Valuation

Valuation is the process of estimating what an asset, a liability or an interest in a business is worth, as of a stated valuation date and under a stated standard of value, and the word also names the figure that process produces. A standard of value is the definition of value the estimate has to answer to. Take either qualifier away and the number stops meaning anything, because the same interest is worth different amounts on different dates, and different standards ask different questions about it. Before reaching a conclusion, an appraiser is expected to identify, among other things, the property to be valued, the interest to be valued, the effective valuation date, the purpose and use of the valuation, and the standard and definition of value (Internal Revenue Manual 4.48.4.2.2, Identifying).

The Standard of Value Decides What the Number Means

For federal estate and gift tax the standard is fair market value, and the two regulations define it in the same words. Under the estate tax regulation, fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts (section 20.2031-1(b)). The gift tax regulation applies the same test to property made the subject of a gift, and both regulations exclude a forced sale price (section 25.2512-1).

Revenue Ruling 59-60 is the framework the IRS built on top of those regulations. Its stated purpose is to outline the approach, methods and factors for valuing shares of closely held corporations for estate and gift tax purposes, and it points at those same two regulations for the definition of fair market value (Rev. Rul. 59-60, Sections 1 and 2, reproduced as Appendix A to the IRS job aid on valuing non-controlling interests in electing S corporations). It then sets out the fundamental factors an appraiser has to analyze in each case, and what those factors do to the price of an accounting practice is a subject of its own.

Financial reporting uses a different standard for a similar-sounding word. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (FASB Statement No. 157, paragraph 5). The hypothetical willing buyer of the tax standard and the market participant of the accounting one are not the same construct, so one interest can support two defensible numbers on the same day.

The Three Approaches

The three generally accepted valuation approaches are the asset-based approach, the market approach and the income approach. Consideration should be given to all three, and professional judgment decides which approach, and which method inside it, best indicates the value of the business interest (Internal Revenue Manual 4.48.4.2.3, Analyzing).

The asset-based approach builds the value up from what the business owns and what it owes. The market approach takes prices from transactions in comparable businesses or interests. The income approach converts an expected benefit stream into a single present amount.

Fair value measurement uses a different set. Valuation techniques consistent with the market approach, the income approach and/or the cost approach shall be used to measure fair value, and the cost approach is based on the amount that currently would be required to replace the service capacity of an asset (FASB Statement No. 157, paragraph 18). Replacing an asset’s service capacity is a narrower question than what a whole business is worth.

Where Valuation Shows Up in a CPA Firm’s Work

Estate returns are the clearest case. Form 706 recapitulates the gross estate from its own schedules in two columns, alternate value and value at date of death, and the executor elects on the return itself whether alternate valuation applies (IRS, Form 706).

Gift returns ask the same question at a different moment. Schedule A of Form 709 takes one line per gift, carrying a description of the gift, the donor’s adjusted basis, the date of the gift and the value at date of gift (IRS, Form 709).

A business sale turns one price into many. Each party reports how the consideration was allocated across the asset classes on Form 8594, the asset acquisition statement (IRS, Form 8594), and what a buyer of an accounting practice is actually pricing works that through.

Financial statement work carries fair value measurements under Topic 820, the fair value measurement standard (FASB Accounting Standards Update 2018-13, Fair Value Measurement (Topic 820)).

Valuation, Valuation Allowance and Valuation Account

A valuation allowance is not a valuation. It is a reduction of a deferred tax asset, recognized if, on the weight of available evidence, it is more likely than not that some portion or all of the asset will not be realized, and sized to leave the amount that is more likely than not to be realized (FASB Statement No. 109), it belongs to the income tax standard, Topic 740 (FASB Accounting Standards Update 2015-17, Income Taxes (Topic 740)), and deferred tax assets carries the rest of it.

A valuation account is different again: the allowance for credit losses is a valuation account deducted from the amortized cost basis of a financial asset to present the net amount expected to be collected (FASB Accounting Standards Update 2016-13, paragraph 326-20-30-1), which is where a client’s accounts receivable meets the word.

Common Questions

Price paid for the interest                    100,000
Share of the equity it represents                  10%
Implied value of the whole (100,000 / 0.10)  1,000,000

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