Chapter 7 Preparation and Review of Financial Projections

• Jurisdiction: United States

Chapter 7 Preparation and Review of Financial Projections

This chapter provides a general discussion of some important considerations in the preparation and review of financial projections. The considerations draw from the general themes in this book. They are not intended to be comprehensive, but serve as examples of areas of inquiry. The items discussed in the context of financial projections may also apply to the preparation of financial forecasts, depending on the situation and its corresponding facts and circumstances and the intended users of such information.

Financial projections are used in a variety of settings to reflect management's estimate of the future performance of a business. Boards, investors and other parties should do more than simply accept management's prospective financial information. Reasonable inquiry and the performance of due diligence is expected.

Financial advisors face their own expectations for performing due diligence on financial projections prior to use. Financial advisors may also be asked to assist in preparation of projections. Those professionals who are providing these services may be guided by their professional obligations stemming from the AICPA, ASA, AIRA or other professional organizations, which have identified professional guidelines for the preparation of financial projections.

For example, the AICPA guide Prospective Financial Information (AICPA Guide) provides comprehensive guidance regarding the preparation, use and verification of prospective financial information. AICPA's AT-C Section 305 Prospective Financial Information also outlines performance and reporting requirements and application guidance for examining prospective financial information. In general, "assumptions should be reasonable and suitably supported," and "care should be exercised to assess the situation objectively," although "hypothetical assumptions need not be reasonable but should be appropriate in light of the purpose for which the projection is prepared."²⁴¹ The suggested guideline is meaningful regardless of whether or not the expert is a CPA:

The attention devoted to the appropriateness of a particular assumption should be commensurate with the likely relative impact of that assumption on the prospective results. Assumptions with greater impact should receive more attention than those with less impact.²⁴²

Regardless of the professional role, a number of considerations should be addressed or considered. They fall into several broader categories.²⁴³

Independence and Objectivity

The major professional associations (e.g., AICPA, ASA, AIRA, NACVA, etc.) that issue certifications for valuation professionals each oversee their members' compliance with ethics standards.²⁴⁴ Generally, they expect their members to be independent and objective when performing their work and analysis. In addition, they expect their members to obtain, evaluate, document, and provide firm support and a clear foundation for their analytical work and conclusions.

For example, the AICPA Guide explains the concept of having a "reasonably objective basis" as the standard for presenting financial forecasts and projections.²⁴⁵ It also recognizes that "considerable judgment is required to evaluate whether a reasonably objective basis exists" to support the forecasts and projec-tions.²⁴⁶ Evaluation of that reasonably objective basis can hinge upon the available support underlying the assumptions and an identification of the "key factors" that "are basic to the entity's operations and thus encompass matters that affect, among other things, the entity's sales, production, service, and financing activities."²⁴⁷ An assessment should determine whether:²⁴⁸

• there appears to be a rational relationship between the assumptions and the underlying facts and circumstances (that is, whether the assumptions are consistent with past and current conditions);
• the assumptions are complete (that is, assumptions have been developed for each key factor);
• it appears that the assumptions were developed without undue optimism or pessimism;
• the assumptions are consistent with the entity's plans and expectations;
• the assumptions are consistent with each other;
• the assumptions, in the aggregate, make sense in the context of the forecast [or projection] taken as a whole; and
• the assumptions that have no material impact on the presentation may not have to be individually evaluated; however, the aggregate impact of individually insignificant assumptions, when considered in an overall evaluation, underlying the forecast (or projection) are appropriate.

In addition, these professional associations and their professional standards have historically recognized the concept of a litigation exception within their standards and procedures that allows for the unique environment in which the work may be performed. These exceptions do not dispense with the requirements for competency, independence and objectivity, but generally recognize the detailed nature of unique work product that may be subjected to a court or other legal setting. The underlying concept is that the litigation exception assumes other parties review and challenge the analysis in a courtroom context, offering a check on the methods and applications used by the expert or analyst. The litigation exception generally permits the professional to present results in a manner suitable for the court, rather than following the typical formats specified under professional standards.

In addition, these professional standards generally recognize the priority of published laws and governmental requirements or judicial rulings that specify stated procedures pertaining to valuation, damages computation or other financial analyses. Generally, this is known as the jurisdictional exception.

Since the litigation and jurisdictional exceptions fall within the broader professional standards, professional guidance still anticipates that the professional will otherwise apply generally accepted valuation methodologies.²⁴⁹ This is consistent with Daubert and its progeny, which specify that litigation experts should utilize techniques generally accepted in the scientific community (see Chapter 6). Thus, the litigation exception generally pertains to the reporting of the analysis (e.g., the valuation report) and not to the development of the valuation itself (e.g., the valuation analysis); in addition, the jurisdiction exception places the law above any professional standards in the priority of selecting, applying and interpreting the appropriate methodologies used within the valuation.

Overall, the role of these standards may or may not impact perspectives about a valuation expert's preparation, use or interpretation of prospective financial information. Counsel and the valuation expert should review and assess their impact on the valuation and/or financial analysis that is being performed.

Preparation

It is important to understand the purpose of the prospective financial information. Who is, or was, responsible for preparing the forecasts or projections, and what was the role of the outside professional? What are the roles and contributions of management, financial consultants/advisors, the board and company counsel? Were multiple forecasts and/or projections prepared, and what are the implications of those other perspectives?

There is nothing inherently wrong with relying on third-party projections or forecasts or other financial analyses; however, third-party financial projections or other prospective financial information should still be shown to be reliable (and they do not have the benefit of any presumption of reliability such as contemporaneously prepared management projections may have). Third-party prospective financial information that is not affirmatively shown to be reliable is likely to be rejected. For example, at the chapter 11 plan confirmation hearings for Granite Broadcasting Corp., the court rejected the third party's financial projections after finding that the third party was not reliable. In particular, the court was troubled by the third party's financial projections because:

• it was not qualified as an expert witness;
• the third party's projections were never described in detail to the court;
• the third party admitted that he was generally unfamiliar with the debtors;
• the third party had recently run a company similar to the debtor that had poor operating results and frequently defaulted on its credit facilities; and
• the third party's specific findings were unreliable with unrealistic expense reductions and unrealistic expectations of increasing revenues.²⁵⁰

The credibility of the third-party projection in that instance was also "seriously undermined by the fact that his compensation" was contingent on the level of recoveries to particular stakeholders under a confirmed plan.²⁵¹ In contrast, the debtors' expert performed substantial due diligence to verify the accuracy of the debtors' financial projections.

In the TOUSA fraudulent transfer action, the court concluded that it was unreasonable for lenders to rely on a solvency opinion provided by a consultant that had been retained by the debtor, TOUSA.²⁵² The court criticized the solvency opinion because it was not an independent projection or analysis.²⁵³ Instead, according to the court, it was a biased opinion provided on a contingent-fee basis and based on projections prepared by TOUSA's management. Therefore, the court found that the solvency opinion was nothing more than an engineered solution.²⁵⁴

Time Horizon and Scenarios

Prospective financial information generally does not need to adhere to a specified time horizon. Typically, financial projections and financial forecasts cover a three- to five-year period.²⁵⁵ In business valuation, the initial discrete financial projection period used in a discounted cash flow may extend until the business reaches a stable performance. Thereafter, a perpetuity period represents all...