Introduction

The objective of this publications is twofold. First, to set out what I think solicitors should be aware of in commissioning and receiving an expert witness report. Second, and because we are generally asked to report on share valuations, to let solicitors have an insight into the mysterious world of price earnings ratios.

Expert witness reports

You know that in civil (and criminal) cases, the general rule is that opinions of witnesses are not admissible in Court. Witnesses are asked to state facts which they claim to have seen. It is then for the Judge and jury to decide what the facts were. It is not important that the Judge and jury lack any specialist learning or expertise.

There are, however, many complex issues which the Court has to determine and which are so outside its expertise that the opinion of an expert in a particular field is required if the court is to draw a proper and right inference from the facts. Only an expert can explain those complex issues to the Court.

Expert witnesses have therefore long been asked to provide opinion evidence as an exception to the general rule. This places a heavy burden of responsibility on the expert witness. His duty is to the Court and not to the parties who engage him. Specific judicial rules enforce a very high degree of independence on him. He must give his honest opinion and it must be provided only on matters which properly fall into his own area of expertise and learning.

I am sure you have found occasionally that an expert accountants report has been deficient. We therefore highlight reasons why reports can be deficient and the issues that are important in an evaluation of the report:

1. Are the instructions covered in the report?

We always include a copy of the letter of instructions as an appendix to the report. Others may summarise the instructions in the report itself. It should therefore be easy to assess the extent to which the report addresses the issues.

However if some issues receive scant detail in the report or if information is so limited that a firm opinion is not possible, it is a matter of judgement for the expert to state that he is not able to give a meaningful opinion or that his report is based mainly on assumptions which are set out in the report and which may change the opinion if more information becomes available.

2. Does the expert express views outside his competence?

Many accountants, because of their general knowledge of business, consider themselves competent to express an opinion in a report which is outside their area of expertise. Such an opinion is of limited value. The expert accountant needs to be provided with information in areas which fall outside his competence.

3. Does the expert set out the assumptions on which he bases his calculation?

The expert accountant will often make assumptions about variables. These will include future turnover, the expected gross profit and the estimated maintainable earnings.

The expert should in his report justify his reasons for adopting them. These may be based on past experience. Many accountants will take an average of previous years business results. But that can only be a guide to future earnings and should not be preferred to latest and current management information.

However, if that is not available the accountant may have to rely on past performance being repeated, and he should explain why he his doing so.

4. Financial statements / accounts

The accounts are probably the most important documents on which experts rely. You should establish whether the accounts upon which reliance is made are final or draft and be aware that draft accounts can be changed materially.

Similarly, you should establish whether signed accounts are being relied upon to ensure that what appear to be final accounts will have not been changed prior to acceptance by the directors.

Bear in mind also two other points in connection with private companies.

• A private company with a 31 December year-end has until 30 September to submit accounts. It follows that a valuation started now will be based on information nearly a year old.
• The second point is that many small companies are not now subject to an audit and therefore no independent assurance of the accounts exists. The same applies of course to unincorporated businesses. Confirmation that HM Revenue & Customs have not enquired into the accounts or made any significant adjustments may give some assurance.

5. Are the experts’ assumptions consistent?

If, for example, the expert is assuming a decline in turnover because of the current economic climate, has he also taken account of the fact that the business may reduce its labour costs and variable overheads so the gross profit may, in fact, be affected only slightly?

6. Background facts

You should check that any background facts which are included in the report are accurate; indeed you should also check that you were previously aware of them.

Also, look out for basic errors on presentation, for example page and reference numbers, arithmetical and computational errors. These may indicate a lack of care and can reduce the credibility of the report and the expert.

Often an accountant will use the background facts selectively to support his conclusions, perhaps by not including some of the facts in the report or failing to mention significant developments, for example, the loss of an important sales contract or a key salesman.

Accountants may also mix fact with comment that is impossible to substantiate. You may have seen on occasions, comments made in order to project a rosy future such as ‘the business has been operating for the last fifteen years (a fact) and this shows that the directors were and continue to be determined to make the business a world leader (a comment)’.

7. Does the report allow you to see how the figures are derived?

You should be able to read at each stage how the expert comes to an opinion by reference to the facts and assumptions. What I term a “clear trail”.

8. Is the experts conclusion reasonable?

An expert can sometimes lose himself in the detail and not take the time to stand back and ask ‘is that reasonable?’. For example, having arrived at a hypothetical valuation, to say to himself ‘would a purchaser actually pay £X to buy those shares?’.

9. Has the expert dealt with matters which may be used to undermine his conclusion?

If the expert acknowledges in his report some issues and facts which do not suit his arguments, and deal with them, his credibility should be enhanced and it will make it more difficult for him to be challenged. The Court will always support a conscientious and professional expert.

Share valuations

I turn then to the mysterious art of share valuations.

There are various reasons for valuing shares:

1. Tax valuations requiring an open market value
2. Fair value
3. Fair market value
4. Commercial value
5. Investment value

I am asked usually to value shares in proceedings in matrimonial breakdown. There is generally no question of anyone selling shares. Indeed, in almost all cases, shares in a particular company will never have been bought or sold, and probably will not be until there is a complete exit.

My instructions will therefore refer to a fair value or will repeat the tax legislation definition of an open market value. Again, there is no question of anyone actually buying or selling shares in the open market. There is no open market. Instead, we are asked to assume that someone wishes to sell and another wishes to buy and that the purchaser will be registered as a member of the company and, otherwise, be subject to the real facts of the case. And precedents have been laid down over the last century which tell us what is and what is not to be assumed in this open market.

You, as instructing solicitors, assume that the expert knows everything about the concept of the hypothetical open market. You also expect that the expert will be able to calculate an estimate of maintainable earnings from the facts or make a calculation of potential tax liabilities on a sale of fixed assets at valuation.

However, the questions which are most asked of me and which will usually arise when there is a difference of opinion to be resolved, are in relation to:

• Trading companies – what P/E ratio should be used;
• Investment companies – what discount from net assets should be used.

I have therefore prepared these tables to guide you towards a range of P/E ratios and discounts which might be acceptable to both sides in a dispute [link required]. Please remember that they are only a rule of thumb and that an expert who is appointed may make several important qualifications to them, for example to reflect the quality of earnings and the quality of any property.

Finally, on an unrelated but relevant matter, there must in the current climate be an opportunity to negotiate historically low values for shares and assets and it could be a very good time for IHT/CGT gift planning, including contributions in specie to pension funds, and for implementing share incentives.