Evaluating an appraiser's report.

A good valuation report should be well-written and well-organized, and should satisfy professional and engagement requirements. Valuation controversies are often decided by a court, and the appraisal report may be the only tangible evidence of how the value was determined. Thus, its appearance can be critical.

A well-written report has several distinct qualities. Such a report is:

1. Thorough. It includes all relevant data and analyses that affected the conclusion of value.

2. Balanced. It discusses both positive and negative factors affecting the company's value. Although the client may have a vested interest in the value being relatively high or low, the appraiser should remain unbiased. Accordingly, the report should be an impartial discussion of all relevant factors. 3. Readable. The report's readers should be able to follow the work done and the conclusions reached. That means the report should be written in clear and concise terms, with minimal use of technical jargon. If jargon is necessary, it should be properly defined. Any data presented in the report should be adequately described so that others can understand it.

4. Coherent. The report should flow logically from the data presented to the final conclusion. Also, the report's conclusions and analyses should be internally consistent.

5. Well-supported. The report should thoroughly document each valuation process step and conclusion. That means presenting detailed calculations and identifying the data sources used, so that another appraiser can follow the process steps and reach a similar valuation.

Recognizing Common Errors

Sometimes more than one business valuation report is prepared. This can occur, for example, when the parties disagree on the appraiser, the valuation approach or a valuation assumption. Differences among a decedents heirs (or between a taxpayer and the IRS) may require a court to determine the value based on differing reports. Courts will often ignore a report with obvious deficiencies. Practitioners can add value to a valuation engagement by critically reviewing the business valuation report for one or more of the following common errors:

1. Failure to follow the definition of value. Business valuation terms are used in most valuation reports or appraisals to inform the reader as to how the value of the business was determined. The stated definition of value in the report is important, as the value can vary significantly depending on which definition of value is chosen (e.g., liquidation value versus going concern value). One of the most common errors found in valuation reports is the failure to follow the definition of value contained in the report. This might cause the valuation to be ignored by the courts if challenged by the IRS. Thus, practitioners should carefully examine how value is defined in the report and ensure that it is reflected throughout the report.

2. Inconsistencies. The data, analyses, calculations and conclusions should be consistent. Some common inconsistencies include:

* Applying value multiples to the wrong benefit stream (e.g., applying after-tax earnings multiples to pretax earnings).

* Failing to match the capitalization or discount rates to the proper benefit stream (e.g., using a net cash-flow discount rate on earnings data).

* Comparing data on the company to comparative data for a different time period without making appropriate adjustments.

* Adjusting financial statements for the company without adjusting comparative companies' financial data.

* Using inconsistent assumptions. An appraiser cannot assume an orderly liquidation of assets for one purpose (e.g., application of an asset valuation method), while assuming a "fire sale" liquidation of assets for another purpose (e.g., calculation of lack of marketability discount).

3. Arithmetic errors. Surprisingly, one of the easiest errors to prevent is one of the most common. All calculations should be reviewed for accuracy.

4. Insufficient support. Inadequately documented reports are easier to second guess. Each report should document the data used, calculations made and conclusions reached. Calculations should tie back to the company's financial statements and those of the guideline company, when used.

5. Overreliance on rules of thumb. Rules of thumb are rarely good primary valuation methods. Accordingly, values indicated by rules of thumb should not be weighted heavily in reaching the value conclusion, unless there is an adequate analysis of market data supporting those rules.

6. Inadequate data. Some appraisers cut corners either because of budget constraints or because of ignorance of available data sources. A practitioner must be satisfied that the appraiser has considered all the data that might significantly affect the valuation conclusion.

7. Inadequate due diligence. Some examples of potentially inadequate due diligence in the preparation of a valuation report include forgoing a visit to the business premises; inadequately interviewing management; failing to consider requirements of state corporate law, articles of incorporation and bylaws; and failing to report or inquire about recent and prospective stock transfers.

This case study has been adapted from PPC's Tax Planning Guide-Closely Held Corporations, 18th Edition, by Albert L. Grasso, Joan Wilson Gray, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, James A. Keller, Kellie J. Bushwar and Leslie D. Singleton, published by Practitioners Publishing Company, Ft. Worth, TX, 2005 ([phone]; ppc.thomson.com).

Albert B. Ellentuck, Esq. Of Counsel King & Nordlinger, L.L.P. Arlington, VA