Chapter 6 Factors in Determining Relevance and Reliability: Due Diligence Considerations

• Jurisdiction: United States

Chapter 6 Factors in Determining Relevance and Reliability: Due Diligence Considerations

This chapter provides a discussion of important factors in determining the relevance and reliability of source information and interpretation of prospective financial information. It includes a discussion of concerns over systematic bias and issues to consider when adjusting prospective financial information. Due diligence investigation can help address these issues.

Courts routinely make determinations about the issues in each case by issuing factual findings after considering all the evidence. Many factual findings may depend on the outlook for the business's future. The best evidence regarding the outlook for a business's future is typically management's prospective financial information and supporting documents and analyses. When analyzing management's prospective financial information (and a valuation expert's interpretation of those documents and other information), courts often review indicia of their reliability. Courts may consider, for example:¹⁷⁵

• whether the financial statements and/or prospective financial information were prepared contemporaneously within the period of time under consideration;
• whether the financial statements and/or prospective financial information were prepared in the ordinary course of business;
• how management intended the particular piece(s) of prospective financial information to be used;
• how the financial statements and/or prospective financial information were interpreted contemporaneously with their creation;
• whether the valuation expert's analysis is consistent with management's intended use(s) of the document(s) and their original interpretation;
• whether the financial statements and/or prospective financial information were subject to any bias at the time of their creation; and
• whether the valuation expert's analysis is a biased reinterpretation based on hindsight or any other factors, reflecting a desire to advance the client's cause.

The keys to answering these and other questions may depend on due diligence considerations, including the depth of the analysis, scope of inquiry, documentary and other support, and other factors that may be relevant. Disputes over the quality (accuracy, support, bias, etc.) of the prospective financial information, and the adequacy of due diligence into the prospective financial information that raises key issues and resolves them in the analysis, may hinge on the valuation expert's professional judgment and the valuation expert's ability to convince others of their assessments and conclusions.

Daubert and Kumho Tire

Federal Rule of Evidence 702 states that testimony from expert witnesses with specialized knowledge is admissible if:

(1) testimony is based upon sufficient facts or data, (2) [testimony is] the product of reliable principles and methods, and (3) the witness has applied the principles and methods reliably to the facts of the case.

In Daubert, the Supreme Court held that judges should ensure that expert testimony is rooted in a reliable foundation and is relevant.¹⁷⁶ Kumho Tire reaffirmed the court's "gatekeeping" function and extended the requirements for reliability to all expert testimony, and does not differentiate between scientific and other knowledge.¹⁷⁷ Therefore, the trial court first determines whether the testimony offered by the expert is "relevant" to the issues under debate. After establishing relevance, then the court addresses "reliability."¹⁷⁸

A court has "broad latitude" to decide the "reasonable measures of reliability in a particular case."¹⁷⁹ Courts have identified two areas of particular concern: (1) the sources of facts and data used by the expert; and (2) any systematic bias that may have informed the expert's opinion.¹⁸⁰

Lack of reliability and lack of relevance are the most common reasons to exclude financial experts from testimony. Common errors include failing to collect sufficient data, using the data selectively, or failing to verify the accuracy of data provided by third parties.¹⁸¹ Historically, plaintiff-side financial experts face nearly twice as many challenges as defendant-side financial experts. However, on average, defendant-side financial experts experience a marginally higher rate of exclusion.¹⁸² Appellate courts have upheld the rulings of the lower courts to exclude, partially exclude, or include financial experts in the vast majority of cases.¹⁸³ Ad-dressing issues of relevance and reliability requires a firm foundation to establish the links to (or assumptions about) causation, facts in evidence, basis for knowledgeable analysis, scope of expertise and the admissibility of expert opinion.¹⁸⁴

Major Issues

In general, the basis and sources of a valuation expert's opinion may affect its weight or credibility, but may not lead to its exclusion.¹⁸⁵ A court may, however, reject a valuation expert's analysis where the expert did not develop, participate in, or supervise testing of the data performed by the client.¹⁸⁶

Courts have not approached the use of business plans, forecasts, projections, financial models and budgets in a uniform manner. A valuation expert who wants to use such information as the basis for calculating business valuations and/or commercial damages bears the burden of justifying such use. Caution should be exercised, and the principal documents should be carefully examined to assess their underlying information, including the purpose, assumptions, intended user, form and method of preparation, convertibility, and reliability in order to satisfy the reasonable certainty standard required in reaching expert conclusions.¹⁸⁷

Moreover, although source documents are frequently available, or missing data can be determined with little debate, a court or valuation expert may still raise questions about the intended interpretation of the information. Pertinent data for damages or a business valuation may include financial forecasts, projections and other prospective financial information compared to actual results for revenues, production statistics, operating income, earnings, cash flows or other data points. The meaning, interpretation and demonstrated pattern(s) of using and relying upon prospective financial information can become important determinants of how these documents can be used and interpreted in a litigation environment. Differences in outcomes and variances with actual results or the alternative prospective, forward-looking measurements may require explanation, or even adjustment in restated financial statements. Open questions and unresolved issues may require further exploration, determinations of whether they are material or significant to the analysis, and decisions on how to reconcile them in the final assessments and in the conclusions reached.

Normalizing Earnings

The incorporation of a future perspective on earnings depends, in part, on the purpose of the analysis. If a business valuation at a point in time is determined from actual conditions that are expected to continue, then a forecast may be more appropriate, since a forecast is based on actual conditions that are expected to exist during the forecast period. If a business valuation requires hypothetical assumptions, normalized conditions, altered tax assumptions or other adjustments, then a projection may be more appropriate because these items may be considered hypothetical. Projections may also be more appropriate when applying probabilities to various outcomes from separate projection scenarios, each based on different assumptions.¹⁸⁸ Either way, both projections and forecasts may be normalized depending on how the financial assumptions are being characterized, i.e., either as hypothetical conditions or as expected continuing conditions.

An expert or court may use the International Glossary of Business Valuation Terms to aid in its analysis. There, the terms "normalized earnings" and "normalized financial statements" are defined as:¹⁸⁹

Normalized Earnings — economic benefits adjusted for nonrecurring, noneconomic, or other unusual items to eliminate anomalies and/or facilitate comparisons.
Normalized Financial Statements — financial statements adjusted for non-operating assets and liabilities and/or for nonrecurring, noneconomic, or other unusual items to eliminate anomalies and/or facilitate comparisons.

The AIRA explains the role of normalization as follows:

Valuation is the process of determining the price of an asset as of a specific point in time; and central to this exercise is the conviction that value is a function of the assets' fundamental characteristics of growth, risk, and cash flows at the time of the valuation.¹⁹⁰
Numerous objective and subjective factors are employed in this [valuation] process, and the value of an asset can be substantially influenced by a number of assumptions, normalizing adjustments and hypothetical conditions. The application of assumptions, financial restatements, normalizing adjustments and hypothetical conditions should be adequately disclosed in the valuation report.¹⁹¹
Normalization adjustments are hypothetical in nature and are not intended to present restated historical results or forecasts of the future. This information should not be used for any other purpose other than to assist in this valuation.¹⁹²

Both AICPA and NACVA apply similar concepts regarding the purpose and use of normalization adjustments. Further, although normalization adjustments are often considered or explained as being unique to valuation, they are also used in damages analysis, transfer-price analysis, fairness opinions, feasibility analysis, and many other forms of financial analysis. They differ from GAAP financial statement adjustments because they may be made to the income statement, balance sheet or cash flows with or without directly affecting the other financial statements.¹⁹³

The usefulness of historical financial statements, accounting data and reported financial...