Caveat appraiser: computer software is great for running the numbers, but a business appraiser's own judgment is crucial to a successful effort.

Computer software is great for running the numbers, but a business appraiser's own judgment is crucial to a successful effort.

Business valuation is among the hottest new services being offered by CPAs to clients buying or selling a company, going through a divorce, splitting up or merging a business, valuing stock in an employee stock ownership plan or preparing an estate or gift tax return. And, along with the new demand for business valuation services come software programs that may appear to make our job easier, faster and more consistent from one engagement to another. While technology is useful to appraisers, danger awaits the unwary.

Recently, a CPA spent two days on the witness stand being cross-examined about his "appraisal" of a business and the resulting report. In the end, it was revealed that the CPA had never appraised the business; he simply copied tax return information onto computer input sheets and mailed them to a computer service bureau in California. By return mall, the CPA received a complete report analyzing the business, comparing it with industry averages, discussing the economy and concluding that the business was worth over $1 million. After the CPA admitted neither he nor the computer company had ever visited the business, talked to management, examined the books or even identified the correct industry, the court summarily dismissed his report and his testimony as not credible. It was more than an embarrassment to the CPA: As a partner, he discredited his firm among the legal community from which it sought future engagements. He also charged his client $10,000 for services of highly questionable value. Could he be liable for malpractice?

Unfortunately, there is an even easier way to perform a business appraisal. Several software vendors offer programs that enable CPAs to produce reports simply by entering relevant business data. While computers can be valuable in all parts of a CPA practice, those who use any software without applying their own research and judgment to the engagement may suffer the same fate as the CPA discussed above.

MORE THAN CALCULATIONS

The computer is a marvelous tool when properly used. However, the potential for misuse is enormous and, sadly, quite prevalent. Too often, inexperienced appraisers and their clients believe that what comes out of a computer must be right because the computer did it. But when the moment of truth arrives and the report must be justified, the entire conclusion falls apart.

To make a credible business appraisal, the CPA must consider much more than the business's historical financial results. The most significant element of value lies not in where the business has been but, rather, where it can be expected to go. Historical results of operations can be a good indicator of expected future company earnings, but without more analysis and information there is no rational basis to expect the future to repeat the past.

For example, if a business owner was personally responsible for historical profitability--through personal business relationships, for example--how reasonable is it to use past results in forecasting profitability after the owner dies? Similarly, if the owner is retiring and selling out, should the buyer expect the historical earnings level to continue without the benefit of the seller's business contacts?

Many appraisers examine the five preceding years' financial information in making projections about a business's future, but the economy was different five years ago from the way it is today. In addition, won't changing technology affect future expectations? Doesn't the changing nature of competition have a bearing on future earnings projections? Today, a handful of nationally recognized chains spend enormous sums advertising one-hour lens crafting, lightweight glasses, no-line bifocals and a second pair at half price. What is the future of a local optician in light of the new competition?

These are only a few of the very significant elements a competent business appraisal must consider. Many other factors affect valuation and future business expectations. For example, even if a business's location has not changed, neighborhood demographics may have altered dramatically over the past few years. What was once a young family neighborhood may be evolving into one of middle-aged people with no small children. This trend likely will have very different effects on the local toy store and on an upscale restaurant.

Other issues can affect an appraiser's judgment, such as significant reductions in government contracts, the opening of a major highway rerouting traffic away from the business, loss of a key employee due to death or retirement, the changing nature of consumer taste and fashion designs, new legislation regulating or restricting business activities and similar nonfinancial issues.

These examples merely illustrate the complexity of business appraisals. Any one of a number of factors can have devastating effects on a small, closely held business, but none will be revealed by examining past operating results. These issues can be identified only by talking with people knowledgeable about the specific business and the environment in which it operates.

This doesn't mean historical financial information isn't important. To the contrary, past operating results can be a crucial element in assessing business value. But they must be analyzed systematically to identify trends that might reveal important information about external forces affecting the business's future and, hence, its value today. This is where the computer can be very helpful.

A FOCUS ON RESULTS

The computer's proper role in business appraisal is as part of the process and not as a means to obtain a valuation result. Unfortunately, the business valuation computer programs available today are result-oriented (actually producing just one final result--the value) rather than process-oriented. They provide a value for the business under several different appraisal methods. Some even write the appraisal report, inserting numbers the program generates.

Reliance on a result-oriented computer program removes the most important element from the process--appraiser judgment. Some programs suggest an appropriate capitalization rate based on a belief that all businesses can be classified into neat pigeon holes. In fact, the appropriate capitalization rate should be based on the particular risks associated with a specific business and not on generalizations about the average company. But many business valuation software program users apply the "suggested" capitalization rates without regard to the business being appraised and, in particular, the environment in which it operates. As a result, a hardware store in New York City is deemed as equally risky as a hardware store in Smallville, Kentucky. This, of course, is illogical.

THE IDEAL

Each of the many business valuation software programs on the market today has attributes that can assist appraisers. When examining these programs, CPAs should consider what the best possible program would offer. An effective program would make the computer do what it does best--perform calculations. It would provide detailed analysis of historical information. The program would produce line, bar and circle graphs and other graphics to make annual comparisons easy and effective, saving hours of manual calculation time by massaging the raw historical data.

The program would allow the entry of historical financial information in as much or as little detail as the appraiser thought necessary. Past information would not be limited to five years, since many appraisal engagements involve businesses with a much longer relevant financial history.

In addition to the numerous financial ratios generated by most business valuation programs, the effective program would provide a separate analysis of any account defined by the user, such as sales, gross profit or insurance expense, that would target the account's historical trend for further study. The program would convert all expense amounts into percentages of sales, gross profit or any other variable the appraiser considers relevant, and print a report showing the trend of any expense account in relation to a defined baseline account. It would cover changes in expenses over the period analyzed in a growth trend analysis report. This might become very important to the appraiser in considering a trend's cause and its impact on future expectations.

The effective business valuation computer program would allow the user to adjust any expense account, or element within an expense account, and run the analysis again to consider the effect the adjusted financial information could have on historical profitability. The computer could generate ratios, trends, growth patterns and comparisons with historical averages to assist the appraiser in the process of business valuation analysis.

The key to implementing the computer as a tool in an appraisal is to use it to identify issues in need of further consideration. For example, if the program shows that cost-of-goods-sold expense is increasing at 5% annually and sales are increasing at 3%, a prudent appraiser would investigate the cause of the trend. Perhaps suppliers are increasing prices, but competition prevents the business from passing along these hikes. The conclusion might be that this trend will dampen future earnings. Or perhaps the appraiser can discover another reason for the trend through discussions with management and consider management's plans to deal with the problem. Regardless of the conclusion, the information the computer generates is a valuable part of the process.

Many of these functions are available separately on existing software. Software programs clearly speed ratio calculations and make financial statement projections, discounted cash flow analyses and return-on-investment studies more efficient. However, undue reliance on the results of any computer program is simply misplaced.

YOU CAN LOOK IT UP

The computer is wonderful at doing calculations, but it has no judgment and cannot become a certified business appraiser. It has no credibility in court in presenting an opinion of value--and neither will the CPA who relies solely on computer results.

Business valuation is an art, not a science, although scientific methods are used throughout the process. The computer can analyze information, but only the appraiser can form a valid opinion of value. Those who doubt the wisdom of this advice can research any of the many court cases involving business valuations. It will become readily apparent that a credible business appraisal is based on the appraiser's professional judgment about the particular facts and environment affecting a specific business and on his or her rationale in applying the facts.

ALAN ZIPP, CPA, JD, CBA, is managing partner of Zipp & Stouffer, Rockville, Maryland. He is a certified business appraiser of the Institute of Business Appraisers, a candidate in the American Society of Appraisers and a number of the American Institute of CPAs, the American Bar Association and the bar associations, of Maryland and the District of Columbia. He is the author of the AICPA self-study course Business Valuation Methods.

EXECUTIVE SUMMARY

* BUSINESS VALUATION is among the hottest new services being offered by CPAs. Several software programs enable practitioners to produce reports simply by entering relevant business data. While the technology is useful to appraisers, danger awaits the unwary. CPAs who use any software without applying their own research and judgment to the engagement are making a serious mistake.

* SOFTWARE SPEEDS ratio calculations and makes financial statement projections, discounted cash flow analyses and return-on-investment studies more efficient.

* HOWEVER, OVERRELIANCE ON a result-oriented computer program removes the most important element from the process-appraiser judgment. The computer's proper role is as part of the process and not as a means to obtaining a valuation result.

* COMPUTER PROGRAMS FOCUS ON historical financial information. Past operating results can be a crucial element in assessing business value, but they won't reveal any one of a number of factors that can have devastating effects on a small, closely held business.

* BUSINESS VALUATION is an art, not a science, although scientific methods are used throughout the process. The computer can analyze information, but only the appraiser can form a valid opinion of value.

THE IDEAL

No business valuation software on the market today can replace the appraiser's judgment, but here are some valuable ideal features CPAs should keep in mind when shopping for software:

* Offers detailed analysis of historical information, including graphics that make annual comparisons easy and effective.

* Allows entry of historical financial information at the appraiser's discretion and does not always limit the time frame to five years.

* Provides a separate historical analysis of any account, such as sales, gross profit or any operating expense, selected by the user.

* Allows projections based on any selected growth rate for any variable, such as sales, expenses, etc.

* Converts all expense amounts into percentages of sales, gross profit or any other variable chosen. Highlights changes in expenses over the period analyzed in a growth trend analysis report. Can adjust any expense account to consider the effect on historical profitability.

* Generate ratios, trends, growth patterns and comparisons with historical averages.

* Allows for discounted cash flows or earnings using a variety of selected discount rates.