< PreviousA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 10 MARCH | APRIL 2020 t h e v a l u e e x a m i n e r note,” O’Dell explains, “to kick in if the company’s value declines as a result of circumstances caused by COVID-19. A reasonable solution.” What Do the Professional Standards Require? Professional standards emphasize that valuation analysts should consider only circumstances existing on the valuation date and events occurring up to that date, even if subsequent events affect the subject’s value. For example, AICPA VS Section 100 (Formerly AICPA SSVS No. 1) states that “Subsequent events are indicative of conditions that were not known or knowable at the valuation date, including conditions that arose subsequent to the valuation date. The valuation would not be updated to reflect those events or conditions.” The difficulty in assessing the impact of COVID-19 is that there is no definitive date when an “event” took place or “conditions” arose. Barrett recalls that in July 2001, he valued a large car rental business located near an airport for divorce purposes. Not long after he completed the valuation, 9/11 happened, which had a devastating impact on the business, but by then the case was closed. Unlike 9/11, which happened in the blink of an eye, the conditions surrounding COVID-19 have evolved over several months. The challenge for valuation analysts will be to determine, for a particular valuation date, whether the economic impact of COVID-19 was known or knowable on that date or whether it is a “subsequent event” that should not be considered in calculating value. One could argue that it was known or knowable as of December 31, 2019, but it is also reasonable to conclude that it became known or knowable at a later date, such as January 31, 2020, when the U.S. declared a public health emergency or even late-February/early March 2020, when the U.S. stock markets first began to react to the threat. Even if COVID-19 is deemed to be a subsequent event, the valuation analyst has an obligation to assess its potential impact on the value opinion and consider disclosing this information in his or her report. VS 100, for example, provides that “In situations in which a valuation is meaningful to the intended user beyond the valuation date, the events may be of such nature and significance as to warrant disclosure (at the option of the valuation analyst) in a separate section of the report in order to keep users informed.... Such disclosure should clearly indicate that information regarding the events is provided for informational purposes only and does not affect the determination of value as of the specified valuation date.” Masten feels that COVID-19 demands such disclosure, arguing that “not including commentary or consideration and some level of quantification in our reports will mislead lenders, investors, and decision makers using our valuation services.” She also urges NACVA members to review several aspects of the association’s Professional Standards before issuing a valuation report as of December 31, 2019, or later. They include: • Are there scope limitations to consider and explain that affect the level of reliance on the information? Examples include (1) the valuation date is before COVID-19 became known or knowable but the pandemic will have an impact on value, or (2) the report’s due date or use date will occur before the impact can be properly assessed. • Is there sufficient relevant data to make normalizing adjustments/valuation conclusions? •Should subsequent events be considered and disclosed? And, if the valuation is meaningful to users after the valuation date, practically speaking, is there a duty to go beyond “disclosure” and provide an alternate valuation conclusion that accounts for these events or, at a minimum, disclose to the client verbally that your opinion is different now, but not yet quantifiable? •Did the valuator rely on hypothetical conditions? Reports that express a conclusion of value or present a calculated value should state any “hypothetical conditions/ assumptions and the reason for their inclusion.” Masten suggests that “there will, no doubt, be many hypothetical conditions and assumptions embedded in our determination of the benefit stream, on both a short-term and long-term basis, when grappling with the impact of COVID-19 on business values.” Even if COVID-19 is deemed to be a subsequent event, the valuation analyst has an obligation to assess its potential impact on the value opinion and consider disclosing this information in his or her report. A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES t h e v a l u e e x a m i n e r MARCH | APRIL 2020 11 Impact on Practice Management In a recent blog post,4 Marc Rosenberg, a leading consultant to CPA firms, offered some advice on how professional service firms can respond to the current crisis. First and foremost, professionals need to get accustomed to working remotely. And, explains Rosenberg, “hand-in-hand with remote working is flexible scheduling. This needs to become the new normal. [P]artners and managers must become experts at evaluating performance based on work results, not hours worked.” It is also critical to conduct partner meetings and retreats via videoconferencing, to train clients on how to communicate digitally, and to ramp up the use of online appointment setting. Rosenberg observes that “many of our clients have been ‘conscientious objectors’ when it comes to using client portals and video conferencing,” but this has to stop. Now is also the time to create a written disaster plan if you do not already have one. According to Rosenberg, the plan should have “continuing action steps, such as rigorous training of our personnel and clients and focus groups of firm personnel to get their ideas for managing future crises.” Given the “enormous scale” of the COVID-19 crisis, Rosenberg urges firms to “hold their partners and staff accountable for compliance with the firm’s disaster policy.” Among other things, that means making violations of the firm’s written virus safety program grounds for dismissal and ensuring that partner compensation systems take into account “being good corporate citizens—complying with the firm’s policies and procedures.” Rosenberg also suggests that firms: •Revise partner buyout plans in light of COVID-19’s potential impact. “Death and disability provisions will need to be revisited regarding the relaxing of vesting provisions for older partners who, God forbid, contract the virus.” •Adapt business development and marketing activities to the current social distancing environment. “CPA firms will have to figure out ways to bring in business with less reliance on face-to-face meetings with prospects and referral sources.” •Put more things in writing. Firm leaders may be “leery of putting an excessive amount of energy into written policies, procedures, and processes for fear of being perceived as heavy-handed…but with the reduction in face-to-face interaction, it may be prudent to ramp up the number of written instructions to ensure that work processes are crystal clear.” Information Security Best Practices One byproduct of the pandemic is that many firms are encouraging or requiring their employees to work from home if possible. As a result, it is critical to pay close attention to information security to avoid compromising your firm’s or your clients’ sensitive information. In a recent blog post,5 Tommy Stephens—a shareholder of K2 Enterprises, a leading provider of technology CPE and consulting—shared five security best practices: 1. Do not use unsecured Wi-Fi. Unsecured Wi-Fi networks, at home or elsewhere, make it easy for cybercriminals to intercept data transmitted over those networks. Stephens advises remote workers to “protect the network, at a minimum, by requiring a password to establish a connection.” Another option is to avoid Wi-Fi altogether and use wired connections. “Not only will they be more secure, but they might also be faster.” 2. Use a VPN. A virtual private network (VPN), Stephens explains, creates “a secure, encrypted ‘tunnel’ in the otherwise unencrypted Internet…[adding] yet another level of encryption to your data.” Many firms’ IT departments already have a VPN option in place for connecting to their networks remotely. Another option is for employees to use one of the many “personal VPN” services that are available. 3. Understand BYOD risks. If employees work remotely on their own computers, be aware of “bring your own device” (BYOD) risks. Firm-provided devices maintained by IT staff likely contain all necessary security features, but personal devices may not. Stephens recommends that staff working at home use firm-provided devices, but if they must use personal devices, “at a minimum, ensure that [their] operating system[s] and all [their] applications have the most recent updates available. Also, verify that anti-malware software is installed on the computer and is updated at least daily.” 4 Marc Rosenberg, “COVID–19: How Your Firm Can Respond,” March 16, 2020, 5 Tommy Stephens, “Responding to COVID–19 with Remote Access? Pay Continued on page 35A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 12 MARCH | APRIL 2020 t h e v a l u e e x a m i n e r VALUATION /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// The New Revenue Accounting Standard: Impact on Economic Damages Analyses By Ralph Nach, CPA and Michael D. Pakter, CPA, CVA, MAFF In the January/February 2020 issue of The Value Examiner,1 we explored the impact on business valuation of the new Revenue Recognition Accounting Standard (the Standard) issued jointly by the U.S. Financial Accounting Standards Board (FASB) and the UK- based International Accounting Standards Board (IASB). The purpose of this article is to continue educating readers by examining the Standard’s impact on financial analyses prepared in connection with economic damages engagements and by discussing the factors that damages experts should consider when performing these engagements. A Brief Recap In our previous article, we reviewed the Standard (ASC 606) in some detail, and we will not repeat that discussion here. A summary follows below. The Standard is now part of U.S. and international financial reporting standards (U.S. GAAP and IFRS, respectively, and GAAP collectively).2 All reporting companies—both public and private—are now required to have implemented the Standard pursuant to staggered implementation dates. The Standard applies to all publicly traded and privately held businesses and not-for-profit organizations, exempting only federal, state, and local governmental entities.3 Unlike legacy GAAP, which contains prescriptive rules that apply to various specialized industries, the Standard is based on the premise that the industry in which an entity operates 1 Ralph Nach, CPA and Michael D. Pakter, CPA, CVA, MAFF, “The New Revenue Accounting Standard: Major Impacts on Business Valuation,” The Value Examiner (January/February 2020): 6–14. 2 FASB Accounting Standards Update (ASU) 2014-09, which added a new Topic 606 to the FASB Accounting Standards Codification® (ASC) and International Financial Reporting Standard (IFRS) No. 15. The U.S. standard is often referred to as ASC 606, and its international counterpart is referred to as IFRS 15. While they closely resemble each other, there are certain differences between the two standards that should be taken into account in financial analyses. 3 ASC 606-10-15-1 provides that the new guidance applies to all entities. However, ASC 105-10-15-1 specifies that the ASC “…applies to financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (GAAP).” should not influence the portrayal of its revenues in its financial statements. The new model is industry agnostic and intended to be universally applied in all industries regardless of whether there were formerly specialized carve-outs or industry-specific rules.4 ASC 606 establishes a core principle—that revenue is to be recognized as the price that a seller expects to receive from its customer in exchange for the transfer of control of promised products or services—and supplements that principle with a five-step process for implementing it.5 It also provides for capitalization as “contract assets” of two types of contract- related costs: the incremental costs to acquire contracts and the costs to fulfill contracts.6 The new model departs from current practice in several significant ways:7 •It eliminates specialized industry carve-outs. To facilitate adoption of a universal rule for revenue recognition, FASB rescinded virtually all its prior specialized industry guidance. • It emphasizes transfer of control. The trigger for revenue recognition is changed from an emphasis on delivery and transfer of the risk of loss and rewards of ownership to an emphasis on transfer of control from the seller to its customer that enables the customer to direct the use of the asset and obtain benefits from the asset. 4 ASC 606-10-15-1. 5 Under ASC 606-10-05-4, the five-step process is as follows: (1) identify the contract with the customer; (2) identify the distinct performance obligations in the contract; (3) determine the transaction price, that includes, if applicable, both fixed consideration and variable consideration; (4) allocate the transaction price to the performance obligations using relative standalone selling price; and (5) if a performance obligation is satisfied over a period, recognize revenue as the seller satisfies the performance obligation or, if the performance obligation is satisfied at a point in time, recognize revenue when the seller transfers control to the customer. 6 The balance sheet may also present contract liabilities representing customer payments made in advance of seller performance, subsequently amortized on a systematic basis. Unamortized balances should be evaluated for impairment. 7 For a detailed discussion of these differences, see Nach and Pakter, “The New Revenue Accounting Standard,” 8–11 (see n. 1).A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES t h e v a l u e e x a m i n e r MARCH | APRIL 2020 13 •It changes the unit of accounting. Under existing GAAP, most sellers record revenue as being earned concurrently with the issuance of an invoice to the customer. The focus of the Standard is on customers; contracts with those customers; modifications to existing contracts; performance obligations; costs to obtain and fulfill contracts; and the related amortization and, if applicable, impairment of those costs. • It redefines transaction price. Transaction price under the previous standard was required to be both fixed and determinable. Under ASC 606, transaction price is a broader concept that encompasses additional elements. •It introduces variable consideration. ASC 606 requires the inclusion of estimated variable consideration as a part of the transaction price at contract inception. •It introduces a significant financing component. Subject to certain exceptions and practical expedients, contracts that contain provisions for extended payment terms or customer prepayments are generally required to reflect a portion of the transaction price as interest income or interest expense by adjusting the transaction price to discounted present value. •It requires analysis of principal versus agent. ASC 606 concerns itself with gross reporting of revenue versus net reporting of revenue. •It creates differences between GAAP and income tax reporting. Many of the changes made by ASC 606 may not be permissible for income tax purposes for some or all taxpayers. •It considers licenses of intellectual property. ASC 606, as amended, sets forth a separate model to apply to transactions between sellers or licensors of intellectual property and their customers or licensees. • It calls for re-estimation of prior period estimates. ASC 606 requires a substantial number of management estimates to be made at contract inception and further requires management to revise these estimates prospectively each time interim or annual financial statements are prepared. • It requires extensive new disclosures. ASC 606 establishes an overarching objective—to inform financial statement users about the nature, amount, timing, and uncertainty associated with revenue and cash flows—and five categories of required disclosures designed to meet that objective. Impact on Economic Damages Analysis Economic damages may involve lost profits, lost earnings or earning capacity, property damages, and the like. Typically, an award of monetary damages is designed to put a plaintiff in the position it would have occupied but for a defendant’s wrongdoing. Damages should be calculated with a reasonable degree of certainty, have a causal link to the defendant’s wrongdoing, and not be speculative. A dispute’s outcome may depend on the effective determination (or rebuttal) of economic damages and, in turn, the proper measurement of revenue levels or trends.8 Accordingly, obtaining a complete and detailed understanding of a subject or comparable company’s revenues is essential to properly determining economic damages—either for a plaintiff’s use or a defendant’s rebuttal. As a result of the new Standard, damages experts will need to carefully consider the comparability of revenue data between subject and peer companies; between periods in which the Standard is effective and periods in which legacy GAAP was effective; between revenues and costs of revenues; between aggregated and disaggregated data; or between tax-exempt and non-exempt companies. It is important to understand how the Standard was implemented, as it provides for certain alternatives (referred to as “practical expedients”) that management can elect to use. Damages experts may now need to consider identifying contracts, invoice dates, transaction pricing, discounts, rebates, refunds, rights of return, and other forms of variable consideration when those items previously were not relevant to economic damages determinations. It may be necessary for a damages expert to determine gross versus net reporting of revenues and to account separately for significant financing components. Depending on the facts and circumstances, a damages expert may need to obtain a sufficient understanding of an enterprise’s contracts with its customers, the underlying performance obligations, and the transaction prices allocated to those performance obligations. If the engagement involves comparing subject and comparable companies; comparing current and prior periods; comparing periods before and after the date of harm; comparing tax-exempt and non- exempt companies; or comparing actual and budgeted data, the damages expert may need to obtain the aforementioned understanding in order to make accurate comparisons. Damages experts, again depending on the facts and circumstances, may need to obtain an understanding of 8 In most but not all instances, this article uses “revenues” throughout, including where the reader may expect to see “sales,” unless in quoted text. Similarly, for “cost of revenues” versus “cost of sales.”A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 14 MARCH | APRIL 2020 t h e v a l u e e x a m i n e r contract-related costs—between companies, periods, or budgets, or before and after harm. Aspects of such contract-related cost analysis may already be embedded into economic damages calculations when, for example, incremental costs9—such as direct labor, direct materials, sales commissions, and similar contract-related costs—are applied to “but for” revenue analyses. The Standard introduces an additional wrinkle when the comparable company or prior period recognized contract assets and then amortized them on a systematic basis consistent with the pattern of transfer of products or services to customers. The damages expert may encounter even greater analytical challenges if the subject or comparable company adopted the Standard during the period being analyzed or when the adoption dates differ between comparable entities. Damages experts may need to assess the Standard’s impact on publicly available metrics, industry studies, or business intelligence research, and determine how that impact affects reported trends in industry growth and profitability data. As the Standard rescinds virtually all prior specialized industry guidance, damages experts may be required to take additional care when analyzing construction contractors, franchisors, software, or similar companies where legacy U.S. GAAP applied specialized accounting rules to the determination of their revenue. Because the Standard focuses on the transfer of control rather than the transfer of risk from seller to customer, “cutoff” issues (e.g., before-and-after distribution 9 Often called “saved costs” or “avoided costs” in certain economic damages engagements. agreement terminations) may need additional attention concerning the terms of customer contract arrangements versus the more traditional invoice/delivery cutoff analyses under legacy GAAP. Some economic damages determinations (e.g., resulting from breach of a distribution agreement) may require additional focus on contractually specified transaction price adjustments between sellers and customers, such as coupons, slotting fees, rebates, nonrefundable up-front fees, financing arrangements, rights of return, loyalty programs, and store credits. In the case of a publicly traded company, this information might be available in the notes to the annual financial statements, but in the case of a privately held entity, the more minimalist approach to required disclosures may require the damages expert to augment the financial statements using other information sources in order to perform necessary analyses. The financial analysis underpinning economic damages engagements may require an evaluation of whether comparable companies, periods, or budgets involved gross or net reporting of revenues, which, in turn, may depend on an assessment of whether a party is the principal to the revenue-generating transaction or, alternatively, is acting in the capacity of an agent on behalf of another party. (Indeed, that may be a central disputed fact in the case.)10 Certain GAAP treatments under the Standard may not be permissible for income tax reporting purposes, so damages experts may need to consider whether there is an effect on the recognition of deferred income tax assets or liabilities. However, the impact may be limited if economic damages are determined on a pretax basis or if the subject company is a flow-through entity for federal income tax reporting purposes. An additional challenge may be encountered when the subject company data is provided solely in the company’s income tax returns whereas the benchmark data is provided in the form of GAAP-compliant financial statements. The Standard may impact the recognition or treatment of management estimates. It requires management to make a substantial number of estimates at the inception of the contract and to revise those estimates prospectively each time interim or annual financial statements are prepared for distribution to external users. This may add to the damages 10 An agent reports revenue as the commission earned while the principal reports gross revenue and accounts for the agent’s commissions as a selling expense. Damages experts may need to assess the Standard’s impact on publicly available metrics, industry studies, or business intelligence research, and determine how that impact affects reported trends in industry growth and profitability data. A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES t h e v a l u e e x a m i n e r MARCH | APRIL 2020 15 expert’s burden (and costs) in evaluating revenue trends between periods, between budgets and actual results, and between subject and comparable companies. The extensive, expanded revenue disclosures required by the Standard should be of considerable assistance to damages experts, who likely will find a host of valuable new disclosures in adopting companies’ financial statements, informing readers of the nature, amount, timing, and risks associated with revenues and cash flows. Experts may find new and useful data disaggregating revenues by geography, type of contract, market, distribution channel, product line, and timing of transfers, providing valuable insights for the development of the economic damages model. The availability of this information will be limited with respect to financial statements of privately held companies that are exempt from a substantial portion of these disclosures. In such cases, experts may be missing information necessary to benchmark comparable public companies and may need to analyze information from other sources to fully justify an assertion that the nondisclosing private company is comparable or not comparable to its public company counterpart. Impact on Approaches and Modeling Techniques The Standard may affect the following typical approaches used to derive revenues for lost profit analysis: • The “before-and-after approach.” Comparing the performance of the company before and after the alleged harmful acts may be affected by elimination of a special industry carve-out present in the before period but absent in the after period; by the trigger for revenue recognition changing to transfer of control; or by subsequent revisions in estimates made in the before period. • The “forecast approach.” Using sales forecasts of expected performance for the business or industry to evaluate the probable effect of harmful acts may be affected by the units of accounting, changes in estimates, or date of adoption of the Standard. • The “yardstick approach.” Comparing the harmed business to comparable but unharmed businesses or locations to assess “but for” results may be affected if these businesses do not recognize revenues in the same way at the same time. • The “market share approach.” Comparing the plaintiff’s market share during the periods before and after the harm may be affected by changes in market share resulting solely from adoption of the Standard. The Standard may affect various modeling techniques used in economic damages analyses. Consider, for example, the following description of the use of averaging in economic damages claims. The use of an average (or the mean) is a basic, but sometimes necessary, technique used in damages claims. Practitioners employ averages when they cannot obtain sufficient evidential matter that provides a more accurate or reliable mechanism for estimating a value. For example, average revenue growth over a historical period could offer the only reasonable means of estimating revenues during a but-for period where the resources needed to provide insight into market trends and the likely impacts of the adverse event are unavailable. Similarly, if useful data regarding cost trends are unavailable, practitioners can analyze averages across time, across an industry, or across operating units.11 Damages experts often justifiably use averages when analyzing stable, mature businesses with predictable growth patterns in revenues and costs. The use of averages might render the analysis of revenues misleading, especially when used as a benchmark in “but for” comparisons. Some damages experts compare a company’s financial performance and share price to a stock market index, such as the Standard & Poor’s (S&P) 500, to establish the relative effect of broader market variations for all market participants versus the 11 Elizabeth A. Evans, Phil J. Innes, and Daniel G. Lentz, “Damages Theories and Causation Issues,” in Litigation Services Handbook: The Role of the Financial Expert, 6th ed., ed. Roman L. Weil, Daniel G. Lentz, and Elizabeth A. Evans (Hoboken, NJ: John Wiley & Sons, Inc., 2017), Section 4.5(a). Damages experts often justifiably use averages when analyzing stable, mature businesses with predictable growth patterns in revenues and costs.A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 16 MARCH | APRIL 2020 t h e v a l u e e x a m i n e r subject company’s results. But the damages expert needs to justify the use of these indices as an appropriate mechanism of comparison or they will be no more defensible than basic averages in proving damages. In making these comparisons, the damages expert should keep in mind the differing effective dates for the Standard that applied to public and nonpublic enterprises. The Standard may affect the financial analyses of averaging by eliminating specialized industry carve outs during the averaging period; changing the trigger for revenue recognition from transfer of the risk of loss to transfer of control during the averaging period; or changing the unit of accounting, transaction prices, or variable consideration during the averaging period. Perhaps the most significant challenge facing damages experts will be to understand the Standard’s impact on analyses of comparable information or companies for engagements dependent on such comparisons. The Standard may have less impact if an expert uses discounted cash flow (DCF) modeling to determine business value or damages. Clearly, the expert will need to make a reasonable and appropriate determination of cash flows from revenues, which may or may not need to consider the impact, if any, of the new Standard. This problem can be avoided by using, as a starting point in lieu of revenues, the data provided in the subject or comparable companies’ statements of cash flows and making any necessary adjustments thereto. Attaining Reasonable Certainty Courts generally require that lost profits and other economic damages be proven with reasonable certainty. Recent guidance emphasizes the critical role revenue plays in such damages analyses. For example, in a practice aid issued by the AICPA’s Forensic and Valuation Services (FVS) Section,12 the authors note that many lost profits claims include two key elements: an estimate of “but for” revenues (revenues that would have been earned but for the alleged bad act) and an estimate of revenue growth (how lost revenues would have grown over the applicable damages period).13 “Given the centrality of revenue estimation and growth to the analysis of lost profits,” they continue, “there is a robust 12 AICPA FVS Practice Aid, Attaining Reasonable Certainty in Economic Damages Calculations: Revenues, Costs, and Best Evidence (Durham, NC: AICPA, 2018). Note: AICPA FVS practice aids are prepared by AICPA staff and volunteers and do not reflect official AICPA positions, nor establish standards or preferred practices. The AICPA’s position is that the practice aids provide illustrative information on the subject matter. 13 Ibid., 11. body of case law that examines the expert’s role in revenue and growth estimation.”14 The practice aid concludes that “it is clear that the courts will exclude expert opinions that contain revenue and growth rate estimates not based upon accepted methodologies and approaches, and which are generally untethered from any meaningful analyses.”15 To avoid exclusion, experts should “conduct some sort of independent investigation or verification to ensure that the data [used] is both accurate and helpful to the court considering the disputed issues” and demonstrate that they have “gained a working familiarity with the borrowed data so that the expert can demonstrate the data’s reliability. Blind adherence to data of unknown origin does not suffice in federal court.”16 The Standard introduces new complexities that affect an expert’s verification of and familiarity with data underlying revenue and growth rate estimates. As a result, the Standard may complicate the process of establishing economic damages with reasonable certainty. Ralph Nach, CPA, is a principal in the training and consulting firm, Epstein + Nach LLC. He serves the accounting profession by designing, developing, and facilitating popular continuing professional education courses throughout the United States and internationally, and by providing technical review and consulting services for CPA firms regarding accounting, auditing, financial reporting, professional ethics, and quality control matters. More information at Michael D. Pakter, CPA, CFF, CGMA, CFE, CVA, MAFF, CA, CIRA, CDBV, has more than 40 years of experience in forensic accounting, business economics, and investigations, including more than 20 years of experience in economic damages and business valuations. State, federal, and bankruptcy courts have recognized him as an expert in accounting, financial analysis, forensic accounting, economic damages, business valuation, and business economics. More information com. Email: 14 Ibid., 11. 15 Ibid., 28. 16 Ibid., 15, quoting Bruno v. Bozzuto’s, Inc., 311 F.R.D. 124 (M.D. Pa. 2015). VEA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES t h e v a l u e e x a m i n e r MARCH | APRIL 2020 17 VALUATION /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// Just Compensation for Taking Property Under the Fifth Amendment Part II: Legal Process and Determination of Just Compensation By Alan B. Clements, PhD, Esq., CPA The Takings Clause of the Fifth Amendment to the U.S. Constitution states: “nor shall private property be taken for public use, without just compensation.” The Supreme Court has held that the Takings Clause also applies to takings of public property.1 Determining just compensation involves a complex interaction of facts particular to the taking, relevant legal authority, and valuation principles. Part I of this article2 explained the legal foundation for a Fifth Amendment takings case, including the legal definition of a taking and the public use requirement. Part II focuses on the procedural steps in the takings process and the unique valuation issues that arise in connection with calculating just compensation. Establishing a Taking As a brief review of the fundamentals outlined in Part I, a taking of property requiring just compensation under the Fifth Amendment occurs in three settings: •Physical occupation, either permanent or temporary, involving an encroachment, occupation, or appropriation of private land •Regulatory taking, where a government regulation (e.g., zoning ordinance) or other action restricts the use, enjoyment, or control of the property, to such an extent that a taking is deemed to occur3 1 United States v. 50 Acres of Land, 469 U.S. 24 (1984). 2 Alan B. Clements, PhD, Esq., CPA, “Just Compensation for Taking Property under the Fifth Amendment—Part I: The Taking and Public Use Requirements,” The Value Examiner (January/February 2020): 15–19. 3 A regulation will constitute a taking if it either (1) fails to substantially advance a legitimate state interest, or (2) denies an owner all economically viable use of his land. Nollan v. California Coastal Comm’n, 483 U.S. 825, 834, (1987). See, also Agins v. Tiburon, 447 U.S. 255, 260 (1980). •An exaction, which is a payment imposed for approval of proposed land use development A taking can deprive the owner of all economically beneficial use of the property or less than a complete interest in the property, in which case a “partial taking” occurs. Examples of partial takings are an easement to install underground utilities or condemnation of a strip of land in front of several businesses to expand a road. Not all regulations restricting property use constitute takings. For example, under its police power, the state (or localities) can impose zoning regulations to further legitimate public ends, i.e., health, safety, morals, or general welfare, such as regulating access to a road for public safety purposes. In this case, the rights of the property owner are subordinated to the public’s right to safer or more efficient use of the road and thus such regulation does not constitute a condemnation or taking for which compensation must be paid. Property owners can challenge government takings, including just compensation offers, in state and federal court. Legal Process The legal process to initiate and challenge a property condemnation or inverse condemnation has several important components. The following brief discussion focuses on three parts of this process: (1) federal requirements to condemn property, (2) statute of limitations, and (3) challenging a compensation award. Federal Requirements to Condemn Property Most federal condemnation cases are initiated by filing a declaration of taking pursuant to the Declaration of Taking Act,4 in U.S. District Court for the district in which the property is located. A declaration of taking must contain:5 4 40 U.S.C. § 3114. 5 Ibid.A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 18 MARCH | APRIL 2020 t h e v a l u e e x a m i n e r •A statement of the authority under which, and the public use for which, the land is taken, •A description of the land taken that is sufficient to identify the land, • A statement of the estate or interest in the land taken for public use, •A plan showing the land taken, and •A statement of the amount of money estimated by the acquiring authority to be just compensation for the land taken. After a condemnation case is filed, the parties proceed to litigate, as necessary, the issues for determination—the right to take and the amount of just compensation—using the procedure set forth in Federal Rule of Civil Procedure 71.1. Statute of Limitations Takings claims against the United States must be filed within six years of the time the taking first occurred. Because physical and regulatory takings may be implemented in stages, it is critical to identify the precise date of the taking. There is no set formula for this determination. In a regulatory action, courts will look at the economic impact of the regulation on the claimant, the extent to which the regulation has interfered with investment-backed expectations, and the character of the government action.6 For example, the EPA might have occupied a portion of property in 2018 for testing and later appropriate the entire property in 2020. In limited cases, a court might “toll” (stop the running of) the limitations period, where the facts giving rise to an alleged taking may not be known to the plaintiff until after the limitations period, due to the government’s failure to disclose. Challenging a Compensation Award Traditionally, inverse condemnation suits against states and localities had to be filed in state or federal courts of general jurisdiction.7 In 2019, the U.S. Supreme Court ruled in Knick v. Township of Scott8 that property owners who have their property taken by state or local governments may file a Fifth Amendment takings claim in federal court without having to first exhaust remedies in state court. The Court’s decision overturned Williamson County Regional Planning 6 Penn Central Transp. Co. v. New York City, 438 U.S. 104, 124 (1978). 7 For example, in Georgia, the petition of condemnation is filed in the state superior court having jurisdiction for a judgment in rem against the property or interest therein. 8 139 S. Ct. 2162 (2019). Commission v. Hamilton Bank,9 which previously held that property owners could not bring a takings claim against a state or local government in federal court unless a state court had previously denied them just compensation. Takings suits against the United States usually must be filed in the U.S. Court of Federal Claims (CFC), a specialized Article I court of nationwide jurisdiction, hearing only monetary claims against the United States.10 Appeals from the CFC are to the U.S. Court of Appeals for the Federal Circuit. Takings suits involving claims of $10,00011 or less or those filed under certain program statutes may/must be filed in federal district court. Just Compensation Just compensation means the “full monetary equivalent of the property taken.”12 Determining this amount is not without controversy, particularly with regard to consequential damages, business loss, and other subjective losses suffered by the property owner. The Supreme Court has held in just compensation determinations that owners are to be made “whole,” which means they should be put in the same position monetarily as they would have occupied if their property had not been taken.13 “He [the owner] is entitled to receive the value of what he has been deprived of, and no more. To award him less would be unjust to him; to award him more would be unjust to the public.”14 In a traditional valuation, the appraiser determines the appropriate standard 9 473 U.S. 172 (1985). 10 Tucker Act, 28 U.S.C. § 1491. 11 Little Tucker Act, 28 U.S.C. § 1346(a)(2). 12 United States v. Reynolds, 397 U.S. 14, 14-16 (1970). 13 United States v. 564.54 Acres of Land, 441 U.S. 506, 511 (1979) (quoting United States v. Miller, 317 U.S. 369, 374 (1943); United States v. Reynolds, 397 U.S. 14, 16 (1970). 14 Bauman v. Ross, 167 U.S. 548 (1897). Determining this amount is not without controversy, particularly with regard to consequential damages, business loss, and other subjective losses suffered by the property owner.A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES t h e v a l u e e x a m i n e r MARCH | APRIL 2020 19 of value and uses income capitalization, comparable sales, and reproduction cost to best determine the property’s value. However, in just compensation valuations, several unique aspects apply to the valuation. Standard of Value The required standard of value in just compensation computations is the fair market value of the property at the time of the taking.15 This value is normally the amount that a “willing buyer would pay in cash to a willing seller.”16 If fair market value does not exist or cannot be calculated, “resort must be had to other data which will yield a fair comparison.”17 The Supreme Court adopted the fair market value standard to establish a “relatively objective working rule…to determine the condemnee’s loss.”18 In determining fair market value, an owner should obtain payment for the highest and most profitable use of his property. The inquiry in such cases must be what is the property worth in the market, viewed not merely with reference to the uses to which it is at the time applied, but with reference to the uses to which it is plainly adapted; that is to say, what is it worth from its availability for valuable uses. Property is not to be deemed worthless because the owner allows it to go to waste, or to be regarded as valueless because he is unable to put it to any use. Others may be able to use it, and make it subserve the necessities or conveniences of life. Its capability of being made thus available gives it a market value which can be readily estimated.19 For example, the market value of land can be influenced by its potential future uses. If the owner can show such use is a reasonable and feasible use of the property, the additional value may be incorporated into the fair market value determination. However, special value of the property to the condemnor will be excluded as an element of market value.20 For example, in U.S. v. Powelson, the Supreme Court held 15 New York v. Sage, 239 U.S. 57, 61 (1915). 16 United States v. 564.54 Acres of Land, 441 U.S. 506, 511 (1979) [quoting United States v. Miller, 317 U.S. 369, 374 (1943)]. 17 United States. v. Miller, 317 U.S. 369, 374 (1943). 18 United States v. 565.54 Acres of Land, supra note 13, at 510. 19 Boom Co. v Patterson, 98 U.S. 403, 408 (1878). 20 United States v. Chandler-Dunbar Co., 229 U.S. 53, 76 (1913). that the value of potential dams on the owner’s property was too remote to be included in the market value.21 Special Valuation Issues General valuation principles applicable to real property or businesses are similar in condemnation cases. The following discussion focuses on unique valuation aspects in eminent domain cases. For illustration purposes, two sample cases are discussed. Case 1 The federal government will acquire a piece of property for expansion of a post office. On this property is a profitable restaurant. The restaurant will remain in business by relocating to another (newer) part of town. It is expected that the restaurant will suffer a loss of customers and long-term value due to relocating to a new area without an established brand identity. The cost of the replacement restaurant facility in the newer area of town will be higher. In preparing the valuation of just compensation, the restaurant owner asks for the following costs: • Higher replacement cost of the new restaurant •Relocation costs •Loss of going concern value and goodwill from operating in a new location •Attorney’s fees Analysis Higher replacement cost. The cost to replace lost property may be higher than the fair market value of the condemned property. Generally, the replacement cost approach is disfavored by courts, since it “sets an upper limit on value which often is not even remotely approached in actual negotiations in the marketplace.”22 Instead, courts focus on ensuring that condemnation awards replace the full measure of what was actually lost by a condemnee, disallowing awards only when they would constitute a “windfall” for the condemnee. In United States v. 50 Acres of Land,23 the Supreme Court held that the mere fact that a replacement facility would cost more than the existing facility did not justify a higher compensation award because the more expensive facility “presumably is more valuable” than the condemned one. 21 319 U.S. at 275–6. 22 See United States v. Benning Housing Corp., 276 F.2d 248, 250. 23 469 U.S. 24, 35 (1984).Next >