Is Your Valuation Biased?
Detecting Bias in Business Valuations: A Framework
Independence is one of the bedrocks on which the usefulness of a business valuation lies. While there are instances in which a biased valuation is appropriate, and business valuation accrediting organizations acknowledge this, most business valuations are damaged when they are biased, and they tend to damage their clients right along with them.
Consequences of Biased Valuations
Biased business valuations in a transaction or litigation context lead to poor decision-making. A biased valuation in a transaction usually creates unrealistic pricing expectations, which in turn prevents deals from taking place that would otherwise benefit the client. In a litigation context, a biased valuation may lead to a client rejecting settlement offers that ought to be accepted rather than leading to a disappointing damages judgment.
Biased business valuations in a compliance context often lead to expensive and frustrating extra work and effort. The Internal Revenue Service challenges business valuations all the time, and they have a dedicated team of business valuation specialists (called engineers) whose sole job is to scrutinize business valuations attached to tax returns for potential defects, including bias in favor of the taxpayer. IRS engineers know what they are doing, and they are trained to flag valuations for bias, which signals to the Service that they should seek corrections to the valuation and the amount of tax paid.
Scrutinizing Third-Party Valuations
Most business valuations for financial reporting purposes are reviewed by the audit firm’s own valuation specialists. And with good reason. Historically, around 50% of comments made by the Public Company Accounting Oversight Board (PCAOB) regarding weaknesses in audit procedures of public companies directly address third-party valuations accepted in support of fair value accounting. The result is that audit firms simply won’t accept a valuation into the audit file unless material weaknesses have been remedied, including bias. Addressing those weaknesses is often expensive, frustrating, and distracting and can lead to the audit deadline being missed.
Framework to Detect Bias
Thus, any reader of a business valuation should be equipped to detect potential bias in the valuation report. This framework will make you so equipped.
- How much independent research was conducted? Were most of the sources of information provided by the client, or did the report demonstrate that information was sought independently?
- Is there evidence that the appraiser attempted to test or validate information provided by the client?
- Were all parties who might be impacted by the valuation result and who might have information material to the valuation result given the opportunity to provide that information?
- Where judgment calls factored into the valuation, how many of them supported a higher valuation, and how many supported a lower valuation?
- Where judgment calls factored into the valuation, were the most impactful supporting a higher valuation or lower valuation?
- How much of the verbiage in the report was copied verbatim (or near verbatim) from the company’s website or marketing material?
- What was the relationship between the client and the appraiser before the start of the assignment?
- Were subjective adjustments made to the valuation where objective information was available?
- Are anomalous variations in the company’s financial statements explained?
- Was a signed certification of independence included in the valuation report?
A negative answer to one or even all of these items doesn’t necessarily confirm the existence of bias in a report. However, they do provide a basis on which to ask more probing questions to discover and, if necessary, minimize the bias in the report. It’s worth the effort, as snuffing out bias before a valuation report is submitted will pay off handsomely in the end.
Questions?
Brady Ware offers a comprehensive range of advisory services, including strategic advisory, financial analysis, tax compliance, litigation support, employee stock ownership plans, succession planning, mergers and acquisitions, quality of earnings analysis, tax structuring, and business valuations. Our team of experienced professionals provides tailored solutions to help clients achieve their financial goals, minimize risks, and optimize their business performance. Brady Ware’s advisory services focus on developing solutions and creating pathways to success for businesses facing complex challenges, leveraging their deep understanding of business operations, transactional situations, and personal and ownership legacies.