New survey explores the strange, unsettled world of normalization adjustments
Normalization adjustments to cash flows continue to be one of the more common—but still controversial—aspects of valuing a private company under the income approach. For instance:
- Do you routinely adjust for nonrecurring expenditures?
- Do you use a normalized capital structure when calculating the cost of capital?
- Do you make compensation adjustments in valuing a controlling interest?
- Do you consider an adjustment to owner’s comp as a “normalization” or a “control” adjustment?
- How do you distinguish between normalization adjustments for a control value versus those for a minority value?
- What is the most common mistake you observe appraisers making in the area of normalization adjustments?
- What is the strangest normalization adjustment you ever made?
- Have you ever had a court disallow an adjustment?
Our latest online survey will answer these and many more questions. The results will provide appraisal professionals with insights into their own practices as well as the general practices of the BV community. To participate, click here now.
Our thanks to Brandi Ruffalo (Valuation & Forensic Partners) and Garth Tebay (Value Defined) for constructing the comprehensive survey. Look for highlights in next week’s ’Wire. On December 6, be sure to join Ruffalo and Tebay with for their Advanced Workshop on Normalization Adjustments. During this intense, four-hour, interactive workshop, the presenters will analyze and discuss the complete survey results and provide the most current and credible methods for making these critical adjustments. Note: 4.5 CPE credits are available for workshop attendees.
Majority of appraisers still rely on S corp models —but more may be adjusting the discount rate
At the start of their most recent presentation on valuing S corporations, Nancy Fannon (Meyers Harrison & Pia) and Keith Sellers (University of Denver) asked the over 300 attendees—a record-breaking number for BVR webinars, by the way—how they currently address pass-through entity status. Their responses:
- Just over half (56%) used one of the four “BV models” (by Treharne, Mercer, Van Vleet, and Grabowski);
- Nearly a quarter (22%) said they didn’t treat S corps any differently than they do C corps;
- Only 6% used the model of the Delaware Chancery (as also adopted by the Bernier court);
- Seven percent made no adjustment for income taxes; and
- The same number (7%) adjusted the discount rate.
“No matter which of those ways you selected, I don’t think there is any ‘wrong’ way from a methodological perspective,” Fannon said. “What [our] research tells us is the magnitude of the adjustment that we have been making is off” and tends to overstate the impact.
“We believe the most proper way to address this issue of the valuation of pass-through entities is to more or less adjust or fix the cost of capital that we derive from publicly traded companies, so that it is a better fit for the pass-through entity that we are looking at,” added Sellers. “We feel that this is consistent with what we already do [in private company valuations]. We already adjust values derived from publicly traded data for size, liquidity and company-specific risk.”
“That does not mean that you can't continue to employ S corp models,” Fannon added. “When you are adjusting a valuation you can either do it in your cash flow or you can do it through your rate of return. Theoretically you can get to the same place either way,” but because “this really is a cost of capital issue like size, like liquidity,… I think it is more properly reflected in the development of our discount rate.”
Notably, when attendees took the same poll at the conclusion of the presentation, roughly the same percentage (58%) said that they would still use one of the four BV models and 6% would still use the DE Chancery/Bernier model. However, only 10% said they would use C corp methods (down from 22%), and only 2% would make no deduction for income taxes (down from 7%). Instead, 22% of attendees said they will now adjust the discount rate—up from 7%.
What Fannon does now. “I make an adjustment to the discount rate, as that is where I believe it belongs,” Fannon tells BVWire. In her current research with Sellers, they are attempting to identify and remove the tax penalty/effect that is already "baked into" the market return data from public companies. “You can accomplish the same thing by continuing to use any of the S corp models,” she says, “but if you do, be familiar with the academic research that indicates such effect is mitigated by other factors.”
Judges to BV experts: admitting weaknesses makes you stronger
“Financial experts are so important in cases,” said the Hon. Alice Blackwell (9th Judicial Circuit Court, Ariz.), who spoke at the 2012 AICPA FVS Conference in Phoenix. Economic damages cases—as well as divorce, tax, and fraud cases—“rise and fall” on an expert’s testimony, Blackwell said, which often “depends on whether juries believe you or not.”
How to convince juries of your credibility? “It’s not by talking more,” said the Hon. Richard Gabriel, who sits on the Colorado Court of Appeals. “Get to the point—juries love that.” They also appreciate consistency. “Presentation is really, really important. The bad expert is the one who looks like one person on direct examination and then [looks like] a completely different person on cross.” When the difference is striking, “you look like a hired gun to the jury,” Gabriel said, “and your credibility is gone.”
What juries (and judges) also want to hear—after experts list their qualifications, their opinion, and how they reached it—is that they used a method that made sense; they didn’t duck a “bad” issue or fact or pretend it didn’t exist. “If you are such an advocate for your opinion that you can’t admit your weaknesses, then you have no credibility,” Blackwell said. Instead, admit that you considered any weaknesses and explain how you accommodated or overcame them. “Wow,” she said, “that’s a powerful opinion.”
“And don’t be condescending,” added the Hon. Rebecca Kourlis (Institute for the Advancement of the American Legal System). If confidence on direct examination turns to condescension on cross, “that will turn juries off,” Gabriel agreed.
Look for more practical tips from the AICPA judges’ panel in the January 2013 Business Valuation Update. And mark your calendar: The 2013 AICPA FVS Conference will take place next November 10-12 in Las Vegas; for more information, click here. The AICPA FVS section has also issued a call for “new and innovative” presentations and papers for the 2013 conference.
IRS refuses to back down on defined-value clauses
After withdrawing its appeal in Wandry v. Commissioner, the IRS has since filed its “nonacquiescence” to the decision. According to the accompanying IRS Bulletin:
“Nonacquiescence” signifies that, although no further review was sought, the Service does not agree with the holding of the court and, generally, will not follow the decision in disposing of cases involving other taxpayers. In reference to an opinion of a circuit court of appeals, a “nonacquiescence” indicates that the Service will not follow the holding on a nationwide basis. However, the Service will recognize the precedential impact of the opinion on cases arising within the venue of the deciding circuit.
According to Peter Reilly (Grant Thornton), writing in Forbes, the news of nonacquiescence is not good for 2012 gift giving:
The Wandry decision has not been overturned. In principle, it still works, but the IRS has thrown down the gauntlet on it. It would seem that relying on it for a mega-gift would be risky. If there is plenty of liquidity to pay the resulting gift tax if it does not work, it might be worth trying, but not otherwise. For those who are charitably inclined, the Petter case, which was upheld by the Ninth Circuit, is worth considering. Under the Petter formula, units would be transferred to charity rather than coming back to the donor. Barring that, 2012 mega-gifts should be made with property that is not open to significant valuation adjustment.
For more on Petter, see our report in BVWire #107-2.
Is convergence dead?
After the SEC staff released its final report on IFRS convergence this summer—essentially backing off any strong endorsement, let alone implementation—the IFRS foundation (the parent of the International Accounting Standards Board) fired back with its own 84-page work plan for “incorporating IFRS into the financial reporting system for U.S. issuers.”
“The publication of the SEC Staff Report represents an important milestone for the SEC on its multi-year evaluation of International Financial Reporting Standards (IFRS),” the report begins. After reciting the long road toward convergence—starting with the SEC’s first efforts in 1973 to help create an international standards-setting committee and culminating with its 2008 “roadmap” for convergence—the report reviews “a range of studies that point to benefits from mandatory adoption of IFRS,” such as the improved efficiency of capital markets and cross-border investments. It also addresses the SEC’s most significant concerns, in particular the funding of the foundation as well as the costs of transition.
However, most of these concerns “are not unique to the U.S.,” the report concludes. Although the size of the U.S. economy is certainly an important factor to consider, “the experience of other countries suggests that many of the challenges can be overcome with the appropriate political will to make a commitment to the mission of a single set of global standards.”
Is the IASB in denial? “So sorry to have to break it to the IASB staff, but they are deluding themselves. The reality is that the FASB believes that U.S. GAAP is better,” says an online article, “The IASB Stages of Grief”:
The IASB must surely understand that the SEC staff's backtracking has posed an existential threat—if not to the IASB's existence, then at least as the standard setter for the U.S. and Europe. After Europe finds that working with an IASB that doesn't control the U.S. does it no good, then it will be all over but the shouting. The next step down will be for every other country with mature standard-setting mechanisms to revert to their old ways, and the IASB will find itself where it was about twenty years ago—where only smaller economies will require companies to represent full compliance with IFRS, and everyone else will pick up the rules they like and leave the rest.
Patent infringement filings at an all-time high
“Last year marked the most dramatic change to the U.S. patent system in nearly six decades, with the passage of the Leahy-Smith America Invents Act (AIA), which converted the patent system from a ‘first to invent’ to a ‘first inventor to file’ system,” says a new report by PricewaterhouseCoopers. “The AIA ... indeed brought significant changes in certain areas. But it did not address the calculation of damages in patent infringement matters,” as prior drafts of the bill suggested. Nor did it help reduce the number of patent infringement filings.
Indeed, according to the PwC 2012 Patent Litigation Study, patent holders filed over 4,000 infringement claims in 2011—the highest number recorded since the annual study began (in 1980)—and a 22% jump over the previous year. Additional highlights of the 2012 PwC study:
- Expect more demands for jury trials. From 2006 to 2011, the annual median damages award was $4 million; however, the median jury award during the same time amounted to more than 20 times the median bench award;
- Expect lower awards. From 1995 to 2011, the annual median award ranged from $1.9 million to $16.1 million; divided into thirds, the median damages award over the most recent five-year period (2006 to 2011) represents the lowest relative point, falling to less than half of the median award between 2001 and 2005; and
- Expect royalty claims to continue. Reasonable royalties “remain the predominant measure” of recovery, representing more than 80% of patent damages awards over the past six years;
- Expect continued scrutiny from the courts. The absence of reform in the damages area means the courts will continue to play the primary role in determining the methods and measure of patent infringement remedies—as evidenced by the Federal Circuit’s rejection of the 25% rule of thumb and its tightening of the requirements to prove reasonable royalty damages.
Patent attorneys and IP experts “should monitor ongoing rulings that could affect damages opinions and methodologies,” the PwC report advises.
Expect to find the most current rulings on IP damages at BVLaw.
A silver lining to superstorm Sandy for
In the wake of an estimated $50 billion in economic losses caused by superstorm Sandy, many businesses and individuals are still struggling. Many companies will be relying on their business-interruption insurance policies to recover some or all of their losses—and “would be wise to bring in a forensic accountant to help with documentation,” says the most recent Forensic and Valuation Reporter (AICPA FVS). “Other companies are using forensic accountants to determine potential exposure before an event.” To highlight the opportunities during hard times, the FVS section is sponsoring a free webinar on December 6: “Disaster Recovery: The Role of the CPA in Insurance and FEMA Claims.”
NY CPAs get a reprieve. To assist local professionals hit hard by Sandy, the New York Office of Professions (NYOP) has just announced that all those with November 2012 and December 2012 license renewal deadlines will now have until Feb. 1, 2013, to meet their requirements. New York licensed professionals should consult the official announcement, posted on the NYOP website, for further details and instructions on how to replace lost or damaged documents.
Appraisers still looking for the best empirical data to value FLPs
Less than half (46.5%) of respondents to our recent survey on DCF inputs and analysis still rely on the data from Partnership Profiles to determine discounts for family limited partnerships and similar companies holding real property interests. Just over a quarter (27.1%) indicated they were “concerned about relying on the decreasing number of transactions in the database,” while roughly the same number, 26.4%, chose to provide further comments.
“We still subscribe and look at the data,” said one respondent, who reflected the general consensus that the database provides “just another data point in helping to quantify the discounts” and serves as a reasonableness check before the appraiser “makes an informed decision” based on all the facts and circumstances. Another participant broadens the sample size “to cover a range of years and asset classes,” and then adjusts the observed discount “down to reflect the element of reduced liquidity relative to a liquid securities market.”
How to make the most informed judgments using all relevant data. On December 4, join Bruce Johnson (Munroe, Park & Johnson) for “Using Empirical Data to Value Family Limited Partnerships,” Part 3 of BVR’s 5th Annual Online Symposium on Estate & Gift Tax.
IVSC tackles valuation uncertainty
The International Valuation Standards Council (IVSC) has just released an exposure draft titled “Valuation Uncertainty.” The proposed guidance examines how analysts can identify, explain, and disclose valuation uncertainty “in a way that is informative to those relying on valuations,” says an IVSC release.
The exposure draft, in part, answers “calls from the G20 and financial regulators around the world for improved standards of transparency and disclosure of valuation uncertainty factors.” Too many institutions were placing “wholly inappropriate confidence in valuations in the period leading up to the 2008 financial crisis,” the IVSC release says, and “the sudden evaporation of that confidence was a major contributor to the subsequent crash.” Further, the exposure draft:
makes a clear distinction between market risk, which is both generally understood and acknowledged by investors and reflected in the pricing, and uncertainty caused by disruption or dislocation in the market place. It also gives guidance to valuation providers on the principles that should be observed in measuring and disclosing uncertainty.
Comments on the draft are due by Feb. 13, 2013.
Last chance to register for customer relationships CPE
Despite the crucial importance of customer relationships in an intangible asset valuation, there is wide divergence among appraisers in their measurement of attrition rates and contributory asset charges, among other factors. This Thursday, November 29, join Poonam Vaidya (Crowe Horwath) and Thomas Zambito (BDO Consulting) for “Valuing Customer Relationships,” which will cover all aspects of the analysis, from data collection through consideration of historic sales and attrition rates to an ultimate conclusion of value.
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