If you’re a finance professional in the business world, you’ve probably heard the term “business appraisal” thrown around a fair bit. But what exactly are business appraisals, and why are they so important when it comes to financial reporting?

In short, business appraisals are professional valuations of a company’s overall value or the value of specific assets and liabilities. They play a critical role in validating the numbers that ultimately get reported on a company’s financial statements.

Appraisals give companies an impartial, third-party assessment of things like property values, equipment values, intangible assets, and equity interests. The appraised values provide justification for the amounts companies record on their balance sheets and income statements.

In this article, we’ll explore when appraisals are required, the methods appraisers use, key valuation inputs, relevant standards and regulations, and how to select a qualified appraiser. Read on to learn why business appraisals are so indispensable for accurate, compliant financial reporting.

What are Business Appraisals?

A business appraisal is a professional determination of a company’s overall value, or the value of specific company assets and liabilities. Appraisals require analyzing a business’s financial statements, operations, industry, competition, economic conditions, and other qualitative and quantitative factors to reach a well-supported valuation conclusion. The appraised values can apply to an entire company, a division or business unit, real estate and fixed assets, intangible assets like brands or patents, or equity interests.

Appraisals are performed for different purposes, including litigation support, mergers and acquisitions, equity transactions, marital dissolutions, ownership transitions, and financial reporting. Financial reporting represents one of the most common uses of business appraisals. Public companies are required to obtain appraisals to comply with accounting rules for purchase price allocations, impairment testing, and fair value measurements. Private companies may also require appraisals for financial reporting related to equity transactions, performance measurement, and compliance.

Why are Business Appraisals Important for Financial Reporting?

Financial reporting standards require fair value measurements and disclosures in many situations. Fair value represents the estimated price that would be received when selling an asset or paid to transfer a liability in an orderly transaction. Fair values are market-based rather than entity-specific. When there is no active market for a specific asset or liability, companies must estimate fair value using appropriate valuation methods and inputs.

In practice, estimating fair values often requires the work of professional business appraisers. Appraisers have the expertise to select suitable valuation methods and derive supportable fair value estimates that align with accounting standards. Relying on qualified appraisers provides assurance that financial reporting values and disclosures meet compliance requirements. Specific examples where appraisals are important for financial reporting include:

– **Purchase Price Allocation (PPA)** – When one company acquires another, the purchase price must be allocated to recognize the fair values of acquired assets and liabilities. A PPA appraisal is required to value things like intangible assets, property, equipment, and contingent liabilities.

– **Impairment Testing** – Companies must periodically test goodwill, indefinite-lived intangibles, and long-lived assets for impairment. Appraisals help determine asset fair values for comparison to carrying amounts to evaluate if impairment exists. 

– **Fair Value Accounting** – Many financial instruments like derivatives and certain investments must be reported at fair values each reporting period. Appraisals establish supportable periodic fair values.

– **Equity-Based Transactions** – Transactions like equity-based compensation and investor buy-ins require determining the fair value of equity interests awarded or granted. Appraisals value the equity awards on the transaction date.

Reliable valuations protect credibility and integrity in financial reporting. Independent appraisers also provide objectivity compared to valuations performed internally by the company.

When are Business Appraisals Required? 

Authoritative accounting standards outline certain events and situations that trigger the need for business appraisals for financial reporting purposes. Some of the most common scenarios include:

– When a company acquires another business – To perform purchase price allocation for the acquisition accounting

– When goodwill and indefinite-lived intangible assets are tested for impairment annually or upon a triggering event – To determine asset fair values to compare against carrying values  

– When long-lived asset groups are tested for impairment upon a triggering event – To determine recoverability through fair value estimates

– When financial instruments and certain investments do not have active markets – To determine recurring fair value measurements each reporting period

– When a company issues equity-based compensation like stock options – To estimate the fair value of equity awards on the grant date

– When ownership interests are sold to investors – To determine the fair value of equity interests on the transaction date

– When a company grants employee stock ownership plans (ESOP) – To initially value and periodically revalue ESOP assets 

– When assets are sold to related parties – To affirm the sale is at fair value 

– When consolidating variable interest entities (VIEs) – To value assets, liabilities, and equity interests of VIEs

Companies should consult with financial reporting advisors and auditors to determine situations where appraisals are recommended or required. Proactive appraisals can also strengthen overall compliance and financial integrity.

What Valuation Methods are Used for Business Appraisals?

Professional business appraisers utilize three main valuation approaches – asset-based, market-based, and income-based. These approaches consist of various methods that follow best practices outlined in appraisal standards. The methods are intended to capture fair value considering all available information about the subject business, industry, and economy. Appropriate methods and weighting are selected based on the purpose and subject of each appraisal.

#Asset-Based Approaches

Asset-based methods seek to determine the sum value of a business’s underlying net assets. Often used for holding companies and investment companies. Methods include:

– **Adjusted Book Value Method** – The company’s net assets are valued as reported on its balance sheet. Adjustments may be made to bring assets like property and equipment to fair values.

– **Liquidation Value Method** – Estimates the net amount that would be realized if the company liquidated all assets and settled liabilities. Used for businesses in distress.

– **Replacement Cost Method** – Values company assets based on the current cost to replace them with new assets. Often used for specialized machinery and equipment.

#Market-Based Approaches

Market-based methods derive value through comparison to actual transactions or pricing of comparable public companies. Often used for minority equity positions in operating companies. Methods include: 

– **Guideline Transactions Method** – Compares the subject company to pricing multiples from recent acquisition transactions of similar companies.

– **Guideline Public Company Method** – Compares the subject company’s performance to public companies in the same industry to derive market-based pricing multiples.

– **Industry Method** – Values a company based on typical rules of thumb or pricing metrics for its particular industry, like multiples of revenue or cash flow. 

#Income-Based Approaches

Income-based methods determine value through analysis of the subject company’s capacity to generate economic benefits. Often used for controlling interests and entire company valuations. Methods include:

– **Discounted Cash Flow (DCF) Method** – Converts projected future cash flows to present value using a discount rate reflecting risk. Value is determined from future earnings potential.

– **Capitalized Cash Flow Method** – Applies a representative cash flow multiple to normalized annual cash flows as an indicator of value. Similar to a DCF simplified to a single period.

– **Excess Earnings Method** – Values a company as the sum of its tangible asset value plus the present value of its excess earnings attributable to intangible assets.

Appraisers use professional judgement to select suitable methods and weigh the results to reach a conclusive opinion of value. Using multiple methods provides checks and balances to produce high-quality appraisals.

Key Inputs for Business Appraisal Valuations

Whether using asset, market, or income-based appraisal methods, certain key categories of information serve as inputs to the valuation process. Appraisers carefully research and analyze details related to the company, industry, competition, and broader economic environment when performing business appraisals.

#Financial Statements and Performance

Historical and projected financial statements provide insight into the company’s growth, profitability, cash flows, capital structure, working capital needs, and performance benchmarks. Common financial metrics analyzed include:

– Revenues, profit margins, EBITDA, EBIT, and net income

– Cash flows from operations, free cash flow, capital expenditures

– Growth rates, return on assets (ROA), return on equity (ROE)

– Debt/equity ratios, current ratios, interest coverage ratios 

– Revenue per employee, profit per customer, average order value

#Industry Data and Benchmarks

Understanding how the subject company compares to its peer group within its industry provides perspective. Relevant industry benchmarks include:

– Average company size, growth rates, profitability margins, and capital structure

– Competition levels, concentration, industry life cycle stage, barriers to entry

– Historical acquisition pricing and transaction activity

– Guidance from industry research reports

#Economic Conditions and Outlook

Analysis of current conditions and projections for the overall economy and within the specific industry help inform underlying assumptions. Important economic factors include:

– GDP growth, interest rates, inflation, unemployment levels

– Business cycles, consumer confidence, industrial production

– Availability of financing, IPO markets, M&A environment

– Credit market health, foreign exchange rates, trade policy

Integrating detailed financial, industry, and economic data enables appraisers to reach well-supported fair value conclusions.

Business Appraisal Standards and Regulations

Professional business appraisers adhere to established standards and regulations governing valuation services. Top standards include:

– **Uniform Standards of Professional Appraisal Practice (USPAP)** – Set by The Appraisal Foundation to ensure appraisals are ethical, impartial, and competent. Mandatory for licensed appraisers.

– **ASA Business Valuation Standards** – Set by the American Society of Appraisers covering developing an appraisal, appraisal methods, and reporting.

– **Statement on Standards for Valuation Services (SSVS)** – Developed by the AICPA specifically for CPAs performing appraisal and valuation services.  

Additional standards exist for specific contexts like litigation, mergers and acquisitions, real estate appraisal, and machinery and equipment appraisal. Professional appraisers hold required licenses and certifications and adhere to continuing education requirements.

For financial reporting, appraisals must comply with accounting standards for fair value measurement and asset impairment testing. The SEC, IRS, state boards of accountancy, and peer reviewers may all scrutinize appraisals behind financial reporting. Adhering to appraisal standards and regulations provides confidence in valuation conclusions.

Selecting a Qualified Business Appraiser

With so much relying on business appraisals for financial reporting, it is critical to select a qualified appraiser. Warning signs of an unqualified appraiser include lack of documented training, absence of appraisal licenses and designations, unrealistically low fees, overly aggressive conclusions favoring the client, and non-compliance with standards.

Characteristics of a qualified business appraisal firm for financial reporting purposes include:

– Licensed or certified appraisers on staff holding designations like Accredited Senior Appraiser (ASA), Certified Valuation Analyst (CVA), or Accredited in Business Valuation (ABV)

– Expertise specific to business appraisal for financial reporting needs

– Documented training and adherence to Uniform Standards of Professional Appraisal Practice (USPAP) and ASA Business Valuation Standards

– Membership in professional appraisal organizations like the American Society of Appraisers, Appraisal Institute, or American Institute of CPAs

– Expertise in specific industries related to the subject company

– Senior appraisal specialists with 10+ years of experience 

– Sample appraisal reports to demonstrate quality standards

– Errors and omissions insurance coverage

– Competitive fees compared to other qualified firms

A properly executed independent business appraisal performed in compliance with professional standards is crucial for financial reporting credibility. Retaining an experienced appraiser with relevant qualifications is the best way to obtain this assurance.

Conclusion

Business appraisals provide essential support for financial reporting processes like purchase price allocations, impairment testing, and routine fair value accounting. While internally derived estimates may seem convenient, authoritative accounting standards often require unbiased third-party valuations. Professional appraisers adhere to established methodologies and industry practices outlined in valuation standards to produce independent and reliable fair value estimates. 

By leveraging qualified appraisers, companies gain confidence that their financial reporting will withstand scrutiny from auditors, regulators, and financial statement users. Appraisals also bolster stakeholder confidence by demonstrating governance over valuation processes critical to enterprise value perceptions. For these reasons, business appraisals will continue playing an integral role in financial reporting activities requiring fair value expertise.