Business Valuation: A Strong Niche as Accounting Standards Evolve

January 2, 2006

By William C. Foote, CPA/ABV, CVA

The accounting landscape has undergone many changes over the past five years, chief among them the enactment of the Sarbanes-Oxley Act of 2002 (SOX). The ensuing emergence of SOX compliance consulting as a niche practice area for public accounting firms was not a surprise.

What may be surprising, however, is that business valuation is a growing specialty area for many firms, even amid the deluge of SOX-related work.

This article will explore the basics of business valuation services and shed some light on its prominence as a niche practice area for CPA firms.

What is Business Valuation?

Business valuation (BV) generally refers to the process of determining the value of a business enterprise (i.e. as a whole), a business ownership interest or a security as of a particular date. The business in question can range from a small sole proprietorship to a large international corporation.

Determining the value of intangible assets, such as patented technology or a non-competition agreement, is another aspect of BV and one that has gained importance in recent years.

The valuation of a business or business ownership interest is a service that is uniquely suited to closely held businesses, as opposed to public companies whose shares are traded in active markets at observable prices. Closely held businesses account for the vast majority of businesses in the United States.

BV involves analysis of financial and non-financial information. It also involves a considerable amount of judgment, since facts and circumstances vary from assignment to assignment. A BV engagement includes, but is not limited to, the following tasks, a full discussion of which is beyond the scope of this article:

1. Understanding in detail the nature of both the thing or things being valued and the related business enterprise (which could be one and the same)
2. Closely studying (but not attesting to) historical and prospective financial information
3. Tracking the industry in which the enterprise operates and general economic conditions
4. Application of accepted valuation approaches and methods (see Table 1)
5. Knowledge and consideration of authoritative guidance
6. Communication of results, typically in the form of a written report

When and Why is BV Necessary?

A critical step for a successful project is identifying the purpose of the valuation early in the planning stage. Purposes for BV generally fall into one of three broad categories: litigation, compliance or transactional guidance.

Litigation-related BV projects include ownership disputes and domestic relations matters, where it is not unusual for the parties' wealth to be concentrated in a closely held business. In the litigation setting, a valuation analyst may provide expert testimony at deposition and trial. A BV assignment in the compliance category might entail a purchase price allocation pursuant to Statement of Financial Accounting Standards (SFAS) No. 141 (see Table  2) or a valuation for gift or estate tax purposes. Examples of transaction-based valuation engagements include mergers and acquisitions and intellectual property sales.

The purpose of the valuation also determines which standard of value (i.e. fair market value, fair value, intrinsic value, etc.) and which authoritative guidance is germane. For example, when BV work is performed in conjunction with the filing of a gift tax return, certain Treasury regulations, Internal Revenue Service (IRS) Revenue Rulings and court cases need to be considered. Likewise, a valuation for financial reporting purposes requires an understanding of the applicable financial accounting pronouncements (see Table  2). And if the BV assignment is pursuant to a divorce proceeding, the relevant civil case law (which can vary significantly by jurisdiction) will need to be considered.

Who Performs BV Services?

BV reports customarily are subject to intense scrutiny, whether by a court in a litigation setting, by regulatory agencies such as the IRS or the Securities and Exchange Commission (SEC) or by the parties to a transaction.

Working in this type of environment means that those delivering BV services must exercise sound judgment and demonstrate competency and objectivity. To demonstrate these traits, BV professionals ordinarily attain one or more BV accreditations (see Table  3), which involves comprehensive training in and testing on business valuation bodies of knowledge and a commitment to continual learning. Valuation specialists must also comply with, at a minimum, the professional standards of the organizations of which they are members.

The most recently introduced BV credential is the American Institute of CPAs' (AICPA) ABV, which stands for "Accredited in Business Valuation." In addition to establishing the ABV credential, the AICPA has committed significant resources to the BV community. Notably, in 2004 the AICPA officially formed the Business Valuation and Forensic & Litigation Services (BVFLS) Membership Section and in 2005 its Consulting Services Executive Committee put out for exposure a Proposed Statement on Standards for Valuation Services.

Cause and Effect

According to Accounting Today's annual Top 100 Firms surveys, SOX consulting was cited as a growth area for 77 percent and 63 percent of respondents in 2005 and 2004, respectively. This makes sense considering when SOX was enacted. Accounting Today also reported that 89 percent of respondents to the 2005 survey listed BV as a growth area, up from 72 percent for the previous survey. So what is fueling growth in the BV niche?

One factor is certainly the litigious nature of our society. For example, with respect to domestic relations matters, data published by the Centers for Disease Control and Prevention indicates that the divorce rate has remained stable in recent years, both in the entire U.S. population and in the Commonwealth of Virginia. There are about 30,000 divorces in Virginia each year.

Statistics published by the IRS also provide insight. For example, the IRS projects that from 2004 to 2010 the number of gift tax returns to be filed will increase at a compound annual rate of 3.65 percent. Estate tax returns are projected to decrease at an average rate of 18.20 percent, due to tax law changes enacted in 2001. The percentage of estate tax returns that included closely held stock or limited partnership interests, however, has risen steadily from 2001 (approximately 19 percent) to 2004 (approximately 27 percent).

With respect to valuation for financial reporting purposes, there have been a number of financial accounting standards issued and/or exposed in recent years that have mandated fair value accounting (see Table 2). The emergence of these standards has created opportunities for valuation analysts. In addition, the Financial Accounting Standards Advisory Council indicated in its 2005 Annual FASAC Survey that both fair value issues and stock compensation arrangements would continue to be a priority for the FASB for some time to come.

Independence rules have also had an impact on BV services. The AICPA Code of Professional Conduct precludes public accounting firms from providing valuation services to attest clients where the result of the services would be material to the financial statements. This has allowed some firms to expand their BV practices, targeting other firms' attest clients. SOX is also thought to have had an indirect impact, insofar as companies and officers placing added emphasis on financial reporting procedures and controls.

The record turnout for the recent AICPA/ASA national business valuation conference also suggests that the demand for BV services is strong. More than 1,650 BV professionals attended the three-day conference, which featured nearly 50 speakers on a myriad of valuation topics.

Practical Considerations

BV is a mainstay for many firms when it comes to specialty service offerings. While BV work, like most niche service areas, can be susceptible to peaks and valleys, it is not likely to see a permanent decline any time soon. Administering a BV practice does present some challenges, though.

Perhaps the most obvious challenge is the non-recurring nature of BV work. Unlike assurance and tax services that recur at least annually and typically in the same timeframe, a valuation engagement is in most cases a one-time deal. Generating a steady stream of valuation work therefore requires a network of referral sources, which usually consist of attorneys, bankers, directors, CEOs and CFOs and CPAs — both inside and outside of one's own firm.

While independence rules can prevent CPAs from doing BV work for attest clients, certain valuation projects won't impair independence because there is not a financial statement impact. These include valuations performed for estate or gift tax purposes and valuations performed in the context of a divorce proceeding.

Establishing a reputation as an expert in a particular industry (information technology for example) can also be remunerative. Many valuators find that creating a niche within a niche in this manner can supplement or bolster referral networks.

Another consideration for BV practices is what model to operate under, which is influenced by the size of the firm and whether BV is a full-time or part-time commitment for team members. Many CPAs who perform valuation services consider themselves "dabblers." Under this model, only a handful of BV projects are taken on each year, and even those may just be to add value for existing clients.

On the other end of the continuum are firms that have a dedicated BV group or department composed of individuals who do BV work year-round. Under this model BV and litigation support services are often combined in the same group.

Somewhere in between the two extremes lies the "valuation guy" model, where a single partner within a CPA firm is dedicated to BV, but with little or no supporting staff. In this scenario, the BV "brand" likely resides with the individual as opposed to the firm. Boutique valuation firms offer yet another operating model. These firms offer no traditional accounting services and may be more likely to employ non-CPA valuation professionals.

Conclusion

In the AICPA's BVFLS Specialty Area 2004–2005 Annual Progress Report, Barry Melancon, AICPA president and CEO, cited BV as one of the fastest growing practice niches for CPA firms. Further, CPA firms consistently rank BV as a top consulting service in terms of the number of firms providing such services — this according to annual surveys conducted by Accounting Today.

That trend is likely to continue in the future, due in part to the expanding role of fair value measurements in financial reporting.

In the wake of recently issued FASB statements and with more pronouncements on the way, CEOs and CFOs of many privately held companies face tough issues concerning fair value measurements. Successfully dealing with these evolving fair value principles may require the services of a valuation professional. 

William C. Foote, CPA/ABV, CVA is a member of the expert services group at Aronson & Company, a nationally ranked top 50 accounting and consulting firm. He is a graduate of James Madison University and also a member of the VSCPA Editorial Task Force.