Exercising Due Professional Care
Obtaining Adequate Information in Small Business Valuations
As valuation professionals, one of the challenges we face in valuing small businesses is the quality of the financial information provided by the subject company. The NACVA professional standards require members to exercise due professional care and obtain sufficient relevant data to prepare a conclusion, recommendation, or position. In this article, Michael Bankus lists several suggestions to obtain adequate information to complete the engagement of a small business.
As valuation professionals, one of the challenges we face in valuing small businesses is the quality of the financial information provided by the subject company. The NACVA professional standards require:
- Due Professional Care: â€ś[a]member must exercise due professional care in the performance of services, including completing sufficient research and obtaining adequate documentation.â€ť
- Sufficient Relevant Data: â€ś[a] member shall obtain sufficient relevant data to afford a reasonable basis for conclusions, recommendations, or positions.â€ť
What is a Small Business?
If we look to the federal government, it has varying definitions across several agencies. The Small Business Administration (SBA) generally considers a small business to be one with no more than 500 employees. For the Affordable Care Act employer healthcare requirements, a small business is one with no more than 50 employees. The IRS does not directly define a small business; rather it enforces the definitions provided in the tax statutes.
However, the IRS Small Business/Self Employed (commonly referred to as SB/SE) Division serves
- individuals filing form 1040, Schedules C (Sole Proprietorship), and E (Supplemental Income and Loss, used to report income from rental real estate, royalties, partnerships, S corporations, estates, trusts, and residual interests in real estate mortgage investment conduits [REMICs]), and
- all other businesses (i.e., corporations, S corporations, and partnerships with less than $10 million in assets
The Larger Business and International (LB&I) Division serves all 1120 (corporations), 1120-S (S corporations), and 1065 (partnerships) returns with assets of $10 million or more.
The SB/SE states that its taxpayer profile is:
- Approximately 57 million taxpayers
- About 41 million self-employed persons
- About nine million small businesses with assets of less than $10 million
- About seven million filers of employment, excise, estate and gift tax returns
Applying the Standards and Gleaning the Most from Tax Returns
Letâ€™s say you have accepted an engagement to value a small business and have requested the last three to five years of tax returns and financial statements. You may only receive tax returns, or, you may receive both tax returns and financial statements. The tax returns you receive may be on the cash basis, and the financial statements on the accrual basis.
Even within the tax code there are different requirements on the required method of accounting. For example, S \corporations can file on the cash basis if they have less than $10 million in annual gross receipts. S corporations, sole proprietorships, and other small businesses that do not carry inventory may use the cash basis if annual (sometimes averaged) gross receipts do not exceed one million dollars. If a business offers credit to its customers, they are required to use accrual accounting. There are other rules on the threshold for cash versus accrual, depending on the industry classification of the business.
Compounding the challenges of the quality of the information received, according to CPA Practice Advisor (cpapracticeadvisor.com March 7, 2017), 18% of small businesses do not use accounting software, while only about 21% (one in five) have integrated their accounting software with an invoice and payments product.
Some suggestions for obtaining adequate information to complete the engagement:
- If you receive only the tax returns and they are on the cash basis, ask the company whether they have accrual-based financial statements. They may simply be reports from the companyâ€™s accounting system (e.g., Quick Books), or they may have CPA-prepared financial statements (even if it is a compilation).
- Do not disregard the information given by the balance sheet. While many valuators use it for the Asset Approach, the balance sheet usually provides insights into how the business operates. For example, are there accounts receivable? Are there investments in other companies (subsidiaries) or nonoperating assets? On the liability side, does anything stand out? Are there transactions with related companies that you need to investigate? Are there distributions? Be sure to inspect and read the explanatory statements referenced on the balance sheet.
- Make sure you â€śmineâ€ť all the data on the federal returns.
- Schedule M-1 (usually shown below the balance sheet) is valuable in that it reconciles the differences between income and taxable income. This can often be a good source for additional questions and expenses that the company incurred but are not tax-deductible.
- Look to see if the tax return includes a worksheet for figuring net earnings from self-employment. Typically, these are included with partnership returns. Read the statements that are referenced, for example non-deductible expenses.
- Review the Schedule K-1s, as these usually show expenses that may not be tax deductible and/or are discretionary or benefit the shareholders.
- If you use a standard intake sheet or questionnaire, does it inquire as to (i) how the company â€śkeeps its booksâ€ť; i.e., is there a controller, a bookkeeper? Are these positions outsourced or in-house and if in-house, is it part time or full time? And (ii) what accounting system or software is used?
- A meeting with management is always good, wherein you can present your historical financial analysis of the company and ask questions about variances and/or trends. If something looks really â€śout of lineâ€ť, this may be an indication that the books and records may not be reliable. For example, I valued a firm with about one million dollars revenue; the balance sheet reported more than $500,000 cash, which the owner advised was plain wrong. This does not automatically mean that the income statements were unreliable.
- You may have an engagement where you simply determine that you do not have â€śsufficient relevant data to afford a reasonable basis for conclusionsâ€ť and need to decline the engagement or advise you cannot go forward. This is a judgment call and is more crucial, in my opinion, for litigation related assignments.
A litigation assignment presents its own unique challenges. The valuator may have requested a â€ślaundry listâ€ť of documents, and as the deadline (usually a hard deadline ordered by the court) approaches, the valuator may be concerned about having enough information to render an option. Michael Kaplan addressed this in the August 29, 2012 edition of QuickRead (â€śInsufficient Evidence and Defensible Opinionsâ€ť) and outlined a valuation professionalâ€™s options:
- Refuse to render an opinion; however, this could lead to legal and/or regulatory action against the expert and sully their reputation in that particular community.
- Pepper the opinion with disclaimers and assumptions; this will most likely dull the impact and efficacy of the expertâ€™s opinion.
- Kaplan suggested a third, creative alternative to those above. â€śAn expert may want to evaluate the evidence and determine if there are any useful options that the evidence will support. Many experienced experts recognize that limited evidence will often support a more limited option.â€ť
And, as we just â€śfell backâ€ť with the end of daylight savings time, in addition to changing your smoke alarm batteries, this is also a good time to review your professional liability insurance.
 NACVA Professional Standards, effective June 1, 2017 (NACVA Standards), at II. C.
 NACVA Standards, at IF.
Michael Bankus, MBA, CVA, AFSB, is principal of Goriano Experts & Advisors, a consulting firm serving the legal and business communities with business valuation, business consulting, and litigation support services, mainly to the construction industry. Previously, Mr. Bankus held senior finance roles at The Bank of New York Mellon, PNC Financial, CentiMark Roofing, USF&G Insurance, and Rite Aid Corporation.
Mr. Bankus can be contacted at (484) 557-6644 or by e-mail to Mike@GorianoLLC.net.