January 2003

Business Valuation Basics

By Martin J. Lieberman, ASA, CPA/ABV, Rosen Seymour Shapss Martin & Co., LLP

In the past, business valuation has generated a number of skeptics because of its basis in prognostications about the future. Historically, business valuation focused on tax matters, litigation among owners of small businesses, and bankruptcy. Financial accounting, on the other hand, has traditionally been based on historical data. The importance of business valuation in the information age resides in its use of the present value of estimated future cash flows in order to arrive at a meaningful valuation. The demand for real-time financial data renders what happened last year irrelevant when compared to what will be happening next year. Investment decisions based solely on the past will not stand up. Historical data is frequently inadequate to predict the future.

Business valuation has taken on a new meaning for accountants since the adoption of SFAS 141 and 142. These standards require initial valuations of tangible and intangible assets when accounting for a business combination, ongoing valuations of goodwill for impairment tests, and measurement of such impairment if detected. FASB’s initial foray into the world of valuation will be followed by additional accounting rules aimed at presenting balance sheets and income statements that more closely reflect the market values of tangible and intangible assets. Audits of financial statements will increasingly require the auditor to understand the mechanics of fair value determinations and their implementation when assessing and attesting to values reflected in financial statements.

Intangible assets are becoming more important as value drivers, but they are generally not recognized in financial statements unless they arise from a business combination. The growing importance of intangible assets will initiate a change in how they are measured and reported. The methodologies to value such assets require a significant amount of knowledge and experience. Auditors will need to either obtain the business valuation skills to adequately audit fair-value-derived balances or engage outside experts for credible audit support.

Many analysts ask for more meaningful financial information focused on what is anticipated rather than what has already occurred. The difficulty lies in producing value-based information that is reliable, consistent, and free from manipulation. New techniques using reliable probability models have not yet been fully developed. In the past few years, new ways of calculating value have been created, such as the real option value theory. This model takes the Black Sholes option valuation theory and expands it into a model to estimate the value of a company. Breakthrough ideas such as this will create new models to digest, assess, and possibly implement.

With the recent new developments in fair-value-based GAAP accounting, and the indication by FASB that we are heading toward a fair-value-based balance sheet, the use of business valuation techniques to arrive at GAAP balances is here to stay. In addition, more and more tax litigation, contract litigation, and shareholder disputes require the measurement of damages based on business valuations.

Editor’s Note: This is the first article in the newly established Business Valuation department. In future issues, this department will present articles and business valuation topics aimed at tying together business valuation on accounting issues. Articles will address issues, techniques, and developments of interest to tax practitioners and auditors as well as business valuators.

Martin J. Lieberman, ASA, CPA/ABV

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