guideline companies’ financial statements must also be normalized to ensure nonrecurring earnings aren’t included or to evaluate the number of shares and how that might have changed. Selecting incorrect multiples and failing to exclude non-operating asset income and expenses from the subject and guideline companies can also lead to errors, according to Alerding.
The vagaries of using the merger and acquisition method of the market approach mostly lie with the databases used by valuation professionals, Alerding noted. Using multiple databases to come up with transactions can cause big problems, so he recommended understanding the intricacies of any databases used.
One of the most common approaches used by business valuation approaches is the income approach, because many appraisers are examining smaller businesses. Challenges can arise in several of the components of this approach, which is forward-looking and requires the valuation professional to determine a discount rate, a cost of capital, and a growth rate. In addition, potential pitfalls exist in determining several of the risk premiums (industry, size, and specific company) that are typically included in calculating the cost of capital, Alerding noted.
As is the case with many aspects of a business valuation, the analyst must be able to explain and support the choice of any risk premia, he said. Indeed, a common theme repeated by Alerding is: “Make sure you support and document whatever it is you’re doing and how you got to it.”
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