September 12, 2012 | Issue #120-1  

Once again, 22% of KMPG fair value audits fail PCAOB inspection

In its first inspection of a Big Four public accounting firm for the 2011 cycle, the Public Company Accounting Oversight Board (PCAOB) reviewed 52 audits by KPMG—plus one in which it was not the primary auditor—and found deficiencies in 12. Among other problems, the PCAOB identified the firm’s failure to sufficiently test the issuer’s valuation of securities, assets and liabilities, business combinations, troubled debt, accounts receivable, and more. To read the 2012 inspection report, click here.

Curiously, the board cited the same number of deficient audits (12 out of 52) in last year’s inspection of KPMG, but in 2009, it cited only eight audits (out of 60); and in 2007, only seven had problems (out of an unnamed total). Another apparent shift: As we noted in our report on the 2007 findings, KPMG was cited for failing to have an external valuation specialist test the conclusions, but in this most recent cycle, such citations related to KPMG’s use of an internal specialist. Has the firm largely brought the fair value work in-house, or is its use of external specialists not leading to deficiencies? And we don’t mean to pick on KPMG; the board will soon post inspection reports of the remaining Big 4 firms as well as McGladrey, BDO, Crowe Horwath, and Grant Thornton. According to at least one report, Jim Doty, PCAOB chair, expects to find at least as many problems with these firms’ fair value audits as KPMG’s.

What can independent valuation specialists do? “For those of you who are valuation specialists providing services to financial statement preparers and/or auditors, consider how you can help increase the understanding of preparers and auditors into what you do and how you do it,” said PCAOB member Jay Hanson (formerly of McGladrey) in his address to an AICPA conference on fair value this summer. “Proprietary valuation models aside, think about how you can explain the assumptions you are using, the sources of information on which you rely, and the judgments that are inherent in your valuation results,” Hanson added. “All of the important work that you do will mean very little if investors decide that they cannot trust the process by which important valuations are established and audited.”

Valuation ‘coming to the fore’ in current ESOP litigation

Valuation evidence and experts were the “big issue” in a recent jury trial—and the big reason why the plaintiffs, former participants in an employee stock bonus plan, won $1.5 million from their employer and plan administrator, reports Steve Whittington (Willamette Management Associates) in the most recent post to WMA’s new blog, Business Valuation Expert.

In Finnerty v. Stiefel Laboratories, Inc., Case No. 09-21871-CV (S.D. Fla.), a group of disgruntled shareholders claimed the plan (which for 25 years was an ESOP) valued their put rights at only $13,000 to $16,000 per share when—during the same period—the plan’s appraiser knew that PE funds offered upwards of $60,000 per share. Indeed, the company closed one of those deals and ultimately sold for $68,000 per share. At trial, the plaintiffs’ experts conducted multiple appraisals under various scenarios, including controlling and noncontrolling as well as discounted values. All showed a range of value well above the plaintiffs’ put price. “In sum,” Whittington says:

ESOP litigation is an area where we are seeing a lot more activity these days than at any time in the past. This case calls to the fore the critical issues for a dissenting or disgruntled shareholder: Did I get all the money I was due? The natural focal point of that question is whether the valuation was properly performed or not. In this case, it appears that the proper due diligence and valuation considerations were not taken into account.

Case update: After the $1.5 million verdict, the defendant immediately moved for a judgment as a matter of law and also—to preserve its rights—filed a notice of appeal to the 11th Circuit. Final pleadings on the former are due any day, and, of course, any published decision by the federal court will serve as binding precedent in the ESOP arena.
Stay tuned …

ASB issues round 2 of proposed USPAP revisions

At the end of last month, the Appraisal Standards Board (ASB) released the “Second Exposure Draft of Proposed Changes for the 2014-15 Edition of the Uniform Standards of Professional Appraisal Practice.” According to the announcement by the ASB’s parent, The Appraisal Foundation, this latest exposure draft includes proposed revisions to:

  • Reporting and Communication Requirements;
  • Reporting Options; and
  • Retirement of Standards 4 and 5.

Linda Trugman, ASA BV chair, and Arlene Ashcraft, the newest editor for the ASA e-update to members, are urging their constituency as well as other interested appraisers to read and respond to the latest revisions. Comments are due by Oct. 5, 2012, to

Download new Duff & Phelps article on size effect

Due to the continuing debate over the size effect—and, in particular, our item last week on the latest contribution—we’ve made the article by Jim Harrington (Duff & Phelps) available at our free resources page. Download your copy of “The Size Effect: A Persistent Effect Over Longer Periods,” originally available only to subscribers of the Duff & Phelps Risk Premium Report & Calculator, by clicking here.

Added benefit for subscribers. Purchasers of the Report now receive the Duff & Phelps Update, a new monthly newsletter available through BVR. Written by Harrington and Roger Grabowski, the D&P Update covers timely topics such as:

  • Estimating the cost of equity with the build-up and CAPM methods;
  • Using the “C” and “D” exhibits to further refine your cost of equity estimate;
  • How to use the “regression equation method” to interpolate cost of equity among portfolios;
  • Equity risk premium—whether the historical ERP is too high; and
  • The ERP size adjustment—why, when, and how to implement.

For more information, visit the Duff & Phelps Risk Premium Report & Calculator.

DE Chancery too quick to dismiss the build-up method?

In response to our coverage of In re Orchard Enterprises, Ted Israel (Eckhoff Accountancy) finds much to compliment in the Chancery Court’s opinion, but also two major points to criticize regarding the court's characterization of the build-up method as: 1) lying outside “mainstream” financial theory; and 2) being a variation of the Duff & Phelps “model” for deriving the cost of capital.

In dicta, the court says it cannot find any corporate finance texts that discuss the BUM, but “I cannot think of any recent BV books that fail to mention it,” Israel says, citing works by Hitchner, Trugman, Practitioners Publishing, and, “perhaps most significantly,” Ibbotson’s SBBI Valuation Yearbook and Pratt and Grabowski’s Cost of Capital, both of which devote entire chapters to the build-up method and are also cited by the court for different propositions. “The build-up method is certainly part of the ‘mainstream’ body of knowledge for valuing private companies,” Israel says, “and is indeed a widely recognized and important tool for developing cost of capital estimates.”

The Delaware court also disparages the BUM for involving a great deal of subjectivity when, in fact, the company-specific risk premium is its “only subjective component,” Israel points out. The remaining inputs—such as the risk-free rate, the ERP, the size premium, and the industry risk premium (or beta)— “are all provided by empirical sources such as Ibbotson and Duff & Phelps.”

As for the CSRP, the court was “absolutely correct” in saying it warrants close scrutiny, Israel says, but it failed to grasp the principle behind its use in private company valuations, i.e., to estimate the risk that data from public companies do not include, largely due to their investors’ ability to diversify. (Pete Butler from Valtrend also picked up on this disconnect, noting the court cited Damodaran on Valuation as one example of the CSRP failing to find support among finance scholars. “However, like all academic textbooks, it is written from the perspective of the public stock investor,” Butler says. “When Prof. Damodaran considers the perspective of a private company investor, he ‘invented’ total beta and/or the ‘private company beta’ to appropriately price for CSR.”)

Finally, both the SBBI and Duff & Phelps Risk Premium Report provide “useful and reliable” data for developing COC estimates using both the CAPM and build-up models, Israel says. However, an “uninformed reading” of the Delaware Chancery’s decision “could cause an analyst to avoid the D&P data, and that would be a disservice.” The complete digest of the decision will appear in the October Business Valuation Update; the court’s opinion is already posted at BVLaw. Look for Israel’s complete commentary on the case in the November issue.

Houlihan Lokey updates annual PPA study

Analysts at Houlihan Lokey have just released the 11th annual Purchase Price Allocation Study, which examines key data points of purchase price allocations recorded by U.S. public registrants. The study analyzes 452 transactions completed in 2011, comparing the data to certain transactions completed in 2009 and 2010. To download a complimentary copy, click here.

FASB’s proposed XBRL-based taxonomy will conform with SEC’s

Last week the Financial Accounting Standards Board (FASB) issued its proposed 2013 U.S. GAAP Financial Reporting Taxonomy, which updates accounting standards and makes other improvements to the official taxonomy that public issuers use when registering with the SEC.

The proposed taxonomy provides “a list of computer-readable financial reporting labels coded in XBRL, an open-source computer language that allows companies to tag precisely the thousands of pieces of financial data included in typical long-form financial statements and related footnote disclosures,” says the FASB release. The tags will allow users of financial statements to electronically search for, assemble, and process data for access and analysis by investors, analysts, journalists, and regulators.

The proposal is subject to a 60-day comment period, in which the FASB hopes to hear from potential users as well as “SEC filers, service providers, software vendors, and other interested parties” who can use the time to become familiar with and suggest further revisions, including incorporating new elements for current filings. Comments are due by Oct. 29, 2012.

SRR merges with Texas-based HFBE

Stout Risius Ross Inc. (SRR), a financial advisory firm specializing in investment banking, valuation and financial opinions, and other dispute and forensic advisory services, has merged with the Texas-based HFBE Inc., an investment banking and valuation firm, effective Sept. 1, 2012.

The merger will provide a synergistic combination of client service and firm cultures, say principals from both firms in their recent announcement. SRR also hopes to “attract the best professionals” for long and diverse careers.

School is back in session, and so is intense, advanced CPE

On September 13, join G. William Kennedy (FTI Consulting) for the interactive Advanced Workshop on Regression Analysis, a four-hour intensive that will use case studies and “live” examples to demonstrate appropriate regression analysis techniques and interpretation.

On Thursday, September 20, join Vincent Covrig and Daniel McConaughy (both Crowe Horwath) for Advanced Topics in Debt Valuation, a 100-minute presentation on how to value debt; assess relevant information for that analysis (credit ratings, agency info, etc.); and apply that information in your WACC, DLOM, and liquidity analyses.



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Copyright © 2012 by Business Valuation Resources, LLC
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