A business owned and operated by one or both spouses is part of community property assets and therefore its value needs to be determined in order to proceed with community property division.
Business valuation is a separate area of professional practice. Business valuations are prepared by appraisers, business brokers, economists and CPA’s for multiple purposes, from mergers and acquisitions to estate tax preparation and shareholder disputes. There are several business valuation standards set by the three major United States valuation societies — the American Society of Appraisers (ASA), American Institute of Certified Public Accountants (CPA/ABV), and the National Association of Certified Valuation Analysts (NACVA). These standards represent codes of practice adhered to by the accredited members of each of these societies. All standards are similar in essential requirements and in general, a business valuation performed by an ASA appraiser is no better o worse than one prepared by a CPA. As a holder of the ABV credential, I follow the AICPA’s Statement of Standards for Valuation Services # 1 issued in June 2007.
The purpose of the valuation influences methods used to prepare it and determines what kind of a report is issued as a result. In a divorce situation the value of a business is determined based on the analysis of its past performance with the understanding that financial results achieved after the divorce (or separation) are attributable to the separate efforts of the managing spouse and should not influence the community value of the business. It is also presumed that the business will not be sold but the managing spouse will continue to run it, which in California precludes the use of discounts for lack of control and marketability. The valuation report is usually tailored to the needs of litigation and is intended to present a logical and concise summary of steps used to determine the business value.
Depending on the type of business, the valuation may use one or more approaches and methods. There are three approaches (asset based, income and market approach) and under each of them there are more than one method that can be applied. In most general terms, asset approach values tangible assets of the business separately from its goodwill, income approach values both these components together, and market approach relies on the analysis of data related to sales of similar businesses. Market approach is not used in divorce related valuations very often, mostly because of the insufficient data currently available with respect to sales of small privately owned businesses.
Both asset and income approaches use capitalization of all or part of the business income stream to arrive at the value of the business. This poses several challenges and requires various assumptions in order to overcome them, which creates a situation where two valuation analysts can arrive at vastly different business values while using the same financial data.
The most challenging part of the valuation is the choice of capitalization rate. The riskier is the business, the higher is the capitalization rate and the lower is the value of the business. Essentially, a capitalization rate used by an analysts reflects his/her opinion of the risks involved in running the business.
The next challenge is presented by owner’s compensation and related adjustments to the business income stream. In a small privately owned business an owner is the person who establishes his/her own compensation, which may be lower or higher than what is paid to a hired manager or executive in this particular industry and area. In the process of valuation, owner’s salary gets adjusted up or down to bring it to a reasonable amount by industry and area standards. Most of the valuation analysts use various statistical sources to estimate the amount of reasonable compensation, which does not prevent them from having different opinions about it.
Finally, when business income is determined for valuation purposes, it needs to be “normalized”, i.e. adjusted to reflect economic reality under most common (normal) for it circumstances. This means that adjustments are made to remove the effects of tax laws and eliminate income or losses resulting from unusual events, as well as to remove owner’s personal expenses from business expense accounts.
Business valuation requires an extensive analysis of information from various sources, not just a review of financial statements and tax returns of the business, although it starts with these documents. In order to prepare a valuation an accountant will ask for detailed bookkeeping records, lease agreements, contracts with major customers or suppliers, shareholder agreements, marketing materials and all sorts of other documents that may be needed to understand how the business is operated, what regular income it produces and what kinds of risks it faces. Valuation analyst will also have to consult various statistical and industry sources. Because of the complexity of the work, properly prepared business valuations take time and tend to be one of the most expensive assignments in divorce accounting.
Copyright: Irina Anissimova, CPA, CFF, 2015