< PreviousA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 10 MAY | JUNE 2020 t h e v a l u e e x a m i n e r Figure 2: Yes-No Distribution Table 4: Probability Set for a Change-of-Control Assumption of an 85 Percent Total Probability Model logic recognizes that when the simulation “draws” a change of control, the model terminates and determines the payout for that draw. If not, the simulation continues and computes the payoff for that draw based on whatever payoff terms are included in the model. Terms can vary widely and the PIU may be structured to pay out differently if a change of control occurs within a specified timeframe such that it meets a target threshold for the PE sponsor’s internal rate of return. Through a combination of model logic, simulation, and contingent probabilities, these payouts can be incorporated into the valuation model. Depending on the stage of the company and its expected capital requirements, simulation can also be used to capture required future financing rounds and the impact on firm value and PIU payouts. Similar to change of control, this can be done with a combination of simulation and contingent probabilities. IPO provisions are most easily handled via a value threshold, where the simulation will trigger an IPO, and the associated payouts, when the firm value threshold is reached. Conclusion Monte Carlo simulation makes it possible to create models with enough flexibility to capture the myriad economic uncertainties that drive the value of PIUs. Current computing power and the easy availability of Excel add-ins have made this “brute force” approach, previously laborious and time intensive, accessible to valuation firms. Using simulation for firm value estimation, payoffs on change in control/ IPO, and future financing rounds allows the valuation professional to develop a model that maps to the specific terms of the PIU award, resulting in a rigorous and defensible conclusion of value. James “Jim” Walling, CFA, CVA, is the founding principal of Accretive Strategies Con- sulting Group. Mr. Walling has worked in the consulting, corporate finance, and valua- tion area for over 25 years and is a founding executive director of the Acad- emy of Certified Valuators and Analysts Pri- vate Limited, which is the India chapter of the GACVA, and the Association of Certified Val- uators and Analysts RVO. He holds an MBA from Santa Clara University and a BS in Ma- rine Sciences from Stockton University. He has spoken, written, and taught on corporate valuation, real options, derivative security structures, and valuation and security design. Email: Want it all? • Ultimate Triple Play Subscription— $625 per month for the first user (receive everything included in all three other subscriptions, plus Damages Advocate calculation software) Visit www.NACVA.com/Ultimate for complete listing of what is included in each subscription. • Ultimate KeyValueData® Titanium Subscription— $250 per month for first user (access to 21 separate databases, reports, libraries, and presentations) • Ultimate Software Subscription— $90 per month for first user (licenses to five valuation and report writing software packages, plus technical support) Add to your Ultimate Training and Membership Subscription: For details and to sign up, visit www.NACVA.com/Ultimate, or contact Member/Client Services at (800) 677-2009. Customize Your CPE with Unlimited Options Annual subscription benefits—for first user: • Membership Dues + Tri-Annual Recertification Fee • Recertification Bonus Point Program Registrations + CPE • All Live Classroom Registrations + CPE • All Live Online Broadcast Registrations + CPE • All Live Online Webinar Registrations + CPE • All Live Online Webcast Registrations + CPE • BVTC Recorded Training Videos On-Demand • All CPE On-Demand Courses (nearly 500) + CPE • Business Valuation and Financial Litigation Super Conference Registration + CPE (in-person or live/online broadcasts) • Financial Valuation Conference Registration + CPE (in-person or live/online broadcasts) • Financial Consultants’ Accelerated Training Institute Registration + CPE (in-person or live/online broadcasts) • Electronic Self-Study Courses + CPE (shipping and handling not included for hard copies) • The Value Examiner® and QuickRead® CPE Quizzes • Surgent CPE | Exclusive NACVA/CTI library of NASBA compliant ethics, accounting, auditing, and tax fields of study Ultimate Training and Membership Subscription Unlimited Continuing Professional Education Membership Dues | Recertification Fees (multi-user options available) Period Range Probability 0-6 0.00% 7-16 1.83% 17-25 2.22% 26-36 2.60% 37-46 3.20% 47-56 4.40% 57-60 7.50% VEWant it all? • Ultimate Triple Play Subscription— $625 per month for the first user (receive everything included in all three other subscriptions, plus Damages Advocate calculation software) Visit complete listing of what is included in each subscription. • Ultimate KeyValueData® Titanium Subscription— $250 per month for first user (access to 21 separate databases, reports, libraries, and presentations) • Ultimate Software Subscription— $90 per month for first user (licenses to five valuation and report writing software packages, plus technical support) Add to your Ultimate Training and Membership Subscription: For details and to sign up, or contact Member/Client Services at (800) 677-2009. Customize Your CPE with Unlimited Options Annual subscription benefits—for first user: • Membership Dues + Tri-Annual Recertification Fee • Recertification Bonus Point Program Registrations + CPE • All Live Classroom Registrations + CPE • All Live Online Broadcast Registrations + CPE • All Live Online Webinar Registrations + CPE • All Live Online Webcast Registrations + CPE • BVTC Recorded Training Videos On-Demand • All CPE On-Demand Courses (nearly 500) + CPE • Business Valuation and Financial Litigation Super Conference Registration + CPE (in-person or live/online broadcasts) • Financial Valuation Conference Registration + CPE (in-person or live/online broadcasts) • Financial Consultants’ Accelerated Training Institute Registration + CPE (in-person or live/online broadcasts) • Electronic Self-Study Courses + CPE (shipping and handling not included for hard copies) • The Value Examiner® and QuickRead® CPE Quizzes • Surgent CPE | Exclusive NACVA/CTI library of NASBA compliant ethics, accounting, auditing, and tax fields of study Ultimate Training and Membership Subscription Unlimited Continuing Professional Education Membership Dues | Recertification Fees (multi-user options available)A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 12 MAY | JUNE 2020 t h e v a l u e e x a m i n e r VALUATION /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// Preparing a Business Valuation Report during an Economic Downturn: What is the IRS Looking For? By Michael A. Gregory, CVA, ASA The IRS has certain expectations for a business appraiser and for a qualified appraisal for federal tax purposes.1 This article focuses on business valuations in connection with an estate or gift tax case in light of current economic conditions resulting from the COVID-19 pandemic. It discusses relevant business valuation standards, IRS expectations regarding its business valuation function based on a previous economic downturn, and what this may mean for valuators in the current environment. Note: Although the author headed up business valuation at the IRS for 11 years, he does not represent the IRS and the opinions presented here are his own. Background The 2008 financial crisis triggered the biggest economic downturn since the Great Depression.2 There was an asset bubble in the housing market, caused in large part by the bundling of good and bad loans that were sold as mortgage- backed securities. Investors in these securities were not protected in the event borrowers defaulted on the underlying mortgages. Overall, housing prices dropped by 31.8 percent.3 The number of announced market deals associated with mergers and acquisitions fell from 3,202 in the first quarter of 2008 to 2,280 by the first quarter of 2009.4 Valuators had to determine how to address risk, cash flows, historical market data that did not reflect the current market, and a host of other concerns. Currently, from the public’s perspective, it certainly is not a seller’s market.5 Regarding potential buyers: Can they obtain 1 IRS Notice 2 Kimberly Amadeo, “2008 Financial Crisis—Causes, Costs, and Whether It Could Happen Again,” The Balance, updated May 7, 3 4 “M&A in the United States,” Institute for Mergers, Acquisitions and Alliances, accessed May 14, 2020, 5 “National Report: COVID-19 Pandemic Puts the Brakes on M&A the cash they need to buy an entity? And do they know what it is they are buying? Before going further, let’s explore the definition of fair market value for estate and gift tax purposes as stated in Revenue Ruling 59-60:6 Section 20.2031-1(b) of the Estate Tax Regulations (section 81.10 of the Estate Tax Regulations 105) and section 25.2512-1 of the Gift Tax Regulations (section 86.19 of Gift Tax Regulations 108) define fair market value, in effect, as the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.7 How does a valuator determine fair market value when the market, in the midst of a serious downturn, may not reflect willing buyers and sellers under no compulsion to buy or sell? How low will it go and how long will it take for a recovery to a new “normal”? These are not easy questions to answer. Clearly, in general this is an inopportune time to enter the market as a seller, and wise sellers will not sell today. Risk comes from not knowing what is ahead in the market. Market,” Business Wire (April 29, 2020), home/20200429005201/en/National-Report-COVID-19-Pandemic-Puts- Brakes-MA; Matt Woods, “The Long-Running Seller’s Market Is No More, But Sellers Can Still Be Successful,” Forbes (May 22, com/sites/forbesrealestatecouncil/2019/03/22/the-long-running-sellers- market-is-no-more-but-sellers-can-still-be-successful/#6565949e3f41. 6 7 Ibid. (Emphasis added).A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES t h e v a l u e e x a m i n e r MAY | JUNE 2020 13 Valuing a Business From our fundamental training, we know that there are three approaches to value: The market approach, which relies on recent comparable sales; the asset approach, which is based on what the market would pay for a company’s assets; and the income approach, which assesses a company’s income earning and risk. At a time like the present, in many cases the income approach is the only reasonable alternative for an ongoing business. This approach requires the development of a discount rate, a growth rate (or rates), and a projection of cash flows. Revenue Ruling 59-60 requires the business valuator to assess eight elements in determining fair market value: 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 company’s earning capacity. 5. The company’s 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. All of these elements are important, but in an economic downturn, items one through four may take on added significance. How are liquidity and banking capacity affecting the market at this time? What about reductions in force? Business valuation standards may offer some insights. Insights from Business Valuation Standards Standards adopted by the National Association of Certified Valuators and Analysts (NACVA), the American Institute of Certified Public Accountants (AICPA), the Institute of Business Appraisers (IBA), and the American Society of Appraisers (ASA) have similar characteristics, as well as some notable differences.8 The ASA standards generally follow the Uniform Standards of Professional Appraisal Practice (USPAP), and include additional principles, standards, and sections applicable to business appraisers as well as other disciplines. A comparison of standards among these organizations, entitled “Business Valuation/Appraisal Standards Comparison Chart” (the Chart), was published in 2018.9 The Chart reflects considerable agreement among the standards, but with some interpretive differences. All of the organizations require that “A member shall remain objective, maintain professional integrity, shall not knowingly misrepresent facts, or subordinate judgment to others. The member must not act in a manner that is misleading or fraudulent.”10 According to the Chart, the NACVA’s standards provide that “Detailed Reports must be coherent, supportable, and understandable. A detailed report should include, as applicable, the following sections titled using wording similar in content to that shown.” This includes item 1(c)(12), “Disclosure of subsequent events considered,” which has also been adopted by the IBA and the AICPA.11 The NACVA’s standards also provide that a “Calculation Report should set forth the Calculated Value and should include the following information,” including a similar disclosure of subsequent events considered, which has also been adopted by the IBA, the ASA, and the AICPA.12 8 “Business Valuation/Appraisal Standards Comparison Chart,” NACVA, January 1, 2018, 9 Ibid. 10 Ibid., 1. 11 Ibid., 6. 12 Ibid., 7. At a time like the present, in many cases the income approach is the only reasonable alternative for an ongoing business.A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 14 MAY | JUNE 2020 t h e v a l u e e x a m i n e r It is also important to understand that the IRS has its own business valuation guidelines,13 as well as valuators with various designations who are required to meet their credentialing organizations’ professional standards. Given the more than 90 percent reduction of funding for training between 2010 and 2018, many IRS valuators have not kept up with training or maintained their professional designations. This is an opportunity for you as a valuator to help IRS employees understand what you have done with your valuation should your appraisal be audited by the IRS and an IRS valuator be assigned to the case. What Is Known or Knowable? In a recent Chief Counsel Advice memorandum (CCA),14 the IRS provided some insights into its current thinking on what was known or knowable at the date of valuation. The CCA concluded that, given the facts presented, “Under the fair market value standard, the hypothetical willing buyer and seller of a publicly-traded company would consider a pending merger when valuing stock for gift tax purposes.” The U.S. Tax Court has used subsequent events in numerous cases, not to determine fair market value, but to affirm that the appraiser used good judgement as of the valuation date. For example, in Ringgold Telephone Company v. Commissioner,15 the court considered a subsequent sale of the subject business. Here are some thoughts on what might be inferred from this case: •If subsequent events were reasonably foreseeable by a hypothetical buyer or seller, they should be considered. • If subsequent events prove the reasonableness of a 13 “Business Valuation Guidelines,” IRS, updated July 1, 14 IRS Chief Counsel Advice 201939002 (May 28, 2019; released Sept. 27, 2019). 15 T.C. Memo hypothetical buyer or seller, they should be considered. What might this imply regarding a valuation today, given the ever-changing global, U.S., economic, industry, and subject company situations related to COVID-19? COVID-19 Timeline and Implications What was known or knowable on a particular valuation date? We are living with an ever-changing economic environment as a result of COVID-19. Various sources have presented what they see as key dates associated with the pandemic.16 The author must preface the following discussion by stating that this is not a political commentary, but rather a factual commentary presented for your consideration. During the NACVA’s Around the Valuation World® webcast on March 16, 2020, the author presented information from an expert epidemiologist17 and the American Hospital Association18 on the outlook should shelter-in-place orders not be undertaken nationally. With vaccines thought to be 12 to 18 months out, the implications were very negative. In addition, the Federal Reserve has raised concerns that until we can test everyone, develop a vaccine or achieve a major breakthrough, COVID-19 will remain a significant risk.19 From a valuation perspective, it is important to explore various perspectives and timelines associated with the pandemic. Here are examples of sources to consider, as of this writing. Valuators should also explore more up-to-date information and additional sources specific to the relevant valuation date. • The Centers for Disease Control update on cases in the U.S.20 16 Carsten Brzeski and James Smith, “Four scenarios for the global economy after COVID-19,” THINK Economic and Financial Analysis, ING, Ana Sandoiu, “COVID-19: How long is this likely to last?,” MedicalNewsToday 17 “Joe Rogan Michael Osterholm Podcast Transcript: Infectious Disease Expert Talks Coronavirus,” March 15, 2020, 18 Anuja Vaidya, “Leaked AHA webinar slide shows U.S. hospitals bracing for 96 million coronavirus cases,” Becker’s Hospital Review (March 12, 2020), 19 Ron Feldman, “Just as in the financial crisis, only testing can save us,” StarTribune (April 1, 20 “Cases in the U.S.,” Coronavirus Disease 2019 (COVID-19), Centers for Disease The U.S. Tax Court has used subsequent events in numerous cases, not to determine fair market value, but to affirm that the appraiser used good judgement.A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES t h e v a l u e e x a m i n e r MAY | JUNE 2020 15 •COVID-19: A timeline of significant events, including the pandemic’s effect on the U.S. stock market.21 • Key dates compiled by the New York Times.22 • Key dates compiled by CNN.23 •Key dates compiled by Pharmaceutical Technology.24 •New York Times commentary on concerns about recovery.25 What might this mean for a subject entity that is a private company? During these times, as business valuators focus on the world economy, the U.S. economy, the industry, and the subject company, it is important to address COVID-19’s implications for vendors, suppliers, customers, employees, and other stakeholders, as well as sources of capital, and a host of other considerations that impact the subject valuation. What is the Outlook? Our work as valuators is both an art and science. The reality is, no one knows. The Economist indicates that, as of March 26, 2019, the global economy is expected to contract by 2.5 percent and the U.S. economy is expected to contract by 2.9 percent in 2020.26 In this environment, it is critical to conduct due diligence beyond your normal analysis. In an April 8, 2020, webinar,27 Simon Rubinsohn, chief economist of the Royal Institution of Chartered Surveyors (RICS), indicated that “we are in a fluid environment” and that, although no 21 James R. Hitchner, CPA, ABV, CFF, ASA and Karen A. Warner, MA, “COVID-19: A timeline of significant events, including the pandemic’s effect on the U.S. stock market,” Valuation Products and Services, accessed April 17, 2020, vps_hitchner-covid-19-timeline.pdf. 22 Derrick Bryson Taylor, “How the Coronavirus Pandemic Unfolded: a Timeline,” New York Times, updated May 12, 23 “Coronavirus Outbreak Timeline Fast Facts,” CNN, updated May 13, 24 “Coronavirus: A timeline of how the deadly COVID-19 outbreak is evolving,” Pharmaceutical Technology, updated May 13, 25 David Leonhardt and Yaryna Serkez, “America Will Struggle After Coronavirus. These Charts Show Why,” New York Times, April 10, 2020, 26 “COVID-19 to send almost all G20 countries into a recession,” The Economist (March 26, 2020), updated April 14, 27 “Global Town Hall: Impact of COVID-19 to Global Business Valuation and Appraisal,” webinar sponsored by NACVA, ASA, CBA, RICS, and GACVA, April 8, one knows when we will return to a level similar to January 1, 2019, it could quite likely be the end of 2021. With all this uncertainty, what should a valuator consider for an estate or gift tax valuation for the IRS? Tips for Preparing FMV Valuations for the IRS The IRS is tasked with auditing gift and estate tax returns and determining the fair market value with respect to closely held businesses or interests therein as of a given date for estate and gift tax purposes. When preparing a valuation, a good place to start is to develop an understanding of the IRS’s historical perspective by reviewing the Discount for Lack of Marketability (DLOM) Job Aid, the Reasonable Compensation Job Aid, and the S Corporation Valuation Job Aid.28 Armed with this knowledge, consider three recent court cases in which the IRS did not fare well: Estate of Aaron U. Jones v. Commissioner,29 Kress v. United States,30 and Pierson M. Grieve v. Commissioner.31 Following are several practice strategies to consider in the current environment, based on experience with the IRS’s approach toward valuations during the 2008–09 downturn. Do not apply a larger discount for lack of marketability (DLOM). One straightforward approach during an economic downturn is to value the business as you may have historically and simply apply a bigger DLOM, given the facts in your case if applicable. This approach may be appropriate in other venues, but it is likely to raise a red flag for the IRS and is not recommended without an extensive explanation and factual development. The most common adjustment the IRS makes to business valuations is to challenge the valuator’s DLOM analysis. The IRS is far more likely to audit valuations that use this approach, to explore how the DLOM was determined, and to scrutinize the valuator’s explanation of the reconciliation of DLOM alternatives. Emphasize the income approach. In the current climate, it is likely that the market approach will be less relevant due to a lack of current data, and that the asset-based approach in many instances is probably not appropriate for an ongoing business (although it may be appropriate in some situations). As a result, the income approach will likely be emphasized 28 See 29 T.C. Memo 30 372 F.Supp.3d 731 (E.D. Wis. 31 T.C. Memo A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 16 MAY | JUNE 2020 t h e v a l u e e x a m i n e r in many cases. Considering the income approach, the key variables of discount rate, growth rate, and adjusted cash flows are likely your most significant areas of concern. Risk is likely to be higher at this time. If so, document this in the development of your discount rate. Consider at least two or possibly three capitalization rates. You might use short-term, mid-term, and long-term discount and growth rates. Perhaps you have an expectation of most-probable, higher-possible, and lower-possible scenarios, or expected recoveries that are V-shaped, U-shaped, W-shaped (or even WW-shaped), or L-shaped. Be prepared to explain the durations you are considering for each stage and why. Get help. You are not in this alone. Be sure to explore resources for ideas, such as Aswath Damodaran’s NYU website32 or Chris Mercer’s blogs.33 Have you considered various models, such as Chris Mercer’s QMDM model,34 as a check? Consult your professional organizations’ websites and other resources.35 Network with others and ask them what they are doing. Consider a sensitivity analysis. A sensitivity analysis focusing on the most significant variables can be highly effective. The key here is to document what you did and why you did it, presenting a reasonable explanation that a lay person could understand. In most cases, your client’s valuation issues will be addressed by an IRS estate and gift tax attorney. If you can provide the attorney with a well thought out, easily understood analysis, it may be possible to resolve the issue without the need to bring in an IRS business 32 “Damodaran Online,” NYU Stern School of Business, accessed May 14, 2020, 33 “Chris Mercer—Useful Business Valuation Information and Insights,” accessed May 14, 34 Chris Mercer, “The Quantitative Marketability Discount Model’s (QMDM) 20th Anniversary,” accessed May 14, 2020, 35 See, e.g., Robert Schlegel, “A Veteran Valuer’s Guidance on COVID-19 and the ‘Soul’ of a Business,” interview, Business Valuation Update 26, no. 5 (May Richard Peil, Craig Jacobson, and Dan Korczyk, “The Valuation Paradigm of COVID-19: Using the DCF Method After an Economic Crisis,” Business Valuation Update 26, no. 5 (May 2020), Dokuchaev, “A Revisit of ‘Known or Knowable’ and Subsequent Events in the COVID-19 World,” Business Valuation Update 26, no. 5 (May valuator. You might also consider applying a Monte Carlo simulation to your discounted cash flow analysis.36 Once you have completed your business valuation using this approach, return to your DLOM analysis. But be aware that much of the impact may already be incorporated into your probability discounted cash flow analysis, so be careful to avoid double-dipping with a larger DLOM. This approach will involve more work on your part to address these questions; to apply probabilities to various scenarios based on your interview with the client, your own research, and your informed judgment; and to adequately document your findings in your report. A panelist on a recent five- society webinar37 suggested that for a one-time client, you should consider charging a significantly higher fee for this service, while you may want to limit your charges for an established, continuing client. Conclusion In the current environment, it is wise to avoid presenting the IRS with a large DLOM in the absence of reliable market information. An approach that considers adjusted cash flows and multiple capitalization rates and probabilities, and includes a well-reasoned explanation, will likely meet the requirements of Revenue Ruling 59-60 and minimize the likelihood of an audit by the IRS. Michael Gregory, CVA, ASA, is the founder of Michael Gregory Consulting, LLC, a firm that addresses IRS valuation issues and conflict resolution, and the founder of The Collaboration Effect® to address public speaking engagements. Mr. Gregory is a Qualified Mediator with the Minnesota Supreme Court, headed up business valuation at the IRS, and authored the most comprehensive text ever written on the subject, entitled Business Valuations and the IRS: Five Books in One. Mr. Gregory has a BS from Valparaiso University, an MS from the University of Wisconsin—Madison, and an MBA from DePaul University. Email: 36 Wasif Mukhtar and Ravi Agarwal, “DCF Valuation of a Firm: A Case for Application of Monte Carlo Simulation,” November 7, 2009, 37 “Global Town Hall: Impact of COVID-19 to Global Business Valuation and Appraisal” (see n. 27). VEA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES t h e v a l u e e x a m i n e r MAY | JUNE 2020 17 VALUATION /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// Interpreting the AICPA’s New Statement on Standards for Forensic Services By Robert W. Carter, MS, CPA, CFF, CVA, CFE, CEPA In the forensics and valuation community, it is essential to monitor the changing standards in the industry, not only to prevent violations, but to make sure we are keeping up with best practices. Recently, the AICPA published the Statement on Standards for Forensic Services No. 1 (SSFS 1). Although these new standards are not specific to NACVA members, they do apply to all AICPA members and could possibly apply to nonmember CPAs as well. Either way, it is crucial for practitioners to be aware of standards that impact the profession. Accordingly, the discussion below provides an overview of the new standards and their implications. Background The new standards were proposed as an exposure draft for most of 2019, with an original effective date of May 1, 2019. After receiving comments on the exposure draft, the AICPA revised and reissued the standards with an effective date of January 1, 2020. It is important to note that SSFS 1 applies to all new engagements that begin after the effective date. However, practitioners are permitted to apply the new standards to engagements that were in process as of the effective date. SSFS 1, like the Statement on Standards for Consulting Services No. 1, is subject to independence and objectivity requirements, including the use of professional competence, due professional care, considerations for planning and supervision, and reliance on sufficient relevant data. Applicability Many current litigation, forensic, and valuation standards determine applicability based on the type of deliverable produced. However, SSFS 1 bases applicability on the purpose of the engagement. According to the AICPA, the new standards apply to members when performing the following engagements: •“Litigation. An actual or potential legal or regulatory proceeding before a trier of fact or a regulatory body as an expert witness, consultant, neutral, mediator, or arbitrator in connection with the resolution of disputes between parties. The term litigation as used herein is not limited to formal litigation but is inclusive of disputes and all forms of alternative dispute resolution.”1 •“Investigation. A matter conducted in response to specific concerns of wrongdoing in which the member is engaged to perform procedures to collect, analyze, evaluate, or interpret certain evidential matter to assist the stakeholders (for example, client, board of directors, independent auditor, or regulator) in reaching a conclusion on the merits of the concerns.”2 As a result, if an engagement is expected to be disputed by a relevant party, then the standards will apply under the litigation clause, regardless of whether a case is filed in the court system. In addition, the investigation clause will cover most forensic engagements. There are a few notable exceptions. SSFS 1 does not apply to: •Internal use assignments—that is, engagements performed by an employee of an organization for management of that same organization. •A member who serves as a fact witness in a litigation matter rather than an expert witness. •A member who provides an expert opinion that is not related to a disputed matter. This includes discussing your knowledge of a specific subject with a client if you are not expected to testify or the matter is not expected to result in a dispute. Implications for Practitioners Although long considered a best practice, SSFS 1 now requires an expert to have an understanding with the client regarding the scope of the engagement. It does not require a written engagement letter, but there must be at least a verbal understanding between the parties. To the extent there 1 AICPA SSFS 1, paragraph 1. 2 Ibid.A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 18 MAY | JUNE 2020 t h e v a l u e e x a m i n e r is a change in the scope of the engagement, an additional understanding with the client must be obtained, whether written or verbal. To verify that this requirement has been met, it would be prudent to have a written document. Note that there is no requirement for any written understanding to include a reference to SSFS 1. A major change relates to the clarification of contingency fees received by experts. Although contingent fees are still restricted in litigation matters or where it can be assumed a third party will rely on the expert’s opinion, subject matter experts may have contingency fee agreements with clients outside of dispute or litigation engagements. This allows AICPA members who serve as business brokers or practice in other fields that regularly charge contingency fees to do so without violating professional standards. Another important clarification relates to an expert’s ability to express legal conclusions. Typically, accounting experts are advised not to do so, but blanket restrictions on legal conclusions are viewed by many as overbroad. For example, if an expert is an accountant and an attorney, it would be unreasonable to restrict him or her from drawing legal conclusions. Similarly, it seems reasonable to allow an expert with tax expertise to reach a legal conclusion regarding interpretation of the tax code. It appears that the AICPA recognized this: Rather than bar forensic accountants entirely from expressing legal conclusions, SSFS 1 specifically prohibits them from “opining regarding the ultimate conclusion of fraud.” This restriction does not apply, however, when a forensic accountant is the trier of fact—for example, when serving as an independent arbitrator. One item that initially caused concern for valuation experts, but has since been clarified, relates to calculations of value. SSFS 1 states that when a member is hired by one party in a litigation context, he or she is not permitted to prepare an agreed-upon procedures report. This was originally interpreted to mean that, under AT-C3 Section 215, a member is not providing an opinion or conclusion when preparing a calculation of value. The former chair of the NACVA Standards Board, Zachary Meyers, contacted the head of the AICPA committee that prepared SSFS 1, who explained that calculations of value do not fall under that restriction unless the expert does not use professional judgment. Thus, a calculation of value that does not rely on professional judgment is an agreed-upon procedure engagement that does not result in an opinion or conclusion and, therefore, is prohibited under the new standards. Note that this restriction does not apply when an expert is engaged by the trier of fact or by both parties jointly. Conclusion In many respects, SSFS 1 reinforces practices that many forensic accountants are already, or should be, following. Nevertheless, practitioners should take the time to review the new published standards. This will allow them to comply with industry best practices and ensure that they are not surprised by any significant changes to their engagements. Robert Carter, MS, CPA, CFF, CVA, CFE, CEPA, is the partner in charge of the Litigation, Forensics, and Business Valuation Department at Hertzbach & Company, P.A., in Owings Mills, MD, and has been performing valuation services for over a decade. He provides expert opinions regarding business valuations, performs forensic accounting and fraud investigations, and serves as a financial expert witness in legal matters. He has held influential positions within his area of expertise as the former president of the Maryland/DC Chapter and the current chair of the Standards Board of the National Association of Certified Valuators and Analysts. Mr. Carter is an adjunct professor at Stevenson University and the University of Baltimore. Email: 3 AT-C refers to the AICPA’s clarified attestation standards. Rather than bar forensic accountants entirely from expressing legal conclusions, SSFS 1 specifically prohibits them from “opining regarding the ultimate conclusion of fraud.” VEA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES t h e v a l u e e x a m i n e r MAY | JUNE 2020 19 VALUATION /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// Firm Life Cycle Stage Explains Fundamentals: Evidence from the Statement of Cash Flows By Davit Adut, Victoria Dickinson, and Philipp Schaberl The concept of life cycle stage (LCS) is taught in marketing classes as it relates to product development. A new product is introduced (introduction), gains traction in the market (growth stage), becomes saturated (mature), and eventually loses market share to new and improved substitutes (de- cline). Recently, however, the life cycle progression has been shown to apply to firms as well. Dickinson (2011)1 states that firms are comprised of multiple products and services, each with its own product life cycle stage. These overlap- ping product life cycles can be aggregated to determine a firm life cycle stage. A primary difference is that a firm’s optimal path is not to progress linearly from introduction to decline, but rather to manage its portfolio of products (or perhaps subsidiaries) to remain in an infinite loop between the growth and mature stages, where profits (and value) are maximized and risk is minimized. Dickinson (2011) introduced a way to classify firms into their LCSs according to the patterns of cash flows from the statement of cash flows. In this paper, we summarize how to estimate firm life cycle based on the Dickinson model and demonstrate differences in valuation fundamentals across firm LCSs overall and within industry divisions. Firm LCS captures the interaction of the firm’s internal resources and capabilities with the competitive environment in which it operates. Moreover, using cash flow patterns to measure firm life cycle utilizes the entire financial information set stemming from a firm’s underlying transactions (i.e., it is organic to the firm’s operations). This means the life cycle measure is not contaminated by managerial accounting discretion or estimates that are afforded within generally accepted accounting principles. Earnings (revenues less expenses captured by operating cash flows), investment (investing cash flows) and risk (financing 1 Victoria Dickinson, “Cash flow patterns as a proxy for firm life cycle,” The Accounting Review 86, no. 6 (November 2011): 1969–1994. cash flows) are combined in one valuation signal: firm LCS. Whether value is modeled as earnings capitalization, discounted cash flow, or residual income, all value drivers are captured by the cash flow activities inherent in the firm life cycle signal. As such, revenue, net income, and operating cash flow will all be differentially affected by LCS in any given year. Understanding the expected levels in these fundamentals for each firm LCS will improve current valuation data, and changes from one LCS to another provide important forecasting insights. Subsequent studies have successfully used this life cycle classification method in a variety of settings. Vorst and Yohn (2018)2 find that analyzing firms by LCS improves profitability and growth forecasting accuracy, while Anderson et al. (2019)3 find that elements of the DuPont decomposition vary predictably by LCS. Dickinson et al. (2018)4 find that investors price earnings versus book value differently based on firm life cycle and Cantrell and Dickinson (2020)5 demonstrate that leader and laggard behavior of firms is captured by the intersection of firm and industry life cycles. The degree of cost asymmetry and investment in innovation versus capital maintenance (Anderson and Lee, 2017,6 and Enache and 2 Patrick Vorst and Teri Lombardi Yohn, “Life cycle models and forecasting profitability and growth,” The Accounting Review 93, no. 6 (November 2018): 357–381. 3 Mark Anderson, Soonchul Hyun, and Dongning Yu, “DuPont Analysis and Firm Life Cycle” (working paper, University of Calgary and University of North Carolina Greensboro, 2019). 4 Victoria Dickinson, Haimanot Kassa, and Philipp D. Schaberl, “What information matters to investors at different stages of a firm’s life cycle?,” Advances in Accounting 42 (September 2018): 22–33. 5 Brett W. Cantrell and Victoria Dickinson, “Conditional Life Cycle: An Examination of Operating Performance for Leaders and Laggards,” Management Science 66, no. 1 (January 2020): 433–451. 6 Mark Anderson and Joo Hyung Lee, “Slack Resources as Real Options: A Life Cycle Analysis” (working paper, University of Calgary and University of Windsor, 2017).Next >