EXECUTIVE SUMMARY
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INCREASED ACTIVITY IN ESTATE
and succession planning and mergers or
acquisitions involving small to midsize
businesses has fueled demand for business
valuation (BV) services. BV malpractice claims
arise most often from a tax planning or
consulting engagement that—at the client’s
request—morphs into a BV in mid-transaction.
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THE PREDOMINANT ALLEGATIONS IN BV CLAIMS
are over- or undervaluation of assets
or liabilities directly affecting the dollars
paid or received. Service-related businesses
have more intangible assets that contribute to
goodwill than manufacturing or retail businesses
do.
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THE BEST SAFEGUARD AGAINST BV DISPUTES
is an engagement letter specific to the
project that defines its scope, briefly explains
the different valuation approaches and methods
that can be applied to a BV, and identifies
those being used. Draft a customized letter for
each engagement before any services are
rendered.
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BV PRECEDENT FOR STANDARD VALUATION
methods was established through common
usage and case law. Consult a lawyer when
drafting a BV engagement letter.
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DISCUSS THE PROVISIONS of the
engagement letter in a face-to-face client
meeting to address any client questions.
Document this discussion in the client workpaper
file. The absence of an engagement letter can
compromise the defense of a claim if a dispute
develops.
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VET A NEW CLIENT THOROUGHLY,
and get references for those from
outside your geographical area. With existing
clients use procedures as thorough as those for
a new client. If a conflict exists, don’t take
that job.
| Joseph A. Wolfe is director of risk
management, accountants’ professional liability, at
CNA Pro., and Sherry Anderson, CPCU, is
vice-president of claims.
|
hen opportunity knocks, a CPA may want to
check what’s out there before answering the door. The good
news is that increased activity in estate planning,
succession planning and mergers or acquisitions involving
small to midsize businesses has fueled client demand for
business valuation (BV) services in recent years. A small
number of CPA firms specialize in performing BV engagements,
and for the many firms considering the risks and rewards of
tackling this niche as a new practice area others’ missteps
can provide valuable life lessons. BV engagements
generated less than 1% of total billings from 1995
through 1999 but were behind 3% of all malpractice
claims—90% of those claims did not result from the
services for which the CPA firm originally was
hired.
Source: Continental Casualty Co. (CNA)
1995-1999 claims statistics.
| Data on
malpractice claims made against CPA firms arising from
disputed valuations offer a roadmap for avoiding trouble
spots. Culled from 1995–1999 claims for more than 22,000
firms insured with Continental Casualty Co.
(CNA—underwriters of the AICPA’s professional liability
insurance program), the data highlight a scenario that’s
easy to avoid. Most of those claims arose from a tax
planning, management advisory or other consulting engagement
that had morphed into business valuation in mid-transaction
at the client’s request. In such cases, business
owners ready to sell their companies—and comfortable with
their CPAs—had pressed the firms for BV assistance,
regardless of whether the CPA was experienced in valuation.
Firms with insufficient training to perform the BV let
themselves be coaxed into it by the client’s assurances the
CPA’s knowledge of the business was the ideal qualification
for the job. In instances involving the valuation of a
closely held business, CPAs said they were caught
unexpectedly, with no sense of a problem during the
engagement. In other claims, the CPA accepted his or her
first BV engagement because the client insisted the
valuation was only a formality for a simple transaction
already agreed on by buyer and seller.
WHERE IS THE RISK?
The data show
malpractice claims arise from disputed valuations of
service-based businesses more often than from manufacturing
or retail businesses (see exhibit 1, below). Because
service-related businesses have more intangible assets that
contribute to goodwill, valuing them appropriately is
critical to avoiding post-transaction disputes.
Exhibit 1:
Claims by Industry Type |
| Source: CNA
Pro. | Key
employees, an established client base or a proven track
record of providing high-quality service are the basis of
goodwill for all business sectors. How to factor such
intangibles into the overall valuation is a point of
contention in a number of claims. In many businesses,
goodwill is tied directly to the owner’s involvement in
managing the company as well as his or her relationships
with the business’s clients and vendors. When the owner
leaves the business the relationships exit too, and the
nature of the company changes. It’s then that disputes
between buyers and sellers can crop up. Exhibit 2: Claims
by Cause of Loss |
| Source: CNA
Pro. | The
predominant allegations in BV claims are over- or
undervaluation of assets or liabilities directly affecting
the dollars paid or received (see exhibit 2, above). Other
disputes may be categorized as
Communication problems. These relate
to engagement-scope disputes, primarily over the extent of
the CPA’s role in negotiations between buyer and seller.
Conflicts of interest. Problems
typically arise when a CPA neglects to disclose up front
that both parties to the prospective transaction are the
CPA’s clients. In such situations the claimant may allege
that, based on previously rendered tax or accounting
services, the CPA had enhanced knowledge of the business
being valued and purposely omitted relevant information to
benefit the other client.
Alleged fraud. These usually assert
the CPA had an undisclosed financial interest in a business
and benefited from a sale based on the CPA’s valuation.
A
Cautionary Tale A CPA firm performed
bookkeeping, write-up, compilation and business
and personal income tax services for many years
for two clients. One client owned a small
industrial equipment dealership, and the other had
a parts-and-service company that specialized in
such equipment. Different partners at the CPA firm
served each client. In 1990 the owner of the
industrial equipment dealership told his banker he
wanted to sell his business and retire out of
state. The banker knew the owner of the
parts-and-service company wanted to expand and
suggested that the two meet to discuss a possible
sale. The owners reached an understanding
and requested a joint meeting with the two
partners at the CPA firm to discuss their
arrangement. Both partners told the clients they
could not provide advice about the transaction
because of the conflict of interest. Each client
asked his CPA to disclose company financial
records held by the firm to the other party. The
CPAs agreed to do this only if both clients signed
a letter acknowledging this conflict of interest,
waiving any objection to it and stating the CPAs
were not providing advice or recommendations on
the sale or its terms. Unfortunately, neither the
CPA firm nor the clients kept a copy of this
letter. Subsequently the CPA firm provided
the requested information to both clients. The
firm reviewed the sale contract and advised both
parties on the tax consequences of the
transaction. The final purchase price was
$750,000, with 25% payable up front and a note
providing payment of approximately $140,000 per
year for four years. The transaction was a stock
sale.
Six months later The
transaction soon began to unravel. The seller had
failed to report outstanding accounts receivable
on some service jobs. The new owners had to
renegotiate financing at less favorable terms than
those obtained by the prior owner. Cash receipts
allegedly received in the two months before the
sale were missing when the buyer took over
operations, as were maintenance tools and other
equipment. The buyer defaulted on the note in the
first year, and the seller filed suit to recover.
Both parties ultimately agreed to dismiss this
lawsuit without payment. However, the
buyer then filed suit against the CPA firm,
alleging improper advice regarding the value of
the business, a conflict of interest in
representing both parties to the transaction and
fraudulent concealment. The lawsuit sought
recovery of more than $2.7 million. The buyer
alleged the CPA firm convinced him to agree to
structure the sale as a stock sale rather than an
asset sale to increase the company’s value for the
seller’s benefit, and that this caused him to
overpay for the business and incur excessive
taxes. The buyer acknowledged the CPA firm had
alerted him to the conflict of interest but said
the firm had not been objective. He claimed that
if the firm hadn’t told him it was a “good deal,”
he wouldn’t have bought the business. The
CPAs said that both parties had agreed to the
transaction’s amount and structure before
consulting them, and that the firm had advised the
buyer to take a physical inventory before closing
the sale but the buyer ignored the advice. This
case was tried before a jury, which awarded a
six-figure judgment to the plaintiff.
Lessons learned from this case study are:
Use careful acceptance procedures
with existing clients who request BV services. A
client that’s an acceptable risk as a tax and
compilation client presents a different level of
risk in valuation.
Avoid conflicts of interests when
providing advice to clients regarding a
prospective transaction. If the CPA firm chooses
to obtain the clients’ consent to perform services
when a conflict exists, the firm should retain
signed copies of the disclosure statement and not
exceed agreed-on engagement-scope limitations.
Maintain complete records of all
client communications throughout any engagement
that involves a proposed business sale. Issue
carefully worded engagement letters, and obtain
client signatures before rendering services.
Don’t allow clients to push you into
making management decisions for them, especially
when a conflict of interest exists. Provide
advice, not decisions.
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THIRD-PARTY CLAIMS
Surprisingly, third
parties rather than clients filed 30% of the BV engagement
claims in our data sample. (Only audit engagements trigger
an equally high proportion of claims from nonclients.) Such
claims generally originated with one of two types of third
parties:
A nonclient party to a business sale.
For instance, prior to the sale of a family
business the children of a client were paid for their
minority stock holdings based on a BV report prepared for
the client. When the new owner turned around and sold the
company based on a significantly higher per share stock
price, they sued, claiming the BV had undervalued the stock.
Lenders and investors. In many other
claims nonclient parties alleged reliance on the CPA’s work
when making an investment decision. In such cases, the
nonclients performed no due diligence and had no
professional advisers to assist them. In other claims, the
nonclient alleged the CPA either had an undisclosed indirect
conflict of interest (such as partial ownership of a
business that subcontracted with the client) or had
communicated opinions or conclusions to the third party
inappropriately. Third parties also claimed that
businesses were overvalued or undervalued based on goodwill
intangibles. Other claims focused on the practitioner’s
failure to consider key employees in the BV, alleging that
when key employees left after the sale there were
operational problems, mismanagement and lost client
relationships. Some buyers claimed the CPA had failed to
properly investigate and comment on ownership of patents,
copyrights or technology under development.
LETTER OF THE LAW
A review of claims shows
that many CPAs failed to use engagement letters. Because
disputes about scope or methodology used to value
intangibles are common in such assignments, a CPA is wise to
protect himself or herself—and the client—by issuing a
letter defining the scope of the project, briefly explaining
that different approaches and methods can be applied to a
BV, and identifying and explaining those being used. The
absence of engagement letters can compromise the defense of
a claim if a dispute develops. Accounting principles
and tax codes set the standards for traditional accounting
and tax services, but BV precedents for standard valuation
methods have been established through common usage and case
law. Case law pertinent to valuations prepared by actuaries,
claims adjusters, real estate agents and real estate
appraisers can affect the acceptance of valuation
methodology by judges and juries when hearing a BV
controversy. The AICPA Statement on Standards for
Consulting Services (SSCS) identifies valuation as a
consulting service, and both SSCS and the AICPA Code of
Professional Conduct apply to CPAs and firms rendering BV.
However, these standards do not include technical standards
and rules of practice. Although the IRS and the Appraisal
Standards Board of the Appraisal Foundation provide
regulations, revenue rulings and professional standards that
CPAs must adhere to when they value businesses in
circumstances such as estate and gift tax return preparation
and reporting to federal regulatory agencies, there are no
universally applicable standards for performing BV services.
Accordingly, engagement letters for this practice area
are essential, and each business valuation should have an
engagement letter specifically drafted for it with the
assistance of legal counsel. It should:
Outline the roles and responsibilities of the
CPA, the client and other professionals involved in a
prospective business sale.
Detail the scope and objective of the
engagement and any key terms used in the letter, such as
fair value.
Include appropriate disclosures regarding the
scope of services performed, the approach and methods used
in performing the BV, and the information supplied by others
that will be relied upon by the BV practitioner.
Establish that use of the CPA’s report is
restricted to specified parties or an intended class of
parties, such as prospective purchasers of the business.
Include disclosures regarding the risk that
taxing authorities or third parties could challenge the
valuation method.
Include provisions for withdrawal.
RISK MANAGEMENT BASICS
A CPA who wants to meet
a high standard of care when performing a business valuation
has to apply appropriate methodology (see
“Tips for the Valuator,” JofA, March00, page 35)
. Several basic practice management techniques can help
CPAs avoid malpractice claims in this specialty.
Obtain solid training. Before
accepting an engagement, CPAs need formal training in
performing BV services—a client’s reassurance to the
contrary notwithstanding. A number of organizations offer
training and credentials in this specialty area (see “Where
to Learn More,” below).
Perform client screening. A CPA
should not accept a BV engagement unless he or she first has
information on a number of issues, such as:
The reason for the engagement. Early
in the client interview, find out why the client wants a
business valuation, and when, how and by whom the valuation
report will be used; consider the liability implications of
those factors. For instance, if investors or lenders will
use the valuation as a basis for determining the value of
equity shares in a closely held business, recognize that in
most states these parties will likely have the right to sue
the firm that prepared the BV if a subsequent valuation
dispute arises. If the BV is intended solely for the
use of a particular party, both the engagement letter and
the BV report should include a paragraph restricting the use
of the report. Consider adapting the example in AU 532.19 of
the AICPA professional standards, which reads: “This report
is intended solely for the information and use of [the
specified parties] and is not intended to be and should not
be used by anyone other than these specified parties.”
The client’s reputation and ethics. If
the engagement is for a new client, a practitioner should
inquire about the client’s prior experience in his or her
industry and whether other professionals will be providing
services relevant to the prospective transaction. Use your
business contacts to verify the information provided and
determine the client’s reputation for integrity and prompt
payment. If the business or client is from outside your
firm’s conventional geographic practice area, thorough
scrutiny is called for. Request references such as lenders,
attorneys, vendors or clients; verify the existence of the
parties supplied as references; and contact them by
telephone to obtain background information. In addition,
consider investigating the prospective client’s credit
rating and performing background checks on officers or
owners of the business. Always disclose to the prospective
client that you’ll be performing background or credit
checks.
Conflicts of interest. Conflicts may
arise from a request to perform a valuation of a family
business in connection with a divorce when the CPA firm has
provided tax advice to both spouses in the past and intends
to continue rendering services to the business and the
spouse controlling the business after the divorce. Avoid
engagements where a conflict of interest exists; although
disclosure and consent make the engagement acceptable under
the AICPA’s Code of Professional Conduct, conflicts increase
liability risk. It’s safer to decline in such instances.
The client’s level of sophistication.
Is a potential client experienced in interpreting
financial data? If the client enters into negotiations based
on the requested valuation, can he or she compare the
relative value of offers made, especially if buyers make
offers based on their own due diligence? An unsophisticated
client considering a merger or acquisition presents greater
risk, as he or she places a high level of reliance on
professional advisers and may have limited experience in
managing a business similar to the one being evaluated.
Mergers or acquisitions involving unsophisticated clients
are more likely to be unsuccessful and result in malpractice
claims against the BV practitioner. As in all areas of
practice, clients with unrealistic expectations are more
likely to sue when their expectations are not met.
Industry type and size of the business.
Lack of related experience within an industry can lead
to valuation errors. Consider hiring an expert to assist, if
warranted.
Use engagement letters. The client
should sign a customized letter for each BV engagement
before any services are rendered. Preferably, the
provisions of the engagement letter should be discussed in a
face-to-face client meeting to address any client questions
or concerns. Document this discussion in the client
workpaper file.
Document thoroughly. Track all
client communications in the workpaper file. In many cases,
a client will make tax planning decisions based in part on a
valuation report. Statements on Standards for Tax Services
no. 8, Form and Content of Advice to Taxpayers,
says that “written communications are recommended in
important, unusual or complicated transactions.” Similarly,
document discussions about valuation methodology in a letter
to the client to avoid any possible misunderstandings.
BV services can be a rewarding and profitable practice
niche if you adopt some basic risk management techniques to
minimize exposure. BV methodology is constantly evolving, so
stay current through training. Screen prospective clients
thoroughly, issue engagement letters and document all client
communications. If problems arise during an engagement,
consult an attorney specializing in the defense of CPAs and
ask your professional liability insurer for additional
guidance. Be safe, not sorry. Where to Learn More
American Institute of CPAs
1211 Avenue of the Americas New
York, New York 10036-8775
www.aicpa.org
AICPA members who have
performed at least 10 BV engagements can earn the
Accredited in Business Valuation designation by
passing an eight-hour examination. Many technical
training programs and practice aids are available.
American Society of Appraisers (ASA)
555 Herndon Parkway, Suite 125
Herndon, Virginia 20170
www.appraisers.org
Practitioners with two years of
appraisal experience and 1 1/2 years of BV
experience can earn the Accredited Member
designation, and practitioners with five years of
appraisal experience and three years of BV
experience can earn the Accredited Senior
Appraiser designation through a combination of
training, testing and submission of past BV
reports. ASA offers five training courses in BV
services.
Institute of Business Appraisers (IBA)
P.O. Box 17410 Plantation, Florida
33318
www.instbusapp.org
The IBA is a membership
organization providing training and assistance to
practitioners specializing in the appraisal of
closely held businesses. The IBA offers workshops,
publications and practice aids.
National Association of Certified
Valuation Analysts (NACVA)
1111 E. Brickyard Road, Suite 200
Salt Lake City, Utah 84105
www.nacva.com
CPAs without prior BV
experience can earn the Certified Valuation
Analyst designation by completing a five-day
training course, passing a four-hour examination
and preparing an extensive case study.
The Appraisal Foundation
1029 Vermont Avenue, N.W., Suite 900
Washington, D.C. 20005
www.appraisalfoundation.org
The foundation promulgates a
set of standards for appraisals known as the
Uniform Standards of Professional Appraisal
Practice (USPAP). Federal regulatory agencies
require that BV reports provided to them comply
with USPAP.
Business Valuation Resources
www.bvresources.com
This is a Web site with a
variety of products and resources pertaining to
BV, including a useful list of “hot links” for the
BV practitioner. | |