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How Calculation Engagements Can Provide an Indication of Value
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Preparing a formal valuation for a client requires much work on the part of the appraiser. It can, therefore, be costly. But in many situations, a full-blown valuation isn't necessary. That's when an appraiser might suggest using a calculation of value instead. Here's an overview of the difference between valuations and calculations and when it's most advantageous to use a calculation of value.
How they're different
Generally, business appraisal work falls into two categories valuations and calculations. Formal valuation engagements require more procedures than do calculation engagements. For example, valuations generate an official conclusion of value in conformity with certain professional standards.
In contrast, calculations provide an indication of value (a calculated value) based on assumptions and procedures to which the client and the appraiser have agreed. In addition, one of the most time-consuming and costly steps in the valuation process is drafting a detailed appraisal report. But a calculation engagement may call for only an abbreviated letter report, numerical exhibits or verbal presentations in lieu of a comprehensive written report.
Situation dictates choice
Calculations can be sufficient when a written report may not be necessary, such as for an owner who's curious about business value for strategic planning or retirement purposes. Calculations also may facilitate settlement talks in shareholder disputes or divorces. Or they might help a client decide whether it's worthwhile to pursue a lawsuit. Before testifying in court, however, the appraiser is likely to recommend upgrading to a formal valuation report. If settlement appears unlikely, the client probably should opt for a formal valuation report from the get-go.
Take note that calculations may raise a red flag when they accompany gift, estate or charitable donation tax forms. Most valuators recommend a formal report that adheres to IRS guidelines for tax purposes and meets the IRSs Adequate Disclosure requirements. A calculation wouldn't meet those requirements, which can have negative consequences in gift tax situations. This is because the written report typically serves as a valuator's direct testimony, should the return wind up in front of the U.S. Tax Court.
Narrowing the engagement
Clients also can save time and money by omitting specific valuation procedures from a calculation engagement. Or they may specifically prescribe a method they deem most appropriate for the calculation's intended use. To illustrate: Suppose two disputing partners opt for a calculation rather than a full-blown valuation report to facilitate an out-of-court settlement. They specifically agree to omit the guideline public company method when calculating the value of their small private accounting firm.
They also stipulate in advance concerning discounts for lack of marketability and control. However, again, the cost and time savings may be for naught if the partners dont settle. To withstand courtroom scrutiny, calculations generally must be upgraded to formal valuation engagements. If they're not taken to the next level, an appraiser may refuse to testify in court. Be aware, too, that the appraiser's value conclusion after completing the omitted steps or analyses may differ materially from his or her calculation.
Disclosure is key
Some clients have limited access to the subject company's financial data, personnel or facilities. Lack of relevant information can be especially problematic when the client owns a noncontrolling business interest or is a non-monied spouse in divorce. But a valuator can perform a calculation without complete access to information. For example, he or she may base the value exclusively on, say, the past two years' tax returns. A calculation also could be performed without interviewing management or conducting site visits. However, all omissions and limitations must be fully disclosed in the calculation letter.
Know the limits
When an appraiser is engaged to perform a calculation, communication is critical. The engagement letter a legal contract between the client and appraiser establishes expectations up front. Additionally, valuators specifically list scope limitations in their engagement letters, spreadsheets and written reports. It's imperative that clients and professional advisors understand the limitations of value calculations. Further, in considering whether a calculation engagement is appropriate, the most important factor is the ultimate use (and users) of the appraisal. In some cases, a value conclusion can differ materially from a value calculation.
When it's all said and done
The next time a client requires a business appraisal, consider whether performing a calculation might be a better alternative. After all, it might provide the needed results for less expense. Your valuation advisor can help you make that determination. Be aware, though, that certain circumstances such as gift and estate tax filings or disagreements that are bound for the courtroom lend themselves to opting for a conclusion of value.