The 2020 AICPA Forensic and Valuation Services (FVS) Conference held this past November was loaded with great speakers and interesting sessions—so much so that we can’t include everything. Here are some key takeaways from the early sessions we attended.
Use of old transactions.
In some cases, you can use decades-old transactions as part of the market approach if an industry has not changed over the years. But, while these old transactions may be perfectly appropriate to use, a judge may simply not accept the notion, says Gary Trugman (Trugman Valuation Associates Inc.). Some judges have a real estate mindset and think that all comparable transactions need to be current—they can’t imagine that a transaction from 20 years ago has any relevance today. Karolina Calhoun (Mercer Capital) noted that she will show the historical data and how they have trended over time (possibly in five-year intervals) to support her use of the data in arriving at a conclusion of an estimated multiple.
Zone of insolvency.
This is a concept that may have escaped valuation experts who do not do a lot of bankruptcy-related work, points out Josh Shilts (Shilts CPA). But it is not uncommon for companies to engage a valuation analyst to advise them on this matter. A zone of insolvency exists when a company is not yet in bankruptcy, but it is insolvent, explains Robert Reilly (Willamette Management Associates). At that point, the directors shift their responsibilities from being directed exclusively toward the stockholders to include debtholders. That is, all of the actions of the management of the company have to consider both the impact of those actions on the debtholders as well as on the equity holders. Companies will engage a valuation analyst to help determine whether the firm is, in fact, in the zone of insolvency.
There is an increasing number of opportunities for analysts in valuing promissory notes, says Chris Mercer (Mercer Capital). As a result of many years of estate planning, there are “thousands and thousands of promissory notes out there” that are “coming of age,” he observes. Mercer was an expert in a 1996 estate tax case, Estate of Crosby, in which a U.S. District Court considered the valuation of a note held by an individual and payable by Champion International, a publicly traded company. The court rejected the valuation approach the IRS expert used and accepted the valuation by Mercer (at $3.6 million), whose analysis reflected greater detail in consideration of factors affecting the note. His method was to use the yield on Champion’s publicly traded debt as the “base” and then add to it based on the specific characteristics of the debt, much like adding company-specific risk to a discount rate. Mercer said he would be doing a white paper on this topic in the near future.
Problems with BI claims.
Business interruption insurance claims are on the rise, and analysts need to look out for misrepresentations. Michael Haugen (JS Held) points out that misrepresentation does not necessarily mean fraud—it simply can mean an honest mistake. Haugen, who is a CPA as well as certified in financial forensics and fraud, says that incorrect records can be one source of trouble. The primary tool to detect incorrect records is to do a book-to-tax reconciliation, he says—that is, examine the differences between the accounting records and what is reported on the tax returns. The business owner will typically assert that the tax returns are correct, so something is missing in the accounting books, such as year-end adjustments not being recorded. If you can’t reconcile the book and tax records, it doesn’t necessarily mean fraud is going on, but this may limit the extent that you rely on certain internal books.
He also notes that policy language is often vague about what documents the business needs to provide, sometimes just referring to “books and records.” This is good for the business owner because it makes compliance easier but may make it difficult for the analyst to measure losses without requesting additional information. He also advises that, before you gather data, have a conversation with the business owner (policy holder) about how the business operates so you can tailor the document request.
Some analysts believe that the past is not always reflective of the future—especially in today’s world—so they do not use an equity risk premium (ERP) based on historical returns. The ERP is a forward-looking concept based on the expected excess return on the stock market, so they use a forward-looking (“implied”) ERP. An implied ERP represents investment expectations as of a particular point, which is what analysts are trying to determine. Mark Zyla (Zyla Valuation Advisors LLC), in a roundtable session on the impact of COVID-19 on valuations, reports that he is looking at more forward-looking measures, such as the implied ERP from Aswath Damodaran (New York University, Stern School of Business).3
We point out that a recent report from Vanguard finds that annual returns of U.S. stocks over the next decade are forecasted to be in the “modest 3.7%-5.7% range.” This implies an ERP in the range of 2.2% to 4.2%, assuming a risk-free rate of 1.5% (the 20-year T-bond spot rate at the time of this writing). The forecast of stock returns “is quite different from the 10.6% annualized return generated over the last 30 years,” the report says.
During a session on the use of regression analysis in calculating damages, an audience member asked for suggestions on how to successfully explain regression in court. Mohan Rao (Epsilon Economics), who has testified in many cases, advises that you start with some background on the origin and history of regression and give some examples of how it helps to solve very interesting puzzles. In his experience, whenever he’s done this, the juries lean forward and are drawn into what you’re saying, which makes it easier to explain the parameters and the output. He also suggests that you use visuals as much as possible. Chris Tregillis (Hemming Morse LLP) agreed and stressed that the use of examples is very important in helping to make regression relatable to the jury and judge. If you can’t articulate good examples, then the jury will not be able to follow it, he says. He also noted that, while some judges are very adept at understanding statistics, you cannot assume that will be the case.
During their session, they referred to an interesting resource: the Federal Judicial Center Reference Manual on Scientific Evidence, which is designed to educate judges on complex scientific and technical evidence. It has a chapter on multiple regression as well as one on estimating economic damages.
Internal CEIV resources.
Nancy M. Czaplinski and Myron Marcinkowski, both with Duff & Phelps, talked about how best practices for fair value for financial reporting have been integrated into their firm. The best practices are contained in the Mandatory Performance Framework (MPF) for the Certified in Entity and Intangible Valuation (CEIV) credential. The speakers recommend developing an “all things CEIV” landing page on your firm’s intranet that links to templates, training, MPF documents, and so on. In terms of MPF training, Duff & Phelps developed short (10-to-15-minute) on-demand webinars so that the training is flexible and module-based. Sample report language is offered that is designed to comply with the MPF’s sometimes unique requirements. For example, if the client directs the expert not to value an asset (such as inventory or machinery) and the expert decides not to withdraw from the engagement, a disclosure of the scope limitation must be made in the report that includes comments on what the impact may have been. For instance, if the client directs the expert to use book value for inventory, an example of the language to include is: “As directed by Client, we have not valued the inventory of ABC Company. If we had been engaged to value the inventory of ABC Company, the valuation may have resulted in a step-up in basis of the inventory, this step-up in basis would affect the fair value of the other subject assets.” When offering sample language and exhibits, more is better, that is, give various options and alternatives that allows staff to eliminate items that are not applicable rather than having to add items and documentation.
New Sub V bankruptcy.
It was good timing that a new niche subchapter of the Bankruptcy Code went into effect in February 2020 as part of the Small Business Reorganization Act (SBRA). Subchapter V (added to Chapter 11) creates an easier and less expensive path for small businesses to reorganize and survive, which turned out to be a welcome lifeline during the pandemic. In their session, Kenneth DeGraw (WithumSmith+Brown PC) and Adam L. Hirsch (Davis Graham & Stubbs LLP) discussed Sub V and its implications on financial advisors. First of all, unlike Chapter 11, there is no creditor committee with Sub V (unless ordered by the court), so that potential client doesn’t exist, the speakers point out. While advisors would have the chance to help creditors file claims (which must be done in a shorter time frame than under Chapter 11), the focus would be on representing debtors and the plan of reorganization.
A new AICPA FAQ guide is being prepared on ESOP valuations, say Natalya Abdrasilova (Wipfli LLP) and Steven L. York (Stern Brothers Valuation Advisors), who have been working on the document, which is designed to provide clarity to certain issues. Business Valuation Update has covered a number of controversial valuation issues that have emerged from a series of court cases the government has been winning that claim ESOPs are purchasing sponsor company stock based on inflated valuations. These court cases have stung the ESOP valuation community. These cases have generated controversy over the tactics and valuation methods the Department of Labor (DOL) has been using. Members of Congress and the American Society of Appraisers (ASA) have objected to the DOL’s aggressive litigation-driven strategy and use of flawed valuation methodology.
Interestingly, two-thirds of poll respondents say they have not yet done any remote court testimony either for deposition or for trial. The poll was taken during a session on practicing in today’s virtual environment, conducted by Nicole D. Lyons (WithumSmith+Brown PC) and Hubert Klein (EisnerAmper LLP). Klein noted that more cases could be settling, as he has noticed a reluctance to go to trial because of the virtual format. Part of this is due to the potential technical glitches but also because of some people being uncomfortable having their court appearance put on video and recorded. If virtual testimony must be done, preparation is the key, the speakers say. For example, do a walk-through of the virtual platform with the attorney, check to see whether your internet connectivity is strong enough to support whatever platform is being used, and have an IT person standing by if possible. Also, redundancy is important, that is, have a backup connection method ready—such as dialing in by phone—in case your internet or device fails. (For additional tips on virtual testimony, be sure to read our blog here.)
For more tips and key takeaways from important conferences, as well as new thinking from leading professionals, analysis of new business valuation approaches, brief analysis of “landmark” legal cases in key business valuation issues, regulatory and standards updates, and much more, be sure to subscribe to Business Valuation Update, the voice of the business valuation profession since 1995.