Business valuation is a cornerstone of financial decision-making, particularly in transactions involving mergers, acquisitions, or financing, such as Small Business Administration (SBA) 7(a) loans for business acquisitions. Accurate financial information is the foundation of a credible valuation, ensuring that stakeholders—lenders, buyers, sellers, and appraisers—can make informed decisions. In scenarios where a division of a business is being valued, the complexity of financial data increases, as divisional financials must be isolated from the parent company’s consolidated records. This white paper explores the importance of accurate financial information in business valuations, with a focus on a case involving a divisional valuation for an SBA 7(a) loan, where inconsistencies between divisional financials and tax returns raised ethical and professional concerns. Drawing on the National Association of Certified Valuators and Analysts (NACVA) Professional Standards, it underscores the appraiser’s responsibility to ensure data reliability and the risks of proceeding with unverified information.

The Role of Financial Information in Business Valuation

Business valuation relies on financial data to assess a company’s economic value using approaches such as the income, market, and asset methods. For a divisional valuation, appraisers depend on financial statements, tax returns, and operational data specific to the division. These records inform key metrics like revenue, expenses, cash flow, and officer compensation, which directly influence the valuation conclusion. Inaccurate or inconsistent data can distort these metrics, leading to flawed valuations that misrepresent the business’s worth.

In the context of an SBA 7(a) loan, the stakes are higher. The SBA requires an independent business valuation for loans exceeding $250,000 or when there is a close relationship between buyer and seller, as outlined in the SBA Standard Operating Procedures. The valuation must be conducted by a qualified source and, for NACVA members, adhere to NACVA Professional Standards. Inaccurate financials can jeopardize loan approval, expose lenders to risk, and undermine the buyer’s ability to service the debt.

Case Study: Divisional Valuation for an SBA 7(a) Loan

Consider a scenario where a client seeks a valuation of a business division being sold, financed through an SBA 7(a) loan. The seller provides divisional financials prepared by an internal bookkeeper, but these records are inconsistent with the parent company’s consolidated tax returns. For example, officer compensation reported in the divisional financials significantly exceeds the amount on the tax return. Other discrepancies, such as mismatched expenses, more cash on the divisional balance sheet than the tax return for the consolidated entities, further cloud the data’s reliability. The CPA who prepared the tax returns refuses to reconcile the divisional financials, and the lender is willing to underwrite the loan based on the unverified divisional records. The client pressures the appraiser to accept the financials without further verification, citing time and cost constraints.

This situation highlights several risks:

Inconsistent Data: Discrepancies between divisional financials and tax returns suggest potential errors, misallocations, or intentional misrepresentation. Officer compensation, a critical adjustment in valuations, can skew earnings and distort value if inaccurately reported.

Lack of Reconciliation: The CPA’s refusal to reconcile the financials leaves the appraiser without a clear understanding of the division’s true financial performance, violating the need for sufficient relevant data.

Lender’s Position: The lender’s willingness to proceed without verified data may reflect pressure to close the deal but increases the risk of an unsound loan decision.

Client Pressure: The client’s insistence on accepting unverified data places the appraiser in an ethical dilemma, as doing so may compromise professional standards.

The Importance of Accurate Financial Information

Accurate financial information is essential for the following reasons:

Credibility of the Valuation: A valuation is only as reliable as the data it relies on. Inaccurate financials can lead to an over- or undervaluation, affecting negotiations, loan terms, and the buyer’s financial strategy. NACVA Professional Standards emphasize that members must obtain sufficient relevant data to afford a reasonable basis for conclusions.

Compliance with SBA Requirements: For SBA 7(a) loans, the valuation must be prepared for the lender by a qualified source and include a conclusion of value based on all the valuation approaches (income, market, and asset) deemed appropriate by the appraiser. Inconsistent or unverified financials undermine compliance, risking loan denial or future audits.

Risk Mitigation: Lenders rely on the business’s ability to generate cash flow to repay the loan. Inaccurate data can lead to over-leveraging, default, or loss of the SBA guarantee.

Ethical Integrity: Accepting unverified financials under client pressure risks violating NACVA’s General and Ethical Standards, which require members to remain objective, maintain professional integrity, and not knowingly misrepresent facts. Proceeding with unreliable data could also damage the appraiser’s reputation.

NACVA Professional Standards and Ethical Considerations

NACVA Professional Standards provide clear guidance for appraisers facing unreliable financial information:

Due Professional Care: Members must exercise due professional care, including completing sufficient research and obtaining adequate documentation. In the case study, the appraiser’s inability to reconcile divisional financials with tax returns indicates a lack of sufficient data, necessitating further inquiry.

Sufficient Relevant Data: Appraisers must obtain data that provides a reasonable basis for their conclusions. The inconsistencies in officer compensation and other metrics suggest the divisional financials may not meet this standard.

Objectivity and Integrity: Members must remain objective and not subrogate judgment to others, even under client pressure. Accepting unverified financials to appease the client may violate this principle.

Scope Limitations: If data limitations prevent a credible valuation, appraisers must disclose these limitations in their report or consider refusing to render an opinion. NACVA standards allow appraisers to evaluate whether limited evidence supports a more limited conclusion, but this must be clearly communicated.

The refusal to accept unverified financials aligns with NACVA’s emphasis on professional judgment and ethical conduct. Appraisers are not auditors, but they must critically assess the reliability of provided data and seek clarification when inconsistencies arise.

Risks of Proceeding with Inaccurate Financials

Proceeding with unverified or inconsistent financials poses significant risks:

Misinformed Decisions: An inaccurate valuation may lead the buyer to overpay or the lender to approve an unsustainable loan, increasing the likelihood of default.

Regulatory Scrutiny: SBA audits may uncover non-compliance if the valuation relies on unverified data, potentially voiding the loan guarantee.

Legal Liability: If the valuation misleads stakeholders, the appraiser could face legal action for failing to exercise due professional care.

Reputational Damage: Compromising on data reliability undermines the appraiser’s credibility and standing in the professional community.

Recommendations for Appraisers

To ensure accurate financial information in valuations:

Request Reconciliation: Insist on a reconciliation of divisional financials with tax returns, ideally prepared by a CPA. If the CPA refuses, escalate the issue to the lender, highlighting the risks.

Document Limitations: Clearly disclose any data inconsistencies or limitations in the valuation report, as required by NACVA standards.

Engage Third-Party Experts: If reconciliation is not feasible, consider recommending an independent forensic accountant to verify the financials, ensuring compliance with NACVA’s due professional care standard.

Communicate Risks: Educate the client and lender about the risks of proceeding with unverified data, emphasizing SBA requirements and ethical obligations.

Refuse to Proceed: If credible data cannot be obtained, the appraiser may need to withdraw from the engagement to uphold NACVA standards and avoid ethical violations.

Conclusion

Accurate financial information is the bedrock of a credible business valuation, particularly for SBA 7(a) loan transactions involving divisional sales. Inconsistencies between divisional financials and tax returns, as seen in the case study, underscore the need for rigorous data verification. NACVA Professional Standards mandate due professional care, sufficient relevant data, and ethical integrity, guiding appraisers to reject unverified information that compromises their work. By prioritizing accuracy, appraisers protect stakeholders, ensure compliance, and uphold the valuation profession’s credibility. In an era of complex financial reporting, the appraiser’s role as a guardian of data integrity has never been more critical.