Revisions to USPAP SR-9 a ‘Must Read’ for Valuation Analysts and Attorneys
Business Valuation Advisor, Fall 2006
The 2006 edition of USPAP—the Uniform Standards of Professional Appraisal Practice— became effective as of July 1st of this year. Unlike prior updates, the revisions by the Appraisal Foundation (Washington, D.C.) are substantial and required reading for anyone conducting appraisals— or reviewing them in court.
In fact, the critical importance of USPAP compliance emerged in the recent Kohler v. Commissioner of Internal Revenue case (July, 2006). In discrediting the IRS’s analysis of value, the Tax Court noted that its appraiser had omitted the customary USPAP certification. Without the certification, the Court could not be assured that “the appraiser has no bias regarding the parties, [that] no other person besides those listed provided professional assistance, and that the conclusions in the report were developed in conformity with USPAP.”
Credibility is the cornerstone
The overarching theme of the 2006 revisions is “credibility,” which now appears as a defined term: CREDIBLE: worthy of belief. Comment: Credible assignment results require support, by relevant evidence and logic, to the degree necessary for the intended use.
Similarly, the newly-added “Scope of Work Rule” requires appraisers to explain what they have—and have not done—in an appraisal; it addresses both the application and the extent of the appraisal’s development. As a defined term, “Scope of Work” has replaced the prior “Departure Rule,” which focused only on agreed-upon departures from the guidelines, and addressed only the application of a specific requirement.
Extensive revisions to SR 9
Standards Rule 9—pertaining to the conduct of appraisals—has seen significant overhaul in 2006 USPAP. In particular:
- Business interest. The opening of SR 9 now contains new language concerning the appraisal of “an interest in a business,” thus clarifying that the coverage extends to business interests (as well as businesses and intangible assets), and conforming with the ASA’s 2002 Business Valuation Standards, which apply to valuations of “businesses, business ownership interests, and securities.”
- Premise of value. SR 9-2 now requires analysts to identify “the standard (type) and definition of value and the premise of value.” Prior language noted only “type and definition.” Without defining “premise of value,” 2006 USPAP is nevertheless calling for greater specificity in the definition of assignments
- Liquid and marketable interests. 2006 USPAP adds “option agreements” to the list of features or factors that may influence value—including buy-sell agreements, stock restrictions, etc. Moreover, SR 9-2 now requires the appraiser to identify “the extent to which the interest is marketable and/or liquid.”
Revisions to Standards Rule 9-4 parallel those to SR 9-2, and are worth quoting in full:
SR 9-4(c) An appraiser must, when necessary for credible assignment results, analyze the effect on value, if any, of buy-sell and option agreements, investment letter stock restrictions, restrictive corporate charter or partnership agreement clauses, and similar features or factors that may influence value.
SR 9-4(d) An appraiser must, when necessary for credible assignment results, analyze the effect on value, if any, of the extent to which the interest appraised contains elements of ownership control and is marketable and/or liquid. Comment: An appraiser must analyze factors such as holding period, interim benefi ts, and the difficulty and cost of marketing the subject interest.
The binding comment to SR 9-4(d) also requires the analyst to consider the nature of minority interests, their lack of an active market and degree of liquidity (or lack thereof). Specifically, it lists three factors:
- Holding period. When valuing a majority or 100% interest in a business enterprise, analysts often consider the holding period to be “forever” by discounting the expected cash flows into perpetuity. When valuing minority interests, however, analysts may need to become comfortable with a “most likely” concept of the expected holding period.
- Interim benefits. In valuing minority interests, an interim benefits analysis estimates expected distributions or dividends, as well as the expected terminal value for the investment to be received at the expected exit (end of holding period). In these cases, a discounted cash flow analysis, which includes expected interim benefits and terminal value over the expected holding period, could help ascertain the effect on value, if any, of these two factors.
Difficulty and cost of marketing. In valuing controlling interests, analysts factor “difficulty and cost of marketing” into the prices paid by market participants. They may do so implicitly—by employing multiples based on guideline transactions; and/or explicitly, by considering it when developing discount rates.
When valuing minority interests, analysts could develop a similar “difficulty and cost of marketing” discounted cash flow analysis for the interim benefits (interim distributions plus expected terminal value) over the expected holding period.
Final reconciliation
Regarding the last major revision to Standards Rule 9, 2006 USPAP expands SR 9-5, requiring appraiser to reconcile the “quality and quantity of data” they used to reach their valuation conclusion, as well as the “applicability or relevance of [their] approaches, methods and procedures.”
All-in-all, these extensive revisions calls for more specific analysis, more consideration for the value-impact of key factors; and greater efforts to reconcile the various aspects of the appraisal process with the appraiser’s conclusions. Without a careful review of the new USPAP standard, appraisals will become more vulnerable to attorneys who do understand the revised requirements.
