Safe Harbor???

So I participated in a conversation yesterday with an IRS representative that was intended to illuminate some common misconceptions regarding what the Service is looking for in 409a appraisals. The initial Code provision was added January 1, 2005 and the final regulations were published on April 17, 2007. In addition to the valuation requirements stipulated by the Code, there was official guidance that outlined “safe harbor” methods for companies and appraisers to follow. It was very, very limited and after what I learned yesterday from the IRS I am here to tell you: as it stands now, we should all be afraid. Very afraid.
I was eagerly anticipating the discussion, as I figured that by now (October 2008), the IRS would be ready to come forward with some new detailed how-to guidance in the 409a realm. After all, people have been doing these valuations since 2005 and since that time there has been a wide disparity in practice, ranging from the CFO or controller doing internal, back-of-the-envelope analysis to highly experienced valuation experts engaging in heated debate over appropriate “allocation methods.” Most would tell you that much of the guidance regarding option valuation for private companies has come from the financial reporting community. But guess what? That’s fair value, not fair market value, so it’s not relevant. Or wait, maybe it is relevant? Where there are two reports out on the same date that are rendered for different purposes (tax and financial reporting) that might indicate different values, we were told in our conversation yesterday that it was certainly possible that the two could be different. However, when a similar situation came up later in the discussion, it was said the different data points could create cause for investigation.
I’m not saying these are conflicting answers, and the IRS representative was extremely courteous in addressing the questions at all (as his answers were in fact his own personal opinions and not official positions of the IRS). To that point, the IRS is STILL developing its 409a review practices. We were told that they will start reviewing 409a appraisals on January 1, 2009. They will review appraisals going back to when the provision was implemented in 2005. Oh yeah, and did I mention they are beefing up their appraisal review processes? At the good old penalty review center, where they figure out whether appraisers did naughty things to help their clients and should be punished (under things like Section 6695a of the Pension Protection Act of 2006), the number of cases went from zero two years ago to 140 currently. Remember, this does not include 409a cases, because they haven’t even started reviewing those yet. Did I mention that appraisers found in violation can be barred from practicing before the IRS?
So let’s sum this up: the IRS has yet to release any hard and fast, detailed implementation guidance of any kind regarding 409a valuation—and yet thousands of these have been done to date AND the IRS is planning on reviewing these thoroughly and vigorously pursuing any appraisers found in violation. Not to mention the poor employees who will have to shell out taxes and penalties where deficiencies are discovered.
Scared yet? That said, it’s not all bad news. The conversation did yield some meaningful editorial commentary from the representative, whom I really do like. Basically, when pressed for best practices, the rep emphasized that the review pile will be somewhat divided into those reports which adhere to one or more of the professional standards (USPAP, AICPA, NACVA, etc.) and those that do not. Those that do not will receive greater scrutiny. Further, the IRS is leveraging the learning process of the financial reporting community, and as a result will likely embrace things like the equity allocation methods (i.e. OPM or PWERM). If you do these kinds of valuations, you know that’s huge. You also know that means every valuation under current value could be open season. We’ll have to see.

How About I Impair Your Face?

I have heard valuation professionals sometimes referred to in the context of being the “fourth service provider”, with the other three of course being the accountant, attorney, and investment banker. Valuation can play a role after all, and does indeed touch all of those domains on the Gant Chart. It’s a wonderful way to visualize the role of a valuation professional in a neat, tidy, soundbite kind of way. When it comes to financial reporting though, it feels like the profession is more like a fourth leg in the chair when the client really just wants to sit on a three legged stool. This is especially true when it comes to FAS 142. Most clients question the value of the FAS 141 in the first place, so when they are presented with the threat of having to do it all over when the acquisition didn’t go as planned, you can imagine their disdain. They basically have to pay us to come in and literally destroy their balance sheet. Think about that. How would you feel if you had to pay someone to come over and wreck your house? We had an engagement recently in this realm that was truly horrible. The CFO didn’t want an impairment, the auditor did, we went round and round on all kinds of technical gobblygook and finally ended up with no impairment. Both sides racked up a ton of fees and the client didn’t want to pay for any of it. The sad thing is I am quite certain in this new era of doom and gloom that these engagements will become very common. I suppose that’s good from the perspective of staying busy, but it’s never fun to service clients that don’t want to hire you in the first place.

Proprietary Fair Value

You have got to enjoy the irony of fair value from the perspective of those in the implementation trenches. On the one hand, the move signifies the transition to the new “principles based” paradigm. On the other hand, you have accounting firms and the PCAOB alike moving aggressively on the CYA front. The result is something akin to a time when history was passed down by spoken word. I realize the analogy may require some explanation, so I will provide a simple, albeit early, example. When FAS 123R came out a controversy was set in motion that pit the venture capital community against the regulatory and audit community. On the one hand, the VCs proclaimed that many of their portfolio companies had a valuation below the liquidation claims of the preferred investments and as a result any options on the common stock would be worthless, as would the common stock. The regulators replied by asserting that if that was indeed the case, then those holding such interests should be willing to surrender them at no cost. This of course silenced the criticism, but what happened next foreshadows a dynamic that will be played out again and again in the coming “fair value” years.
Satisfied with the fact they had won the battle, the SEC was content with letting the spirit of those comments circulate through the audit and preparer community, where it hoped acceptable solutions would materialize. This of course did happen, and a number of academics, valuation practitioners, auditors, and venture investors came together to develop a practice aid which provided a number of detailed implementation alternatives. However, the practice aid was not formally a part of GAAP, nor is it taught to mainstream CPAs. Further, the document was essentially digested by the Big Four, where very specific guidelines were developed in terms of what was and what was not acceptable in terms of specific methods and approaches. The only way for a layman valuation practitioner or non Big Four auditor to learn these acceptable approaches was to be subject to a SAS 73 review of the FAS 123R work of the Big Four client.
In its most basic form, this represents a classic example of a set of principles being transformed into a set of rules as they are translated into practice. The Big Four have essentially been assigned this task, and in doing so now hold a pseudo regulatory status. However, the irony of it all is that these rulesets are not publicly disseminated. What’s worse, if one does not have prior knowledge of them chances are good that the analyses or work pertaining to the audit review will be rejected without feedback. Professionals at the Big Four claim such feedback would be considered a violation of independence, and that further they are not in the business of auditor and valuation education.
What this all translates to is a cornering of the audit market by the Big Four – an essential annex of audit and valuation rules which will make them proprietary. This is absolutely ridiculous. How can a company (or valuation practitioner assisting said company) be expected to comply with a ruleset it doesn’t have access to. Even more ridiculous, when the ruleset shouldn’t exist in the first place, but instead be consistent with the spirit, or “principle” of the requirements, as so explicitly stated in the framework of the new fair value standards? I fear that as each principles based requirement progresses through implementation, the existing rules based mindset of the audit community will prevail, and a new age of proprietary accounting standards will replace the old standards that were publicly available. In addition, accounting standards will experience a profound bifurcation – those audited by the Big Four who have the sophistication and contacts to stay on top of the new proprietary standards, and main stream American accounting, which will stick to the old ways or develop their own, “non-compliant” ways.

The Perils of False Precision

It is often said in the realm of business valuation that when it comes to conclusions of value that involve exact figures, “reasonable professionals can come to different conclusions using the same facts and circumstances.” To the layperson, this notion might seem rather ridiculous. After all, science and accounting, close cousins to the fields of finance and valuation, are usually concerned with exact numbers and definite solutions. Precision in these disciplines is achieved through thoughtful diligence and careful application of time tested rules. In the field of accounting, the performance and condition of business enterprises have traditionally been presented in historical and present contexts, making precision both possible and highly desirable by users of such analyses.

However, times are changing. Recent events have thrust the discipline of accounting deeply into the domain of finance. This has caused a fair amount of turmoil and confusion. At the center of the issue rests the fundamental premise that finance, as a discipline, is based upon the science of risk and probability. The oft mentioned FAS 157 is based on the concept of mark to market, which in turn functions best when there are liquid markets where the subject interest being measured can experience rapid and objective price discovery. When markets are not liquid, theory must be used in the place of trading information, and it is at this juncture accounting becomes a matter of estimation, not measurement. In making an estimate, one must apply one and sometimes many assumptions, which are introduced into some theoretical framework that ultimately renders a conclusion. These frameworks usually deal with either cross sectional or time series based analysis, meaning they approximate values through the observation of other information available at the time or similar information that has occurred or will occur at different times in the past or future. An example of the former is a pricing matrix, where the yields on bonds of similar credit quality from similar issuers is used to approximate yield and price of the subject bond. Examples of time series based analysis is the discounted cash flow method, where financial information is projected into the future. The approximated value is derived by applying discount rates that incorporate observations regarding the relative risk of the investment.

The problem with these estimates, which generally occur at what is known as Level III under FAS 157, is that they are indeed just that – estimates. What is currently happening is that these “mark to market” estimates are being presented under the old, precision oriented accounting paradigm. In essence they are presented as factual, precise representations of the “intrinsic value” of whatever the relevant asset or liability might be. Investors, auditors, regulators, and lenders alike in turn are relying on these numbers as such. When information is presented that might suggest otherwise, constituents are caught off guard and new figures are developed. This in turn introduces substantial volatility and widespread proclamations of management incompetence and unscrupulous manipulation. Preparers and auditors subsequently point to illiquid markets and unforeseen circumstances as the real culprits. In the past few weeks many have declared that the new mark to market standards are deficient, calling for a return to the tried and true foundations of historical accounting.

I am here to say the move to mark to market accounting is not the problem nor the culprit. The problem is the paradigm needs to shift to suit the new framework. The idea behind mark to market accounting is to improve relevance and reliability of financial information. The accounting of yesteryear is mired in rulesets that are needlessly complex, and I use the term needless because they are still subject to substantial manipulation. Further, the historical cost framework is not flexible enough to keep pace with the velocity of the changes inherent in the evolution from industrial to knowledge economy. Intangible assets and liabilities for example, which are now argued to constitute almost 70 percent of the value of most companies, require valuation approaches that are derived from financial theories, not accounting rules. Merging the accounting systems of all developed and developing countries requires a framework which is flexible and adaptable, yet offers consistency and standardization. The new fair value standards offer all this in spades. The problem is that the standards, even if properly followed, present a portfolio of estimates, not precise representations. The constituents in the accounting community are not used to this.

I propose that when the new fair value standards are implemented in their entirety, the regulatory frameworks require disclosures that adequately communicate the fact that these asset and liability measurements, in the absence of completely liquid and transparent markets that provide real time data as support, are better represented by ranges of values driven by assumptions. The disclosures should be transparent and detailed enough to allow the user of the financial statement to arrive at their own conclusion through the identification and description of the potential effects the critical assumptions have on the estimate. If the old guard wishes to preserve the old financial statement presentation format which is comprised of exact figures, so be it, but footnotes should contain sensitivity tables and monte carlo analyses that clearly outline the impacts of variations in assumptions. Further, the language in financial statements should be adjusted to communicate, clearly and prominently, that the figures presented are the result of estimation, and that other people may arrive at different conclusions given the same information.

I think the consequences of not moving to this paradigm are indeed dire. I would go as far to say the future of the. capital markets depends on it. If, going forward, constituents are led to believe that measurements of mark to market values of illiquid assets are precise, we will see litigation and fraud on an unprecedented scale. The integrity of the financial statement information on which the investor community depends will be severely compromised. As the effects of profound deleveraging and asset devaluation take hold, investor confidence worsens. The migration to fair value, which is being trumpeted as a long run panacea by its proponents, will ultimately be viewed as a failure. The IASB will lose influence and the march towards a global accounting standard will not happen. Consequently, the United States will not receive the level of foreign investment it so desperately needs as a result of a reduction in global liquidity, and the country at serious risk for a protracted downturn.

On the other hand, if the FASB, SEC, IASB, and other regulatory institutions moved to get behind the notion of the estimate paradigm, these pitfalls would be avoided. Volatility would be substantially reduced and investor confidence would be replenished. The change would be welcomed by management and auditors alike, as estimates and ranges would afford companies additional flexibility and legal protections. So let’s not throw the baby out with the bathwater – let fair value take it’s rightful place in the global financial system – but give it its proper introduction.

The New Age Accountant

There has been much discussion surrounding the immediate necessity for the business valuation profession to present a united front to the financial reporting community. The three primary professional organizations, the ASA, NACVA, and the AICPA, stand apart for a host of political and economic reasons. It appears that the enormous opportunity that fair value and the new accounting requirements present to the valuation industry as a whole has only served to elevate efforts for each organization to differentiate. It is clear each is striving to become the thought leader and gold standard in terms of both resources and brand value with regards to their respective credentials. The AICPA, for example, has no less than four Practice Aids in the works which will address various issues and challenges in valuation for financial reporting. The Appraisal Foundation, parent of the ASA, has two working papers addressing slightly different issues.

The SEC and the FASB have both publicly admonished the valuations community regarding their fragmentation and lack of unified infrastructure, to which each organization has responded not by seeking in earnest to consolidate organizations but rather to simply “win” the battle for survival. The AICPA and the ASA seem to both have compelling proposals – the AICPA touts its massive installed base of CPAs, long history, and well established infrastructure as primary reasons why it should be the central organization for business valuation, with an additional implication being that valuation should in turn be subsumed by the accounting professional and the CPA credential. The ASA, on the other hand, points to its pseudo government status vis-à-vis the Appraisal Foundation and its long history in the valuation realm across the spectrum of disciplines as its primary differentiating features. Further, many would agree that the ASA is currently the most well regarded pure play business valuation credential and that the ASA has served as the prevailing organization to date.

I have to say that the challenges that lie ahead appear too large and too profound for any of the organizations mentioned above. The fair value movement is global, and represents a profound departure from historical accounting standards. Preparers of the future will need to gain significant comfort with advanced financial concepts. Further, they will be determining, not verifying, values that are represented on financial statements. This is already the case with identified intangible asset values recorded in M&A transactions under FAS 141. At this point in time anyone can do this work – there is no credential required. Even though in many instances these values can constitute over half the book value of the assets and can have a profound impact on earnings, anyone can create these values. To make matters worse, this example is the tip of the iceberg. When fair value is implemented in the form envisioned, which will happen (some in the US believe it will be peeled back, but fail to see the global momentum behind it and the fact the USA must be a part of the global financial system or risk losing trillions in foreign investment capital), there will be a massive skill deficit. There must be a global organization that steps in to fill the void. The organization must have a recognized credential that demonstrates the preparer has sufficient knowledge and training to engage in valuation practices. There is only one organization, and one credential, that can make the claims – the CFA Institute and Charter Financial Analyst designation. The CFA Institute has more than 97,000 members, who include the world’s nearly 84,000 CFA charterholders, in 134 countries and territories, as well as 136 affiliated professional societies in 57 countries and territories.

I make the argument here that if the valuation community truly wants to solidify its position in financial reporting activities, the domestic, legacy organizations of ages past need to graciously admit a new market entrant and provide ways for their members to get the CFA certification. The credential has incredibly strong brand value and would immediately elevate the reputation of the profession from “disorganized and unskilled” to “undisputed gold standard”. The SEC, FASB, IASB, PCAOB, and all other regulatory organizations would fervently welcome the organization and investor confidence, so absolutely critical to the success of the migration to fair value and undergoing significant challenges in these times, would be upheld. It would also allow the CPA profession to continue its course in the discipline of accounting while allowing seamless integration of finance into financial reporting, governed by an organization that knows it better than anyone else.
Personally, I think this is inevitable. Unfortunately, political forces, pressing on many sides, will continue to delay the process. The ramifications will be significant. Rattled investor confidence, rampant abuse and manipulation as a result of both under-skilled preparers and reviewers, and continued infighting on behalf of organizations surviving beyond their natural lives.