Reviewing Appraisals: The Devil is in the Details

by L. Paul Hood, Jr.

The questions and observations in this article are contained in the “Lessons from the Trenches” section of the upcoming book, A Reviewer’s Handbook to Business Valuation: Practical Guidance to the Use and Abuse of a Business Appraisal, by L. Paul Hood, Jr. and Timothy R. Lee (John Wiley & Sons, May 2011)

It is always a daunting task for a non-appraiser like myself to review a business appraisal report, whether it is in draft form or in final form, although I far prefer to review them in draft form. It is virtually impossible for a layman to review a business appraisal report except by asking the business appraiser pertinent questions to determine whether the responses reconcile with the facts and with common sense. Here are a few questions that I always ask.

• Does any position taken in the business appraisal report conflict with any article or paper the appraiser has ever written? If yes, is this conflict explained? Many business appraisers publish articles and professional papers for their peers in various professional forums. In a conflict, you can bet your last dollar that the other side will research to see if the business appraiser has taken opposing positions publicly in print or otherwise. Few things are more embarrassing, and undermine a business appraiser’s credibility more, than to discover that your business appraiser has, in fact, asserted or taken positions that run contrary to those taken in your report, particularly when not disclosed to you previously.

 

• What is the range of value for the asset being valued? Why is that the range? Does the conclusion of value fall on either end of the range? If so, why? Is that rationale sufficiently explained in the report? If not, would it be helpful to do so? Given the potential for an array of seemingly reasonable findings in a business valuation exercise, conclusions in many valuations may best be expressed in the form of a range. However, the tax law and developed customs require appraisers to definitively express “a value.” If that value is close to either end of the range of an array of reasonable values, I want to know why and I prefer to see that discussed in detail in the business appraisal report.

 

• Does any application of valuation theory in the opinion run counter to current reasonably accepted valuation theory as applied to this assignment? If yes, how? Is that discussion in the report? If not, why not? If a business appraiser utilizes a method that is novel or cutting edge that has not yet been reviewed by the peers of the business appraiser, there is a risk of a Daubert challenge to the admission of the business appraiser’s report. It would be horrible for your appraisal expert to be prohibited from testifying! If the appraisal report has any novel or cutting edge techniques in it, I want to know about it as early as I can. Obviously, I far prefer that novel or cutting edge methods not be used unless they are absolutely necessary. I usually encourage the business appraiser to publish a paper on the matter for his or her peers in order to gain feedback on the method.

 

• What methods did the appraiser consider in developing a discount for lack of marketability? Is this discussion in the report? If not, why not? There are two basic approaches for a business appraiser to arrive at a discount for lack of marketability: a market approach and an income approach. Within each approach, there are several different methods and models. There also are methods that don’t fit into either the income or market approach. I like to know what approaches and methods that the business appraiser considered, even if that information is not contained in the business appraisal report. Just as often, I want to know why certain methods or models were not used too. I like to see several methods used (directly or indirectly), if for no other reason than to corroborate the result that the business appraiser’s chosen method produced.

 

• Have you received, or are you aware, of any other business appraisal report pertaining to an interest in the subject company? Is that report still relevant? If such a report exists, was the current appraiser supplied with a copy? If yes, did he/she reconcile or explain the differences, if any, with the prior report? Is the reconciliation/explanation in the report? If not, why not? Differences in appraisal reports of interests in the same subject company issued by different appraisers that are fairly close in time must be well explained in the business appraisal report. While a business appraiser might not know that other business appraisers have appraised interests in the same subject company, this must be a part of the business appraiser’s due diligence. If there are significant differences in methodology or approach, e.g., a prior appraisal disregarded a guideline company approach because the appraiser could not find any suitable guideline companies, while the subsequent appraisal relies upon a guideline company approach and cites several guideline companies, this could signal a significant problem with either or with both reports. This is a significant difference that must be explained.   Valuation reports of interests in the same subject company that are issued by different appraisers at the same time as one another should be explained and reconciled. Again, a business appraiser must inquire in the due diligence phase as to prior and even ongoing appraisals and must explain any significant differences in methodology, particularly if the IRS has accepted the prior business appraisal methodology for interests in the subject company in the past. This can happen in any number of different contexts, e.g., an annual business valuation engagement, a change in business appraisers, or a prior business appraiser retiring or dying.
   
• Has the appraiser documented his/her due diligence and research for this engagement in the report or workpapers? If not, why not? I like to see the checklists and requests for information that the business appraiser uses. I want to know that the business appraiser followed his or her standard operating procedure for due diligence, as tailored for this particular engagement. From time to time, the attorney has to get involved in the information gathering phase of a business appraisal engagement, often acting as an advocate for the business appraiser in getting the subject company to release important requested information to the business appraiser. There simply is no excuse for a subject company to withhold information requested by the business appraiser. Quite often, the withheld information would have had a material effect upon the conclusions that the business appraiser reached, which can spell doom for that business appraisal report.

 

• Are all data sources referenced in the report, particularly websites, accurate and current? Is the date of access to those websites current? Few things irritate me more in a draft business appraisal report than to see stale references to data sources, particularly web sites. There is no excuse for not having the most up-to-date data. To me, it suggests that the section in which the stale reference was cited may have been grafted from another business appraisal report or was from an outdated piece of research material. I check the web site links in draft business appraisal reports, and if the valuation date rolls forward between circulation of the draft business appraisal report and issuance of the final business appraisal report (or there has been an extended period of time since the issuance of the draft report), I expect to see the references updated in the final report.

 

• Has the appraiser ever appraised any interest in this entity (or any successor entity) previously? If yes, please describe. Differences in appraisal reports issued by the same appraiser of interests in the same subject company that are fairly close in time to one another must be well explained.(1) One must assume that all prior business appraisal reports will be discovered and plan in advance to explain these differences in detail before the opposition even asks about it. If there are significant differences in methodology or valuation approach used by the same appraiser to value an interest in the subject company, the opposition, e.g., IRS, could argue that the results were predetermined. Therefore, it is imperative that these differences be well explained. One should assume that the opposition will attempt to exploit those differences and take preemptive action to explain them in detail before they are called into question. The existence of secondary or recent appraisal work product from a given appraiser regarding a given subject interest is rising given the recent USPAP disclosure requirements.

Even though there usually is a significant difference in the knowledge level of the business appraiser and the person who is reviewing the business appraisal report, by asking the right questions, such as the ones discussed above, one usually can improve the business appraisal report by requiring the business appraiser to explain more of what he or she did in order to prepare the business appraisal report. I prefer to see an all-encompassing business appraisal report. Unfortunately, not all clients see the value in this approach.

ENDNOTES
(1) See, e.g., Mosher Est. v. Comr., T.C. Memo 1988-24.

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About the Author

L. Paul Hood, Jr. received his J.D. from Louisiana State University Law Center in 1986 and Master of Laws in Taxation from Georgetown University Law Center in 1988. Paul is a frequent speaker, is widely quoted and his articles have appeared in a number of publications, including BNA Tax Management Memorandum, CCH Journal of Practical Estate Planning, Estate Planning, Valuation Strategies, Digest of Federal Tax Articles, Loyola Law Review, Louisiana Bar Journal, Tax Ideas and Charitable Gift Planning News. He has spoken at programs sponsored by a number of law schools, including Duke, Georgetown, NYU, Tulane, Loyola (N.O.) and LSU, as well as many other professional organizations, including AICPA and NACVA. From 1996-2004, Paul served on the Louisiana Board of Tax Appeals, a three member board that has jurisdiction over all Louisiana state tax matters. A former fellow of the American College of Trust and Estate Counsel, he is a member of the Louisiana State Bar Association (inactive).

Originally published in Mercer Capital's Value Matters (TM) 2011-01, released March 2011.