Normalization Adjustments

Are there hidden risks to the valuator?

The best defense against liability is a good offense. As Joseph Petrucelli explains in this article, a good starting point to ensure the appropriate level of professional skepticism and due professional care is maintained in engagements is asking the question: “What would a reasonable person think about my judgment?”

Introduction

As valuators, we are asked to determine the necessary normalization adjustments needed to formulate an economic benefit stream that will generate an accurate value for a moment in time. Often, we base this determination on the client’s or management’s representations. We have statements built into our limited conditions and assumptions that declare we are not responsible for the quality of the information being provided to us and that it is deemed to be accurate.  This is supported by a host of other so-called protections that we believe will ensure we are not sued or implicated, but are we really shielded?

In order to be truly shielded as valuators, we need to assume a position of offense, rather than defense, in order to avoid liability. This can only be achieved by maintaining due professional care and an appropriate level of professional skepticism. I have established my own standard that asks the following question: What would a reasonable person think about my judgment? After all, it will be these same reasonable people that will decide whether or not we should be implicated or sued.

Focus of the Article

I propose that we start developing positions of offense, since a good offense is the best defense when avoiding liability. My goal is to create an understanding of the risks, created by limited conditions and assumptions, we often state in our reports. In fact, these limited conditions and assumptions will likely put you in the hot seat when being cross examined, and likely destroy your credibility.

“I take no responsibility.” “The client told me.” “I have not audited the records.” These are just a few examples of the language used as limiting conditions and assumptions.  Will this provide convincing evidence to a reasonable person that we have done our due diligence?  Have we provided reasonable certainty to the average person with this type of language hanging over our opinion? I say, no. When the opposition begins to twist and turn our words, a reasonable person may begin to doubt that the appropriate level of professional skepticism has been applied.  Will a juror or a judge appreciate that we completed our report without looking into the credibility of documentation used to support our position and merely relied on the unchecked representations of the client or management? Yet, we are asking these reasonable people to believe we have arrived at an objective and independent opinion with due professional care. Let’s take a look at due care and negligence in legal terms. Forget the accounting terms, reasonable assurance or certainty.

Due care is the conduct that a reasonable man or woman will exercise in a particular situation in looking out for the safety of others. If one uses due care, then an injured party cannot prove negligence. This is one of those nebulous standards by which negligence is tested. Each juror has to determine what a “reasonable” man or woman would do.¹ Negligence means a person has acted negligently if he or she has departed from the conduct expected of a reasonably prudent person acting under similar circumstances.²

What if the records we examine indicate tax evasion or avoidance, manipulations to create sudden income decline syndrome (SIDS), or fraudulent transfers of assets that would have been found by looking at a bank statement? These are only a few examples of the potential mistruths our client or management may represent to advance their own self-interests. Do you think clients and management are concerned that we are licensed and that we can be implicated by their actions? None of us want to have to defend ourselves by saying that we may or may not have known, or that we should have known.

We need to be able to defend ourselves from positions of strength, and that can only be achieved through analyzing key documents and meeting the sufficient evidence standards under Rule 201 of the American Institute of Certified Public Accountants (AICPA). Meeting these standards will put us in an offensive position ready to defend our actions.  The failure to uphold the highest level of support for your opinion is exposing yourself to liability. Reliance on exclusionary language will not save you when the reliance may be deemed by a “reasonable” man or woman to be negligent.

Who is Responsible for the Risks We Face?

Like an audit, tax return preparation, or any other engagement, we are only as good as the management and client we represent and the documentation and supports we are provided. Hearing from lawyers, management, or clients that they do not have the records should be a big red flag. When documents such as bank statements can be directly subpoenaed from the bank, tax returns can be obtained with a filing of IRS Form 4506, and large transactions of receivables or payables can be verified through third parties, valuators should exercise due diligence to obtain proper documentation and verify accuracy when they are material to the adjustments. This is an offensive approach to make sure the documents we are heavily relying on are accurate. Nothing is more devastating than finding all your credibility and work have been destroyed because you relied on the wrong information. Remember that “reasonable” person. Do you really believe he or she will give you the benefit of the doubt if it’s concluded that the item would have been material to your estimation and could have been readily obtained?  We can assume that we are covered because we said so in our limited conditions and assumptions. Yet in the outcome, we may be faced with the dreaded net opinion, and/or have been found to be not credible, and even worse, deemed negligent.

Materiality, one of the ten basic accounting principles, is critical in evaluating risk. Materiality serves as the great equalizer in the reasonable person’s thinking. If you use exclusionary language with respect to a significant fact finding which is based solely upon your client’s statements, and you ignore the fact that supporting documents could have or should have been obtained, which were not provided, think twice before drawing any opinion…unless of course, you like liability.

Misprision

I first found out about this word in a valuation risk weekly webinar I was giving, and it is a word we all should add to our thinking as valuators. The Webster Online Dictionary describes it as a “neglect or wrong performance of an official duty, a concealment of treason or felony by one who is not a participant in the treason or felony, or a seditious conduct against the government or the courts.”  Let’s assume normalization adjustments for taking expenses in violation of the internal revenue code, unreported income, or hidden assets. Do we get to hide behind the limited condition and assumption exclusionary language? Tell it to the IRS Special Agent who shows up at your door and asks you to explain, or the judge or juror who is saying in their mind ,“Yeah right. He didn’t know about it.”  Whether you did or you didn’t is irrelevant. You are now in a defensive position.

Did you prepare a letter that notifies the client and/or his representative that Circular 230 of the Internal Revenue Code says, “I have to alert you to potential tax irregularities and errors and to correct them?” Make sure you have documented and alerted the necessary parties if this occurs to avoid misprision.

If any fraud is found to be present in any of the documents or information you based your opinion on, you could be deemed negligent. This is especially the case if found by a reasonably prudent person acting under similar circumstances, namely the opposing expert. In such a scenario, you will quickly find yourself in defensive position.  All the exclusionary language (defensive thinking) will not replace due professional care, application of the appropriate level of professional skepticism, and proper sufficient evidences (offensive thinking). This is also called covering your back.

Assessing Your Risk 

There are obvious risks that we need to consider as valuators. The normalization adjustments, discount and/or capitalization rate development, and what supports were relied on in formulating our opinions are just some of the areas to be concerned with, based on my experience. The offensive valuator understands the available evidences needed to support his or her opinion.

Normalization Adjustments

There are varying normalizations, and I could write articles on each of the potential normalizations or, better termed, necessary adjustments. Instead, I am proposing a ranking system to determine the risk associated with the judgments we make with five (5) being the highest exposure to my opinion and credibility and one (1) being the lowest. The reasonable compensation adjustment is always a five (5) due to the complexities in developing the adjustment and the potential impact it can have on the value. The higher the compensation, the lower the value.

It is extremely concerning that two experts who  have been provided with the same facts can often have extremely different adjustments in arriving at a final value. With the potential existence of conflicting interests, we need to clearly explain to the parties involved that we do not advocate for our clients, but rather our opinion. Maintaining this principle is the foundation behind arriving at an objective, independent and supportable opinion.

Summary

Here is a simple rule: any adjustments that are material to the value opinion we arrived at need to pass the “reasonable” person test.  The test is that, upon their review of the adjustments made in determining the value, they would conclude that the appropriate level of professional skepticism and due professional care was maintained by the valuator.

Joseph R. Petrucelli, CPA/CFF/CGMA, FCPA, CVA, MAFF, PSA, CFE., is the managing partner of PP&D Accounting Services, Inc., and author of Detecting Fraud in Organizations published by Wiley. He serves as a testifying expert in federal and state courts involving valautions. He also developed a five-day valaution risk webinar for NACVA. He can be reached at jpetrucelli.@ppdaccounting.com.