November 14, 2012 | Issue #122-2  

Tax Court excludes draft reports from discovery

Following the trend in federal district and circuit courts, the U.S. Tax Court recently amended its Rules of Practice & Procedure to exclude the draft of expert reports from discovery, “regardless of the form in which the draft is recorded.”

In addition—and also to align with the federal rules—the Tax Court’s Rule 70 now protects communications between experts and attorneys from discovery, “regardless” of their form, with three important exceptions relating to communications that contain:

  • The expert’s compensation;
  • Facts or data that the attorney identifies for the expert; and
  • Assumptions that the attorney provides to the expert.

The new Tax Court rules also protect the reports and opinions of any consulting (nontestifying) expert. To read all the changes to the rules—which became effective in July 2012 and which the court has made available prior to official publication—click here.

Not surprisingly, the Tax Court has yet to issue any decision interpreting the amended rules, in particular, the two exceptions concerning communications in which the attorney identifies facts or provides assumptions that the expert later uses to form a final opinion. This also follows a trend in federal courts, which have published few cases concerning the revised Rule 26, leaving many unsettled or “gray” areas. Consider, for example, a discussion in which an attorney mentions a fact that the expert might have already gleaned from another source, such as a deposition, but then the two continue to talk about the fact’s significance in the case. Clearly, the second part of the discussion is protected under the revised federal rules—but is the first part?

“That’s slicing the salami pretty thin,” says attorney John Rogers (Perkins Coie), whose overview of the amended federal rules appears in the December Business Valuation Update and provides best practices for BV experts testifying in all federal courts, including now the Tax Court. Our thanks to Brad Pursel (Brown Smith Wallace), who touched on the Tax Court’s amended rules as part of his broader presentation on “Taxes in Valuation: Where Are We?” at the AICPA Forensic & Valuation Services (FVS) Conference this week in Orlando, Fla. More conference highlights to come …

ABV credential still going strong, while CFF has ‘taken off’

When the AICPA first introduced the CFF credential just four years ago, it was hoping to admit 1,000 practitioners with the certification in financial forensics. Instead, it registered 3,000. Since then, the CFF credential has “taken off,” according to Ralph Stephens (Postlethwaite & Netterville), who addressed the FVS Town Hall at the Orlando conference on Monday.

In fact, the most recent AICPA Forensic FVS Trend Survey identifies financial forensics as one of the fastest growing practice areas for accountants, valuation analysts, and computer investigators. In terms of engagements, the growth areas for forensic specialists appear to be divorce, economic damages, and financial statement fraud. “For valuation professionals, the areas with greatest jumps in demand within the past year included shareholder/partner disputes, contractual disputes, family law, and gift and estate issues,” says the survey’s executive summary. Respondents also ranked the top five challenges for forensic professionals over the next two to five years:

  • Attracting and retaining qualified staff (25% of respondents);
  • Keeping abreast of regulatory changes (14%);
  • The economy (13%);
  • Competition and fee pressure (11%); and
  • Technology (9%).

In the meantime, ABV certification is still seeing an annual growth rate of about 24%, according to Bill Kennedy (FTI Consulting), who also addressed the FVS Town Hall as chair of the ABV credential committee. Currently, approximately 3,000 professionals hold the Accredited in Business Valuation credential, with just about 250 new registrants every year. “We want to continue to drive these numbers,” Kennedy said, in large part by supporting members’ FVS practices. Both the ABV and CFF committees oversee a “champion” program, in which individual practitioners actively promote the respective credentials to their state bar, CPA, and other professional associations; and both committees are revisiting exam and other educational requirements with an eye toward continuous improvement.

The FVS executive committee has also had a “busy year,” said Eddy Parker, senior technical manager for the FVS division. For instance, Parker met with the SEC’s Paul Beswick to discuss the latter’s desire to see a more unified valuation profession. The committee also drafted “robust” comment letters in response to recent proposed revisions to USPAP as well as international accounting ethical standards (see item below). All in all, “you are in the right place,” Parker told the conference room full of CPAs, ABVs, and CFFs. “You are on the cutting edge.”

What isn’t unsettled about the DCF analysis?

Our most recent online survey explored the more debatable aspects of the DCF, such as the treatment of cash, depreciation and capex, and marketability discounts. In a final question, we asked respondents to name any additional, unsettled areas of the analysis.

“Where to begin,” says one. The terminal growth rate, for example: If inflation is 2%, then how can the terminal growth rate be anything less? If global GDP is 6%, how can your terminal rate be any more? “It can’t,” this participant insists, “yet we see appraisals with such growth rates.” Similarly, some BV analysts use minority cash flows and don’t use a minority discount; some use controlling cash flows and then take the discount, or, when valuing a controlling interest in a company with different classes of stock, some appraisers ignore the preferred holders and assume industry weights when calculating WACC. “I’m sure the list could go on.”

In fact, survey comments provided the following (but not final) list of debatable DCF mechanics:

  • “I wish people would stop including the option pool in their OPMs when the equity value is based only on outstanding securities.”
  • Loan guarantees do not affect valuation; however, “we all know that if one partner pledges personal assets against some debt, the distribution of equity shouldn’t be 50/50. This should receive more attention in the valuation community.”
  • “Which size premia to use—10v, 10a, 10b.”
  • WACC: which tax rate to use, which interest rate, and what weightings to use for debt and equity.
  • “All aspects of the cost of equity estimate—even the appropriate risk-free rate.”
  • “In almost all DCF valuations I have seen, there is never even an attempt to make sure that in the terminal value assumption, the return on invested capital is equal to WACC.”
  • The length of the projection horizon: “There is no rule that says it has to be five years. Theoretically, the time horizon could be cut off as soon as you can incorporate a steady growth assumption.”
  • “Gordon Growth vs. EBITDA multiples in the terminal value and the relevance of EBITDA reasonableness checks in high-risk, high-growth companies.”
  • Tax affecting pass-through entity cash flows for non-tax-related engagements, such as divorce, shareholder disputes, etc.

“Everything is unsettled in the courts!” another participant believes, particularly in Daubert cases, when poor expert testimony may lead a court to reject even “settled” DCF assumptions. At that same time, another respondent believes: “The only things that are unsettled are by … judges who do not understand valuation or by academics who always try to reinvent the wheel with things that nobody who buys real companies does.” Bottom line: The debate on the DCF will continue in the valuation community and the courts. Is there any particular “unsettled” aspect of the analysis you’d like us to survey in-depth? Please email the editor.

Best practices on portfolio valuations, by
Houlihan Lokey

Investors are demanding greater transparency and reporting integrity from asset managers, particularly those overseeing illiquid investments, says a new release from analysts at Houlihan Lokey. Regulators have added to the pressures of the valuation process, leaving asset managers with many questions about the selection and use of third-party valuation analysts.

To help provide answers and address evolving trends in the area, Houlihan Lokey's division of portfolio valuation and advisory services—led by Cindy Ma—has just released a new best practices overview: Independent Third-Party Valuation Insights. To download a copy, click here.

Five questions lawyers will ask about your cap/earnings approach

The capitalization of earnings/cash flows approach “is more complex than just selecting the final year earnings/cash flows or trying to derive a value use of a weighting scheme,” writes J. Richard Claywell in the current Family Lawyer Magazine. “The appraiser must understand and have the experience to apply the methods correctly.” If not, attorneys can use the following five questions to identify any problems with the appraiser’s cap/earnings approach:

  • How did you select and use the assigned weights?
  • Based on your calculations, can you demonstrate that the earnings/cash flows are stabilized?
  • If you are capitalizing the earnings/cash flows, why does the final year not represent the future?
  • If the earnings/cash flows are not stabilized, why would you use this method?
  • If growth is expected to continue beyond the final year, why would you use lower earnings than the final year’s earnings?

Publishing potential for BV experts. The complete article, “Capitalization of Earnings Method of Value, Will Your Expert’s Opinion Withstand Scrutiny?” is available here. The Family Lawyer Magazine publishes in hard copy once a year, but continually supplements its online edition with articles by legal and valuation experts, including Shannon Pratt and Alina Niculita, who have recently written pieces on the critical standard of value in divorce and the distinction between enterprise and personal goodwill.

New chapter on qualitative testing for goodwill impairment

In its continuing effort to update the valuation and accounting guide, Testing Goodwill for Impairment (2011), the AICPA’s Financial Reporting Executive Committee (FinREC) has just issued a working draft of Chapter 2, “Qualitative Assessment.”

The new chapter discusses and illustrates how to perform the optional qualitative assessment, which, in turn, helps appraisers and auditors determine whether to perform the two-step, quantitative goodwill impairment test set forth in FASB ASC 350-20. The working draft of the new chapter is available here. Comments are due by Dec. 31, 2012.

When a client commits a crime: International ethics board proposes new reporting standards

The International Ethics Standards Board for Accountants (IESBA) recently released for public exposure new requirements that address a professional accountant’s responsibilities to disclose a client’s (or an employer’s) suspected illegal act to an appropriate authority. Notably, such disclosure would likely breach the accountant’s duty of confidentiality, one of the five fundamental principles in the international Code of Ethics for Professional Accountants (the Code).

The exposure draft (ED), Responding to a Suspected Illegal Act, proposes adding two new sections addressing illegal acts to the Code—one each for professional accountants in public practice and professional accountants in business—and several revisions to other related sections. “Breaching confidentiality is not something to be taken lightly,” said Jörgen Holmquist, chair of the IESBA, in a related release. “However, when the consequences of non-disclosure are potentially harmful to individuals or society, confidentiality must be overridden. Accountants have an important role to play in protecting the public interest and enabling authorities to take appropriate action.”

Comments on the ED are requested by Dec. 15, 2012. Notably, the AICPA FVS Executive Committee has drafted comments that point out the proposal would “directly contradict AICPA requirements,” said Eddy Parker, who indicated the draft is currently sitting with the Professional Ethics Executive Committee for further comments and a coordinated statement. For more on the IESBA proposal, see, “When Should Accountants Spill the Beans?” (

Are the Georgia-Pacific factors dead, too?

The Federal Circuit’s recent Whitserve decision didn’t just sound the death knell for the 25% rule of thumb in patent litigation. It also “turned the Georgia-Pacific analysis on its head,” said Dan Jackson (AlixPartners), in a session on IP damages at the AICPA FVS conference in Orlando. In particular, experts may not simply recite each of the factors in a “cursory” or “conclusory” manner, the court ruled, but must fully analyze each factor and its impact on the damages calculation.

Although the court didn’t go so far as to discredit the analysis in every case (as it did the 25% rule), the decision may signal a turn toward fulfilling the prophecy by Chief Judge Randall Rader that the court will eventually “shoot down” the Georgia-Pacific framework entirely, Jackson said.

Indeed, just this past summer, Judge Rader admitted that he “bristles a bit” whenever he hears the words “Georgia-Pacific.” The factors are “just a laundry list to be considered,” he said, during an online interview with analysts from Stout Risius Ross; they “were never meant to be a test or a formula for resolving damages issues.” And yet:

Somehow it gets blown out of context—I see it time after time after time. […] The expert … is sitting on the stand and he or she will testify: Well, there are 15 Georgia-Pacific factors and six of them favor us and the other nine are neutral. Well, that is an attempt to convert this laundry list into some kind of a methodology. However, many of those 15 factors may be overlapping or irrelevant to a particular case. Yet some will try to make their case seem more reasonable by stacking up so many Georgia-Pacific factors in their favor and the rest are against their opponent or neutral. And that’s not what the Georgia-Pacific case was ever about and it’s a flawed methodology.

A game-changer. In his 30 years of practice, Jackson has “never seen as much change as I have in the past three years,” and the courts—particularly the Federal Circuit—are “changing the rules of the game that we have lived by for a long time.”

Legal market has not yet recovered from recession

Weakening demand combined with rising costs continue to curtail law firm profitability, according to the Peer Monitor Economic Index (PMI), a composite database drawn from domestic U.S., as well as international, firms, which measures the relative health of the legal marketplace. A PMI of 65 or more indicates robust health for the legal market—but during the third quarter of this year, the PMI fell one point, to a reading of 50, its second consecutive quarterly decline.

“Demand for law firm services was down 0.8 percent in the third quarter compared with the same time a year earlier,” says a PMI release. Nearly all practice areas suffered: Demand for litigation work fell 0.8% during the 3rd quarter, and, for the first time in nearly two years, IP litigation suffered a 3.6% drop. Likewise, corporate work fell 1.0%; bankruptcy was down by 2.6% and real estate by 2.7%. Labor/employment law was the only major practice area to improve in this last quarter, rising 2.5%.

Get a bounty of CPE credits before the holiday

On November 29, join Poonam Vaidya (Crowe Horwath) and Thomas Zambito (BDO Consulting) for “Valuing Customer Relationships,” which will cover all aspects of the analysis of customer relationships, from data collection through consideration of historic sales and attrition rates to an ultimate conclusion of value.

On December 6, Garth Tebay (Value Defined) and Brandi Ruffalo (Valuation & Forensic Partners) will lead an “Advanced Workshop on Normalization Adjustments,” which will cover the most current and credible methods for making these critical adjustments as well as recent court decisions interpreting what the experts did right—and what they got wrong—in the normalization process. Note: 4.5 CPE credits are available for attending this intense, interactive workshop.

Holiday hiatus: BVWire will be taking a break to enjoy the U.S. Thanksgiving holiday next week and hope our readers will have occasion to do the same with friends and family. We will resume publication on Wednesday, November 28.


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Copyright © 2012 by Business Valuation Resources, LLC
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