Business Valuations: Applicable Standards for CPAs

By Randy Swad

Business valuation is a growing service area for CPAs. The author describes who establishes the standards and rules, what they are, and how to achieve competency and compliance.

CPAs are becoming more involved in valuations of closely held businesses. Some choose to specialize in this area; others provide business valuations in conjunction with other services. A CPA considering the business valuation area is typically confronted with the following questions:

1. What are the professional standards that apply to business valuations?

2. Am I professionally competent to offer these services?

3. Is it necessary to perform a formal appraisal before advising a client on the value of his or her business?

AICPA Standards

AICPA standards, which apply to business valuations, are the Code of Professional Conduct (CPC) and Statement on Standards for Consulting Services No. 1 (SSCS No. 1). The most recent version of the CPC was adopted in 1988 and amended in 1991. It contains the principles and rules listed in Exhibit 1. The six principles are broad rules of professional behavior and provide the framework for more specific rules. AICPA members must comply with the Code in all types of engagements.

In terms of applicability, the rules could be divided into three categories. Rules 101 and 203 apply to attestation services. Rules 102, 202, 501, 502, 503, and 505 are general rules of professional behavior which apply to all types of services. Rules 201, 301, and 302 also apply to all types of services but are of special concern to CPAs performing business valuations.

Rule 201 contains the following general standards:

Professional Competence. Undertake only those professional services that the member or the member's firm can reasonably expect to be completed with professional competence.

Due Professional Care. Exercise due professional care in the performance of professional services.

Planning and Supervision. Adequately plan and supervise the performance of professional services.

Sufficient Relevant Data. Obtain sufficient relevant data to afford a reasonable basis for conclusions or recommendations in relation to any professional services performed.

The standard on professional competence is important as a reminder that CPAs, before undertaking this work, should evaluate whether they possess the training and education necessary to perform business valuations adequately. The other three standards of care appear to obligate CPAs to also follow business valuation standards established outside the AICPA, which are discussed in more detail later.

Rule 301 prohibits a CPA from disclosing confidential client information without specific consent of the client. However, when a business valuation is done as part of a litigation engagement, the CPA may be required to submit his or her workpapers to opposing counsel. Rule 301 specifically permits compliance with a validly issued subpoena.

Rule 302, which prohibits contingent fees in attestation engagements and for preparation of tax returns, does not expressly prohibit contingent fees in business valuation engagements. A contingent fee in a business valuation engagement would appear to compromise the integrity and objectivity of the practitioner and is prohibited by all of the standards issued by the appraisal profession. In addition, some state licensing boards and state societies' codes of conduct do not permit contingent fees under any circumstances.

SSCS No. 1 was issued in 1991. It contains definitions and standards for CPAs who provide consulting services. According to SSCS No. 1, consulting services include six basic types of servicesÑconsultations, advisory services, implementation services, transaction services, staff and other support services, and product services. Valuation and litigation services are considered transaction services.

SSCS No. 1 refers to the general standards of CPC-Rule 201 and establishes three additional standards for consulting services, shown in Exhibit 2. The standard also addresses the issue of whether a CPA may perform consulting services for an attest client:

The performance of consulting services for an attest client does not, in and of itself, impair independence.

This statement would seem to permit the performance of a business valuation for an attest client. The wording, however, indicates that judgment is required and some CPAs feel that valuation services are not compatible with attestation services.

Appraisal Standards Board

The Appraisal Standards Board (the Board) is to the appraisal profession what the FASB is to the accounting profession. It was established in 1989 as a nongovernmental standards-setting body. The Board publishes the Uniform Standards of Professional Appraisal Practice (USPAP). The Board also issues statements and interpretations in a manner similar to FASB. The full text of USPAP, including all the Board's statements and interpretations, is published annually. USPAP consists of a preamble, several special provisions, and ten standards. Much of the preamble, special provisions, and standards 9 and 10 apply to business valuations (see Exhibit 3). Standard 9 concerns the steps involved in performing an appraisal. It is followed by more specific rules 9-1 through 9-5. Standard 10 concerns the reporting of the results of the appraisal. It is followed by rules 10-1 through 10-5.

Are CPAs required to comply with USPAP? CPC-Rule 202 requires CPAs to comply with standards issued by bodies designated by the AICPA Council. While the Board has not been so designated, USPAP has become generally accepted in the appraisal community. Anyone performing a service covered by USPAP would be well advised to follow these standards. Also, a CPA who performs a business valuation that is not in compliance with USPAP would probably be in violation of the professional care standard of CPC-Rule 201.

Internal Revenue Service

Rev. Rul. 59-60 was issued in 1959 to provide guidance on the valuation of closely held corporate stock for estate and gift tax purposes. Subsequently, it has been made applicable to valuations for other tax purposes and to other types of business interests.

Rev. Rul. 59-60 is not a set of professional standards. It was, however, the first authoritative document to provide general guidance on how a closely held business should be valued. Business valuation standards developed by the appraisal profession have all been influenced by that ruling. It is still referred to in court cases and business valuation literature.

The most significant part of the revenue ruling is in Section 4 where it lists eight factors to consider in valuing a closely held business. These factors require the appraiser to take a very comprehensive approach, as shown in Exhibit 4.

Appraisal Organizations

The American Society of Appraisers (ASA) is a multidisciplinary organization of appraisers, founded in 1936. ASA sponsors educational and credentialling programs in seven appraisal disciplines including business valuation.

The ASA Principles of Appraisal Practice and Code of Ethics as outlined in Exhibit 5 apply to all types of appraisals. The Business Valuation Committee of the ASA has issued standards for business valuations which are also listed in Exhibit 5.

The Institute of Business Appraisers (IBA) is an organization of business valuation professionals founded in 1978. It sponsors business valuation seminars as well as a business valuation credentialling program. IBA has issued business valuation standards which are outlined in Exhibit 6.

Both ASA and IBA incorporate USPAP into their standards. Many CPAs who practice in the business valuation area are members of ASA, IBA, or both. Should nonmember CPAs follow ASA and IBA standards? While the case may not be quite as clear-cut as USPAP, ASA, and IBA standards have probably also achieved the status of general acceptance in the business valuation area. Thus, nonmember CPAs are probably prudent to follow ASA and IBA standards. Further, ASA and IBA standards provide guidance on issues not covered in detail by USPAP, e.g., both ASA and IBA provide specific guidance on limited scope engagements.

Competence Standard

Professional competence is probably the most significant issue facing the CPA contemplating entering the business valuation arena. Is a CPA qualified to perform business valuation services by virtue of being a CPA? There is a certain amount of confusion on this issue because

1. in most states, anyone can perform business valuation services without legal restriction,

2. the general public, including many lawyers and business executives, tends to think of CPAs when the need arises for a business valuation,

3. while many properly qualified business valuation professionals are CPAs, others begin doing business valuations before they are properly qualified, and

4. many practicing CPAs, because of their general business knowledge and experience, feel they are capable of estimating the value of most small businesses.

A substantial body of professional standards and technical material has been developed in recent years by business valuation professionals. There are several possibilities for a CPA wanting to obtain professional competence in the business valuation area.

ASA Program. ASA has an educational and credentialling program in business valuation leading to accreditation as either Accredited Member (AM) or Accredited Senior Appraiser (ASA). To achieve AM status a member mustÑ

1. complete a series of courses and exams. There are five three-day courses. The first three courses are each followed by a three-hour exam. The fourth course is followed by an eight-hour exam. There is no exam after the fifth course.

2. submit two actual appraisal reports for critical review. These reports must be approved by the review committee before accreditation is granted.

3. submit evidence of at least two years of full-time business valuation experience.

To achieve ASA status, the member must satisfy all the AM requirements and submit evidence of at least five years of full-time business valuation experience. Thus, AM is generally a temporary credential until the candidate has satisfied the five-year experience requirement.

IBA Program. IBA has a credentialling program leading to accreditation as a Certified Business Appraiser (CBA). To achieve CBA status an IBA member must pass a half-day exam and submit two appraisal reports for critical review. The reports must be approved by the review committee before accreditation is granted. There is no experience requirement for the CBA credential.

AICPA Program. The AICPA, in conjunction with certain state CPA societies, has recently begun offering an educational program in business valuation. This program consists of eight full-day courses. There are no exams and the program does not result in any type of accreditation. A certificate of educational achievement, however, is issued upon completion of the program.

One-Day Seminars. There are numerous one-day seminars available on business valuations. Some of these seminars represent that they will provide the attendee with all the knowledge necessary to do business valuations. Caution is advised to any CPA attending this type of seminarÑa one-day seminar is probably not sufficient.

Scope of Work Standards

What is the scope of work required to estimate the value of a business? First, the terms "business appraisal" and "business valuation" have the same meaning. A CPA cannot avoid the requirements of a business appraisal by referring to his or her work as a business valuation.

CPC-Rule 201 requires the gathering of sufficient relevant data to afford a reasonable basis for a conclusion. SSCS No. 1 requires that the client be informed of significant engagement findings. These standards appear to provide the CPA with a great deal of flexibility in the performance of business valuation services. When Rule 201 and SSCS No. 1 are considered in conjunction with the standards established by the appraisal profession, however, a much more structured scope of work standard emerges.

In a standard business valuation, the scope of work is very comprehensive. USPAP Standard No. 9 requires an appraiser to employ recognized methods and procedures. Rule 9-4 requires the following scope of work:

1. Consider all appropriate valuation methods and procedures, and

2. Collect and analyze relevant data regardingÑ

a. the nature and history of the business;

b. financial and economic conditions affecting the business enterprise, its industry, and the general economy;

c. past results, current operations, and future prospects of the business enterprise;

d. past sales of capital stock or other ownership interests in the business enterprise being appraised;

e. sales of similar businesses or capital stock of publicly held similar businesses; and

f. prices, terms, and conditions affecting past sales of similar business assets.

Standard No. 9 contains many other requirements but Rule 9-4 generally defines the scope of work involved in a standard business valuation engagement. Working through the steps of Rule 9-4 and preparing a formal report in accordance with Standard No. 10 is a time-consuming process requiring a substantial fee. CPAs, however, are often asked to advise a client on the value of a business in circumstances which do not justify the expense of a standard business valuation under USPAP, e.g., a client may ask for assistance in establishing a selling price for a business.

USPAP, ASA, and IBA standards all provide for limited scope business valuations. USPAP contains a departure provision which permits limited exceptions to specified USPAP sections. Rule 9-4 is one of the sections permitting departures. The departure provision, however, contains the following requirements:

An appraiser may enter into an agreement to perform an assignment that calls for something less than, or different from, the work that would otherwise be required by the specific guidelines, provided that prior to entering into such agreementÑ

1. the appraiser has determined that the assignment to be performed is not so limited in scope that the resulting appraisal, review, or consulting service would tend to mislead or confuse the client, the users of the report, or the public; and

2. the appraiser has advised the client that the assignment calls for something less than, or different from, the work required by the specific guidelines and that the report will state the limited or differing scope of the appraisal, review, or consulting service.

A CPA, therefore, may agree with the client to limit the scope of work generally required by Rule 9-4. For example, the agreement might provide that the CPA will not investigate and analyze the economic and industry factors which could affect the value of the business.

USPAP also permits oral appraisal reports. Written reports are not required and may not be desirable in certain types of engagements. For example, in some litigation engagements, appraisers are instructed by counsel not to prepare written reports. USPAP Rule 10-1 sets forth the following requirements for written or oral reports:

Each written or oral business or intangible asset appraisal report mustÑ

1. clearly and accurately set forth the appraisal in a manner that will not be misleading.

2. contain sufficient information to enable the intended user(s) to understand it. Any specific limiting conditions concerning information should be noted.

3. clearly and accurately disclose any extraordinary assumption that directly affects the appraisal and indicate its impact on value.

ASA standards (BVS-I) provide for two types of limited scope appraisals--limited appraisals and calculations. A limited appraisal is an appraisal which is based on limited procedures to collect and analyze information. In a calculations engagement, the appraiser performs only those procedures which are agreed upon with the client.

IBA standards contain a departure provision similar to the one in USPAP. They also permit two types of limited scope appraisals--letter reports and preliminary reports. A letter report presents conclusions together with brief generalized comments, not all the details of the appraisal. A preliminary report reflects a limited opinion of value. It would be used when a client desires a limited opinion based on a limited investigation and analysis. *

Randy Swad, PhD, CPA, is professor of accounting at California State University­Fullerton.

SEPTEMBER 1995 / THE CPA JOURNAL

Principles

Article I Responsibilities

Article II The public interest

Article III Integrity

Article IV Objectivity and independence

Article V Due care

Article VI Scope and nature of services

Rules

Rule 101 Independence

Rule 102 Integrity and objectivity

Rule 201 General standards

Rule 202 Compliance with standards

Rule 203 Accounting principles

Rule 301 Confidential client information

Rule 302 Contingent fees

Rule 501 Acts discreditable

Rule 502 Advertising and other forms of solicitation

Rule 503 Commissions and referral fees

Rule 505 Form of practice and name

Client Interest

Serve the client interest by seeking to accomplish the objectives established by the understanding with the client while maintaining integrity and objectivity.

Understanding with Client

Establish with the client a written or oral understanding about the responsibilities of the parties and the nature, scope, and limitations of services to be performed, and modify the understanding if circumstances require a significant change during the engagement.

Communication with Client

Inform the client of a) conflicts of interest that may occur pursuant to interpretations of Rule 102 of the Code of Professional Conduct, b) significant reservations concerning the scope or benefits of the engagement, and c) significant engagement findings or events.

Source: AICPA, Statement on Standards for Consulting Services No. 1, 1991.

40SEPTEMBER 1995 / THE CPA JOURNAL

Preamble

Ethics provision

Competency provision

Departure provision

Jurisdictional exception

Supplemental standards

Definitions

Standard 9

In developing a business or intangible asset appraisal, an appraiser must be aware of, understand, and correctly employ those recognized methods and procedures that are necessary to produce a credible appraisal. (followed by five rules)

Standard 10

In reporting the results of a business or intangible asset appraisal, an appraiser must communicate each analysis, opinion, and conclusion in a manner that is not misleading. (followed by five rules)

Source: Appraisal Standards Board, 1029 Vermont Avenue, NW, Suite 900, Washington DC 20005-3517 [Tel. (202) 347-7722]

1. The nature of the business and the history of the enterprise from its inception.

2. The economic outlook, in general, and the condition and outlook of the
specific industry, in particular.

3. The book value of the stock and the financial condition of the business.

4. The earning capacity of the company.

5. The dividend-paying capacity.

6. Whether or not the enterprise has goodwill or other intangible value.

7. Sales of the stock and the size of the block of stock to be valued.

8. The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.

Source: Rev. Rul. 59-60, 1959-1 CB 237, Sec. 4.

Principles of Appraisal Practice and Code of Ethics

Introduction

Objectives of appraisal work

Appraiser's primary duty and
responsibility

Appraiser's obligation to his client

Appraiser's obligation to other
appraisers and to the society

Appraiser's methods and practices

Unethical and unprofessional
appraisal practices

Appraisal reports

Business Valuation Standards

BVS-I General requirements for developing business
valuations

BVS-II Financial statement adjustments

BVS-III Asset based approach to business valuation

BVS-IV Income approach to business valuation

BVS-V Market approach to business valuation

BVS-VI Reaching a conclusion of value

BVS-VII Comprehensive, written
business valuation report

Statement of Business
Valuation Standards

SBVS-1 The Guideline Company Valuation Method

Source: American Society of Appraisers, P.O. Box 17265,
Washington DC 20041
[Tel. (800) 272-8258].

Standard One, Professional Conduct and Ethics

1.1 Competence

1.2 Confidentiality

1.3 Disinterestedness

1.4 Nonadvocacy v. advocacy

1.5 Engagement

1.6 Coherence and production

1.7 Supportable opinion

1.8 Replicability

1.9 Appropriateness

1.10 Jurisdictional exception

1.11 Fiduciary duty to clients, and
other duties

1.12 Duty to profession

1.13 Substance v. form

1.14 Professional fees

1.15 Access to requisite data

1.16 Valuation approaches/
methods

1.17 Definitions

1.18 Principal sources and
references

1.19 Site tours and interviews

1.20 Eligibility of data

1.21 Departure

1.22 Hypothetical reports

1.23 Dissenting opinion

1.24 Membership designations

1.25 Certification

1.26 Qualifications of the appraiser

1.27 Force and effect

1.28 Enforcement

1.29 Amendments to standards

1.30 Signing reports

Standard Two, Oral Appraisal Reports

2.1 Usage

2.2 Mandatory content

2.3 Conformity

2.4 Written follow-up

2.5 Recordkeeping

Standard Three, Expert
Testimony

3.1 Definition

3.2 Mandatory content

3.3 Conformity

3.4 Record keeping

Standard Four, Letter-Form
Written Appraisal Reports

4.1 Definition

4.2 Conformity

4.3 Mandatory content

4.4 Distribution of report

4.5 Valuation conclusion

4.6 Transmittal letter

4.7 Record keeping

Standard Five, Formal Written Appraisal Reports

5.1 Definition

5.2 Conformity

5.3 Mandatory content

5.4 Distribution of report

5.5 Valuation conclusion

5.6 Transmittal letter

5.7 Record keeping

Standard Six, Preliminary Reports

6.1 Definition

6.2 Conformity

6.3 Usage

6.4 Disclosure

6.5 Departure

6.6 Oral v. written

6.7 Record keeping

Source: Institute of Business Appraisers, P.O. Box 1447, Boynton Beach FL 33425 [Tel. (407) 732-3202].