Valuation Audit: What to Expect and How to Prepare

A valuation audit is an independent examination of a business or asset valuation. Its purpose is not to create a new valuation from scratch, but to review an existing one to determine if the conclusion is reasonable and supportable. This process involves a detailed assessment of the methodologies used, the assumptions made, and the data relied upon in the original valuation report. The goal is to provide assurance to stakeholders, such as investors, regulators, or courts, that the valuation presents a fair and credible estimate of value.

This independent review gives confidence to those who rely on the financial information. An audit of a valuation provides an objective perspective, which is important when the valuation has significant financial consequences. It scrutinizes the work of the original appraiser, focusing on whether the final number is justifiable based on standard and accepted valuation practices. The process is analytical and evidence-based, designed to confirm the integrity of the valuation itself.

Triggers for a Valuation Audit

A valuation audit is often initiated by specific events or regulatory requirements that demand an independent verification of value. One common driver is financial reporting compliance. Under Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), companies must perform regular impairment testing for goodwill and other intangible assets. A valuation audit supports the carrying values of these assets on the balance sheet, especially during an annual financial statement audit.

Tax reporting and disputes frequently necessitate a valuation audit. When filing estate or gift tax returns, the Internal Revenue Service (IRS) requires a qualified appraisal for business interests, and an audit can substantiate the reported value if challenged. Private companies issuing stock options need a 409A valuation to set the fair market value of their stock. An audit of this valuation helps defend against IRS scrutiny and potential tax penalties.

Litigation and shareholder disputes are another major catalyst for valuation audits. In legal conflicts, such as dissenting shareholder actions, divorce proceedings, or partner buyouts, the value of the business is often a central point of contention. A valuation audit can serve as expert evidence to support or challenge a stated value, helping ensure a judgment is based on a fair assessment.

Transactional due diligence is a frequent trigger. In mergers and acquisitions (M&A), a buyer may commission an audit of the target’s valuation to validate the asking price and identify risks. The audit gives the buyer confidence to proceed or leverage to renegotiate terms based on the findings.

Key Areas of Scrutiny

The core of a valuation audit involves an analysis of the original appraisal. Auditors begin by assessing the valuation methodology. The three primary approaches are the Income Approach, the Market Approach, and the Asset-Based Approach. The Income Approach is often used for established businesses, while the Market Approach compares the company to similar businesses.

The Asset-Based Approach is used for holding companies or businesses where value is tied to tangible assets. An auditor’s first step is to determine if the selected approach aligns with the business and the valuation’s purpose.

Auditors then analyze the assumptions and inputs in the valuation model, as small changes in assumptions can significantly impact the final value. For an Income Approach valuation, auditors will scrutinize revenue growth rates, profit margins, and the discount rate. For a Market Approach valuation, they examine the selection of comparable companies and the appropriateness of the valuation multiples. The audit focuses on whether these assumptions are reasonable and supported by market evidence.

The audit also includes verifying the source data. Auditors trace financial inputs to their original sources, like historical financial statements, to confirm accuracy. They also examine management’s financial projections against historical trends and strategic plans. Other documents, like material contracts and legal agreements, are reviewed to support the valuation’s assumptions.

Information and Documentation Required

To prepare for a valuation audit, a company must assemble a comprehensive set of documents. The starting point is the original, full valuation report being audited, which contains the appraiser’s analysis and conclusions that guide the review. Other required documentation includes:

• Historical financial information, including at least three to five years of income statements, balance sheets, and cash flow statements. Audited statements are preferred.
• Detailed financial projections and the underlying business plan, including documentation that supports assumptions for growth rates, market share, and profit margins.
• Legal and corporate documents, such as articles of incorporation, operating agreements, and any shareholder buy-sell agreements.
• A current capitalization table (cap table) showing the ownership structure, along with details of any recent transactions in the company’s stock.

The Valuation Audit Process

The valuation audit process begins with signing an engagement letter that outlines the audit’s scope, responsibilities, timeline, and fees. After engagement, a kickoff meeting is held to introduce the teams and finalize the audit plan.

The audit team then requests information and begins fieldwork. Fieldwork involves reviewing these documents and interviewing management to understand the business and the rationale behind the valuation’s assumptions.

With the information gathered, the auditors analyze the valuation’s methodology, inputs, and assumptions. They may build their own models to test the reasonableness of the original conclusion and assess the report’s credibility.

Before finalizing, auditors present preliminary findings to management in a draft report. This allows for discussion and clarification, ensuring the final report is accurate and considers all relevant information.

The final step is issuing the formal valuation audit report. This document details the audit’s scope, procedures, findings, and the conclusion on the valuation’s reasonableness. It is the official deliverable for the company to share with stakeholders.

Understanding the Valuation Audit Report

The final valuation audit report communicates the auditor’s findings and conclusions. It is structured for clarity, starting with an executive summary of the engagement and the final opinion. The report then details the scope of work and summarizes the audit’s findings.

The report’s conclusion on the valuation can take several forms. The auditor may conclude that the original valuation is reasonable and well-supported. Alternatively, they might find that the valuation is reasonable, but only subject to certain adjustments. In some cases, the auditor may conclude that the valuation is not reasonable because of significant flaws or unsupported assumptions.

The report also describes any identified issues, which can range from mathematical errors to using an inappropriate valuation methodology. Other common findings include overly aggressive or unsupported assumptions for inputs like growth rates. The report explains these findings in detail, providing the rationale for the auditor’s conclusions.