For years, tax courts have expressed concern about adjusting discount rates for the risks associated with projected cash flows. Language in FASB ASC 820, Fair Value Measurement, suggests a conceptual preference for capturing risk in cash flows rather than in a discount rate adjustment. But there’s a perception that too many valuation experts simply accept the projections they’re given without question and then dump some extra percentage points into the discount rate for the DCF analysis.
As a result, the architects of the Fair Value Quality Initiative have addressed this by including in the Mandatory Performance Framework (MPF) some specific requirements for appraisers pertaining to prospective financial information (PFI). The MPF is designed as best practices for anyone doing fair value for financial reporting, but much of it can be applied to any type of engagement. For example, the MPF lists some of the steps you can use to test PFI for reasonableness. They include, but are not limited to:
- A comparison of the PFI to expected cash flows;
- A comparison of the PFI to historical performance;
- A comparison and evaluation of prior years’ PFI against actual historical results (when prior PFIs are available); and
- An analysis of the forecast relative to economic and industry expectations.
For more information: The May issue of Business Valuation Update includes an article, “Do You Share Business Valuation’s ‘Dirty Little Secret?’” which provides a checklist to help you better scrutinize PFIs. Also, there will be a session on this topic at the ASA/USC 12th Annual Fair Value Conference in Los Angeles on June 1. The session, Prospective Financial Information and Appraisers, will be conducted by Dave Dufendach (Alvarez & Marsal Valuation Services), who will discuss best practices associated with PFI and its incorporation into the valuation process.
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