SSVS 1: Applying New Standards for CPAs Providing Valuation Services

By Walter A. Robbins and Gary Taylor

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The purpose of SSVS 1 is to improve the consistency and quality of practice among AICPA members providing valuation services. Specifically, the standard provides guidance to CPAs when they perform engagements to estimate value that culminate in the expression of a conclusion of value or a calculated value. The standards contained in SSVS 1 apply to all AICPA members who perform an engagement that estimates the value of a business, business interest, security, or intangible asset for purposes such as sales transactions, financing, taxation, financial reporting, mergers and acquisitions, management, financial planning, and litigation. Because of the increasing number of CPAs providing business valuation services, and the fact that SSVS 1 provides professional guidance as to generally accepted best practices within the valuation and business communities, it is imperative that CPA valuation analysts become familiar with SSVS 1’s requirements.

Scope of SSVS 1

SSVS 1 provides guidance for the practitioner in determining when an engagement is deemed to be a valuation engagement. It also identifies previously issued AICPA standards that all CPAs who provide valuation services should observe.

Business valuations are required for a variety of purposes (see Exhibit 1). SSVS 1 indicates that in instances where a CPA is required to apply valuation approaches and methods, and use professional judgment in applying those approaches and methods, the CPA is subject to the AICPA’s special valuation standards contained in SSVS 1. Furthermore, the valuation standards apply even when estimating value is only a part of a larger engagement. For example, CPAs are frequently required to provide estimated value for certain assets involved in tax, litigation, or acquisition-related engagements.

To further assist CPAs in determining whether a particular service falls within the scope of SSVS 1, the statement specifically identifies services that are excluded:

• Audit, review, and compilation engagements;
• Use of values provided by the client or a third party;
• Internal-use assignments from employers to employee members not in the practice of public accounting;
• Engagements that are exclusively for the purpose of determining economic damages and that do not include an engagement estimate value;
• Mechanical computations that do not rise to the level of an engagement to estimate value;
• Engagements where it is not practical or reasonable to obtain or use relevant information and, therefore, the member is unable to apply valuation approaches and methods described in SSVS 1; and
• Engagements meeting the jurisdictional exception.

SSVS 1 establishes that any CPA involved in an engagement to estimate value is identified as a valuation analyst. Such individuals are expected to possess special skills and knowledge specifically for valuation engagements. The SSVS recommends that a CPA analyst have a fundamental awareness of the professional standards contained in the AICPA Code of Professional Conduct and the Statement on Standards for Consulting Services (SSCS) 1, Consulting Services: Definitions and Standards. The CPA must understand the extent to which such professional standards apply to valuation engagements. The CPA should also be aware of other AICPA standards that, depending on the circumstances, may or may not be applicable to a valuation engagement, but that the CPA needs to consider when providing valuation services. Such standards relate to the following:

• Standards on reporting on historical financial information;
• Standards on financial forecasts and projections; and
• Quality-control standards.

Pre-engagement Requirements

The SSVS identifies the following items that a CPA should evaluate before accepting a valuation engagement.

Professional competence. In performing a valuation analysis, the CPA must be able to complete the engagement with a reasonable level of professional competence. The CPA must have the requisite knowledge and skills that will enable him to identify, gather, and analyze data; consider and apply appropriate valuation approaches and methods; and use professional judgment in developing the estimate of value. In determining whether the CPA analyst has the required professional competence for a particular valuation engagement, SSVS 1 recommends that, at minimum, the CPA consider the: 1) subject entity and its industry; 2) subject interest; 3) valuation date; 4) scope of the valuation engagement; and 5) any government regulations that apply to the subject interest. When assessing the scope of the valuation engagement, the CPA should always identify the purpose of the engagement, identify all assumptions and limiting conditions expected to apply, establish the applicable standard of value (i.e., fair value or fair market value) and the applicable premise of value (i.e., going concern), and determine the type of report to be issued, including the intended use and users.

Nature and risk of the valuation services. To understand the nature and risks of a perspective valuation engagement and the expectations of the client, the CPA should consider the following:

• Terms of the valuation engagement;
• Identity of the client;
• Nature of the business interest and ownership rights in the business, security, and intangible assets being valued, including control characteristics and the degree of marketability of the interest;
• Procedural requirements of a valuation engagement and the extent of any limitations imposed by the client or circumstances;
• The use of and limitations of the valuation report; and
• Any obligation to update the valuation report in the future.

Objectivity and conflict of interest. Objectivity is a state of mind. Rule 102 of the AICPA Code of Professional Conduct requires objectivity in the performance of all professional services, including valuation engagements. The principle of objectivity imposes the obligation on the CPA to be impartial, intellectually honest, and free of conflicts of interest. Therefore, a CPA analyst must be independent of relationships that may impair his objectivity in rendering valuation services.

Independence. Maintaining integrity and objectivity calls for avoiding both actual and perceived conflicts of interest. This concept is known as independence. Being independent in fact and in appearance means that the CPA must not only be unbiased, impartial, and objective, but also be perceived that way by others. The AICPA’s rules pertaining to independence for CPAs who perform audits are detailed in the Code of Professional Conduct, Rule 101.05. However, AICPA Interpretation 101-3, “Performance of Nonattest Services,” addresses the issue of independence in instances where valuations services are provided to attest clients. Therefore, the CPA should meet the requirements of the interpretation so as not to impair his independence with respect to the client.

Assumptions and limiting conditions. Assumptions and limiting conditions are common to valuation engagements. For example: 1) arriving at a conclusion of value while assuming that the current level of management expertise and effectiveness will be maintained, or 2) relying on management’s financial statements without any verification of their accuracy and integrity. While the CPA should attempt to identify all assumptions and limiting conditions before accepting a valuation engagement, sometimes additional assumptions or limiting conditions will arise during an engagement. In any case, restrictions and limitations should be disclosed in the valuation report.

Using the work of specialists. In some cases, the CPA may deem it necessary to have a portion of the valuation engagement performed by a third-party specialist. For example, using an appraiser who specializes in real estate to appraise a unique parcel of land is not uncommon.

However, the CPA must note in the assumptions and limiting conditions the level of responsibility, if any, he will assume for the work of the third-party specialists. Moreover, SSVS 1 allows the CPA the option of including the written report of the third-party specialist in the CPA’s valuation report.

The Engagement Letter

The CPA should use an engagement letter as a way to formally establish an understanding of the services to be performed and to define the responsibilities of each party. In particular, the understanding should include the identity of the client, the nature, purpose, and objective of the valuation engagement, the client’s responsibilities, the CPA’s responsibilities, the applicable assumptions and limiting conditions, the valuation methodologies to be employed, a listing of the types of information the CPA will use, the type of report to be issued, any limitation on liability, the fee basis, and a statement that the CPA has no responsibility to update the resulting valuation report. A well-prepared engagement letter that clearly establishes an understanding with the client reduces the likelihood of any misinterpretation by either party.

While a written understanding for an engagement is preferable, an oral presentation is acceptable though not advisable. The only exception is if the engagement is being performed for an attest client. In such cases, AICPA Ethics Interpretation 101-3 requires that the engagement understanding be in writing. SSVS 1 indicates that if the understanding is oral, then the CPA should document that understanding by appropriate memoranda or notations in the working papers. Moreover, any significant changes in the services to be performed should be documented by written modification.

A word of caution to CPAs providing valuation services as part of a litigation engagement: If the CPA has been retained as an expert witness, then the engagement letter is discoverable. Consequently, an engagement letter that contains specific information about the services to be provided can be used by opposing counsel to challenge the CPA’s work product and conclusions. A detailed engagement letter may provide the opposing attorney with considerable insight into the client’s litigation strategy. Consequently, in litigation valuation engagements it is preferable for the CPA to provide only broad statements.

Types of Engagements for Estimating Value

An engagement for estimating the value of a business, business ownership interest, security, or intangible asset is identified in SSVS 1 as being either a valuation engagement or a calculation engagement. A valuation engagement is when the CPA is required to estimate the value of a subject interest based on the valuation methodologies the practitioner has selected as being appropriate in the circumstance. A valuation engagement results in a conclusion of value. In contrast, a calculation engagement does not include all of the procedures required for a valuation engagement, and the valuation methodology is jointly determined by the CPA and client. Unlike a valuation engagement, a calculation engagement results in a calculation of value. Whether it is a valuation or calculation engagement, the resulting value may be either a single amount or a range. In both engagements a report will be issued.

Valuation Engagement

A valuation engagement begins by identifying and analyzing the subject interest. Next, the CPA selects a valuation methodology based on the facts and circumstances in the case. The CPA must then apply the valuation methodology to the subject interest, preparing and maintaining appropriate supporting documentation. The final step requires the CPA to prepare a valuation report. (While the SSVS lists these steps sequentially, a valuation engagement is a continuous process, with the analyst constantly gathering, updating, and analyzing information.)

Analyzing the subject of interest. The “subject of interest” refers to a business, business ownership interest, security, or intangible asset that is the subject of a valuation engagement. Because the subject interest is the focus of a valuation engagement, the CPA analyst begins his valuation process by analyzing the subject interest. The initial step in this process requires the CPA to determine the type of information needed. SSVS 1 points out that, to an extent, the information needed will consist of at least the following:

• Nature of subject interest;
• Scope of the valuation engagement;
• Valuation date;
• Intended use of the valuation;
• Applicable standard of value;
• Applicable premise of value;
• Assumption and limiting conditions; and
• Applicable governmental regulations or other professional standards.

In the assessment of a subject interest, the CPA will need to consider both financial and nonfinancial information. Nonfinancial information promotes an in-depth understanding of the subject entity. The CPA will examine information relating to the subject entity’s nature, background, and history, and should consider items including the following:

• Entity’s facilities;
• Organizational structure;
• Management team;
• Ownership information;
• Product or services provided;
• Economic environment;
• Geographical markets;
• Industry considerations; and
• Competition.

Examining the ownership information requires the determination of the type of ownership being evaluated, an analysis of the different ownership interests of other owners, and an understanding of the classes of equity ownership interests and rights. When the object interest is a business, business ownership interest, or security, the CPA should understand any equity-holder agreements, operating agreements, voting-trust agreements, buy-sell agreements, prior sales or transactions, loan covenants, restrictions, and other contractual obligations or restrictions that affect the owners and the subject interest. If the subject interest is an intangible asset, the CPA needs to understand all legal rights, licensing agreements, sublicense agreements, nondisclosure agreements, development rights, commercialization or exploitation rights, and other contractual obligations.

The CPA must also gather financial information to assist in the valuation engagement. The practitioner must identify what financial information is relevant to the engagement and is reasonable in the circumstance. The CPA will usually read and evaluate the following financial items, among others, if they are available:

• Annual and interim financial statements;
• Income tax returns;
• Key financial statement statistics;
• Prospective financial information such as forecasts or projections;
• Comparative common-size financial statements for the subject entity;
• Comparative common-size industry financial information;
• Owners’ compensation, benefits, and personal expenses;
• Key executives’ or officers’ life insurance; and
• Management’s response to the analyst’s inquiries.

Formulation of valuation methodology. The value of any business, business interest, security, or intangible asset is derived from the future benefits it provides. Because the object interest in each engagement has different risks and earnings characteristics, no single methodology can be used to determine valuation in every situation. Consequently, different methodologies have evolved.

A business valuation methodology consists of two aspects: the valuation approach, and the valuation method. The valuation approach refers to a general way of determining a value measure for a business, business ownership interest, security, or intangible asset, using one or more valuation methods. The valuation method is the specific way to determine business value within a general approach. A valuation methodology requires the CPA to first select a valuation approach. Then, depending on the facts and circumstances of the engagement, the CPA selects an appropriate valuation method. Exhibit 2 provides a general overview of the three valuation approaches and their associated methods as set forth in SSVS 1. (Because the SSVS mentions valuation methods only briefly, the reader is encouraged to consult other professional publications for an in-depth discussion. The authors suggest the following publications: Understanding Business Valuation, AICPA, 2005; Guide to Business Valuations, Practitioners Publishing Company, 2007; and Financial Valuation: Applications and Models, Wiley, 2003.)

Income approach. This approach requires the CPA to value a business, business interest, security, or intangible asset as the present value of all expected future benefits of owning that interest. When calculating value under the income approach, SSVS 1 indicates that the CPA may use either a discounted-future-benefits method or a capitalization-of-benefits method.

When using the discounted-future-benefits method, the present value of a company’s future returns (either net cash flow or earnings) that are expected to be realized up to the time they reach a stabilized level is calculated first. To that amount is added the present value of the company’s terminal value. With the capitalization-of-benefits method, a single-period benefits stream is converted into value by dividing the benefits stream by a rate of return that is adjusted for growth.

The discounted-future-benefits method is more appropriate when future returns are expected to differ significantly from current operations. The capitalization-of-benefits method is generally more appropriate when a company’s current operations appear to be indicative of its future operations. When applying the valuation methods under the income approach, SSVS 1 suggests that the CPA consider, at minimum, several factors. (See Exhibit 3.)

Asset-based/cost approach. This approach considers the value of the underlying business assets and liabilities. SSVS 1 points out that the asset-based approach is appropriate for valuing businesses, business ownership interests, and securities. However, when valuing significant intangible assets, the cost approach is more appropriate.

SSVS 1 indicates that a frequently used asset-based valuation method is the adjusted net asset method. This method requires the CPA to estimate value by adjusting the values of the individual assets and liabilities of the business to fair market value. The difference between assets and liabilities represents the total value of the enterprise. In using this approach, the practitioner must identify all assets and liabilities of the business.

Exhibit 2 shows that when valuing intangible assets, the cost-to-create method is used. The cost-to-create method is similar to the adjusted-net-asset method, except that the value of intangible assets (e.g., intellectual property) is also considered. Value for intangible assets can be measured as either reproduction cost or replacement cost. Reproduction cost is the cost to reproduce an exact replication of the asset. Replacement cost is the cost to produce an asset with similar economic benefits.

Market-based approach. This approach can be used for business entities or intangible assets. However, SSVS 1 identifies three frequently used valuation methods under the market-based approach specifically for valuing a business, business ownership interest, or security. They are the guideline public company method, the guideline company transaction method, and the guideline sales of interests in the subject entity method. The comparable uncontrolled transactions method, the comparable profit margin method, and the relief from royalty methods are identified for valuing intangible assets. Exhibit 4 summarizes the differences and similarities in these methods.

Calculation Engagement

In a calculation engagement, the client and CPA will agree on the valuation approaches and methodologies to be used. The procedures required in a calculation engagement are more limited than those required in a valuation engagement. In performing a calculation engagement, SSVS 1 suggests that the CPA consider the following:

• Identity of the client;
• Identity of the subject interest;
• Whether or not a business interest has ownership control characteristics, and its degree of marketability;
• Purpose and intended use of the calculated value;
• Intended users of the report and the limitations on its use;
• Valuation date;
• Applicable premise of value;
• Applicable standard of value;
• Sources of information used in the calculation engagement;
• Valuation approaches or valuation methods agreed upon with the client; and
• Subsequent events (defined as events that could affect the subject entities’ value and that occur subsequent to the valuation date).

SSVS 1 also points out that, when arriving at a conclusion of value in a calculation engagement, the CPA should:

• Correlate and reconcile the results obtained under the different approaches and methods used;
• Assess the reliability of the results under the different approaches and methods using the information gathered during the valuation engagement; and
• Determine, based on the first two items, whether the conclusion of value should reflect the results of one valuation approach and method, or a combination of the results of more than one valuation approach and method.

Engagement Reports

The last step in a valuation engagement requires the CPA to prepare a valuation report. Through this report the CPA communicates to the client his conclusions of value or calculated value of the subject interest. The CPA must be sure that the report is in compliance with all professional guidelines and represents the utmost quality in a work product.

While reports issued for purposes of certain controversy proceedings are specifically exempt from the reporting provisions of SSVS 1, in all other instances the standard allows both written and oral reports to be presented. (Examples of controversy proceedings include a matter before a court, an arbitrator, mediator, or other facilitator; or a matter in a governmental or administrative proceeding.) If an oral report is presented, the CPA must take precautions to prevent any misunderstandings between the CPA and the recipient of the oral report. The CPA should include in the oral report all information relating to the scope, assumptions, and limitations, and the results of the engagement. Moreover, the substance of the oral report communicated to the client should be documented in the CPA’s working papers.

SSVS 1 also identifies three types of written reports that a CPA may use, depending on the type of engagement. For a valuation engagement, the CPA may issue either a detailed report or a summary report. A detailed report is organized to efficiently communicate an understanding of the data used and the reasoning and analysis applied in the conclusion of value. A summary report is an abridged version of the information that would be provided in a detailed report. SSVS 1 suggests that the following major sections should be presented in a detailed report:

• Letter of transmittal;
• Table of contents;
• Introduction;
• Sources of information;
• Analysis of subject entity and nonfinancial information;
• Financial statement and information analysis;
• Valuation approaches/methods considered;
• Valuation approaches/methods used;
• Valuation adjustments;
• Nonoperating assets and liabilities;
• Representation of the valuation analyst;
• Reconciliation of estimates and conclusion of value;
• Qualifications of the CPA analyst; and
• Appendices and exhibits.

In contrast, a calculation report should be issued only in a calculation engagement, and the report must explicitly state that it is a calculation report. While somewhat similar to a detailed valuation report, a calculation report has specific differences. Recommended disclosures that should be presented in a calculation report include:

• A statement that it is a calculation report;
• The representation of the CPA analyst;
• Identification of any hypothetical conditions used and the basis for their use;
• Any application of the jurisdictional exception;
• Any assumptions and limiting conditions;
• If the work of a specialist is used;
• Any subsequent events when appropriate;
• Appendices or exhibits where appropriate; and
• Summary of the calculated value.

Effective Date

The requirements of SSVS 1 are applicable to engagements beginning on or after January 1, 2008. CPAs who provide valuation services or intend to expand into this practice area are encouraged to become familiar with the provisions of the standard in order to better assist their clients.

Editor’s Note: For another discussion of this subject, see “Will the Real Business Valuation Standards Please Stand Up? The AICPA’s SSVS Compared to USPAP and Other Business Valuation Standards,” by Martin J. Lieberman and David Anderson, The CPA Journal, January 2008, available at www.cpajournal.com.

©2009 The New York State Society of CPAs. Legal Notices