Practice continuation agreements; no sole practitioner or small firm should be without one.

Most CPAs have not planned in advance to preserve one of their most valued assets--their practices--in the event of their untimely death or disability. Because most practices deteriorate substantially within 30 days of a CPA's death--and rarely last much longer than that if the CPA is permanently disabled and unable to manage or meet client demands--timely action can preserve practice value. It also can help prevent a CPA's spouse or immediate heirs from facing a hasty sale or disposition of the practice in an emergency.

This article defines the practice continuation agreement, a vehicle that helps ensure the orderly transfer of a practice, and reviews the types of contractual agreements available. It also discusses the various issues CPAs should address in their agreements.

WHAT IS A PRACTICE

CONTINUATION AGREEMENT?

A practice continuation agreement is a contract made between an individual practioner or a small two-partner-shareholder firm (in case of a dual calamity) and another CPA firm. It describes a course of action to transfer a professional CPA practice and sets payment for its value. In the event of death or temporary or permanent disability, a practice continuation agreement protects the practice, the business interests of the accounting firm's clients and the financial interest of the CPA and his or her family. The agreement can even be used as a retirement vehicle.

WHAT PLANS ARE AVAILABLE?

There are many different kinds of practice continuation agreements. A practitioner may enter into a one-on-one agreement with another sole proprietorship, partnership or professional corporation in the community. It generally is advantageous to enter into a one-on-one agreement with a larger firm that has the money and the staff necessary to absorb a smaller practice on a moment's notice. Under group agreements, several CPAs acts as successors to each other's firm. When one member dies or is unable to continue practicing, each of the firm's clients is asked to select a member of the group as its new CPA firm. These plans cover only the transfer of clients. Another alternative is offered by some state CPA societies, which assist the spouse and heirs to perpetuate a CPA's practice. If a member CPA hasn't made other arrangements, these state society plans, also called emergency assistance plans, provide help for the practice's disposition.

CONTRACTUAL AGREEMENT ELEMENTS

There are many elements to a practice continuation agreement. The key to creating effective terms and conditions involves basic definitions for the concepts of temporary disability, permanent or total disability and retirement.

Permanent disability is total disability due to ill health, either physical or mental. In contrast, temporary disability is defined as a physical or mental disability that does not last more than approximately six months. Retirement is simply defined as the exit from public accounting on a immediate or phase-out basis. These definitions must be a part of any contract and must be addressed with care to allow flexibility.

Temporary disability. The agreement should call for the successor firm to provide employees to assist in the practice's daily business. The employees generally would be supervisors, such as managers, so they can review staff work and provide the necessary experience and background to make management decisions. The manager would be in contact with and under the supervision of the temporarily disabled practitioner.

The two firms would negotiate a compensation arrangement for the assisting firm. Firms that need help should expect to pay a manager the standard fee charged to clients by that person's firm.

The agreement would provide for a conclusion of the arrangement once temporary disability ends. The temporarily disabled practitioner probably would give advance notice of his return, but the agreement would not require it.

Permanent disability or death. The provisions called for in these cases are much more detailed. They must allos for an orderly transfer of firm clients to the successor firm with no assistance from the practitioner and for the beginning of predetermined regularly scheduled payments to his heirs.

ESSENTIAL ELEMENTS

Each practitioner will have his own concerns to be addressed in an agreement. The following checklist, developed with the help of the Texas Society of CPAs management of an accounting practice committee and input from practitioners across the country, lists some of the basis elements that should be part of every contract.

* Client information. The list of clients should include information such as type of industry or service; fees for at least three years detailed by type of CPA service provided; firm accounts-receivable payment history; types of CPA services provided; and contact people at the client's office. The list is vital to practice valuation and its ultimate sale or disposition.

* Working papers. The successor firm must have access to the firm's workpapers detailing tax and accounting standards applied to each client. Up-to-date workpapers help determine the status of work-in-process and can enhance practice value.

* Files. The successor firm must receive all files, such as billing and personnel files. They should be easy to locate and easily understandable to outsiders.

* Books and records, financial statements and tax returns. Since the entire practice is being transferred, the predecessor firm's books must be available. This includes subsidiary ledgers, such as payroll and accounts receivable. There should be at least three years of firm financial statements on the accrual and cash basis. The cash basis allows interpolations of the cash flow to be generated by the firm; the accrual basis shows assets' book value and related firm liabilities on a generally accepted accounting basis to assist in determining the value of those practice elements. Tax returns also should be available. As a practical matter, the successor firm's financial statements and tax returns should be available to the predecessor firm while contract negotiations are being made and periodically afterward until the practice continuation agreement takes effect.

* Work-in-process, accounts receivable and unbilled expenses. Work-in-process is one of the most difficult areas to define in a CPA practice and generally is carved out as a special valuation issue in the transfer. Payment to the predecessor firm owner depends on identifying and determining the status of work-in-process. Accounts receivable records also are vital to the transfer of firm clients. The agreement must address who will be responsible for collecting accounts receivable or if they will be valued (usually at a very heavy discount) and sold to the successor firm. If they are sold to the successor firm, then there must be an accounting of the predecessor's accounts receivable and any client activity associated with them separate from the successor firm's accounts receivable records. The agreement should include information on the size of the collections fee, which is usually between 10% and 15%.

* Tangible property, equipment and supplies. CPAs sometimes don't follow their own advice to clients to use a tag identification system for their office furniture and equipment. Many have only depreciation schedules on hand. It can be extremely difficult for the surviving spouse or successor firm to identify equipment without a good identification system. In addition, a good fixed-asset subsidiary ledger will assist greatly in valuing this part of the balance sheet if the date of purchase, cost, serial and model number and other peripheral attachments can be identified. Supplies need to be organized to allow for an inventory if they are to be sold.

* Existing leases. The agreement must address the disposition of leases, because determination of who shall be responsible is imperative. If necessary, the surviving spouse can negotiate a firm's current leases, usually by paying about six months' lease payments in advance. However, practically speaking, successor firms often don't want a second office in the same city or favor negotiating a lease settlement. Secondary leases for storage facilities shouldn't be overlooked when drawing up the practice continuation agreement.

* Employee records. Records should contain salary scales, personnel policies, equal opportunity practices and performance and raise reviews. Most agreements call for the successor firm to hire the predecessor's personnel provisionally until they prove incompatible with the successor firm's staff.

* Existing and contingent liabilities and professional liability suits. All liabilities must be identified. Most agreements address this issue specifically. Successor firms don't want to be associated in any way with specific client professional liability suits and some contingent liabilities. Existing debts that are to be assumed, such as notes payable or current liabilities, should be cited.

* Property and casualty insurance. Successor firms are practicularly interested in this element. Firms should have proper coverage and records of expiration dates to insure protection of purchased assets being trasferred from one office to another. The surviving spouse or heirs should maintain coverage until they can dispose of any assets not transferred. A well-organized insurance file containing all current policies in recommended.

* Fees and billing information. Standard fees at the predecessor and successor firms must be compatible to ensure client acceptance. Similar fee structure and billing procedures also are vital to the successful transfer of clients. The fee structure is key in determining use of personnel.

PAYMENT FOR THE PRACTICE

A practice continuation agreement's provisions for the sale of a practice must contain a reasonable valuation and a realistic payment structure. There really are only two elements being sold: The tangible balance sheet items have been discussed above; the intangible income statement items are the clients and the related net income generated by services that are rendered to them.

To understand valuation and payment issues, it's important to determine the object of entering into a practice continuation agreement. Protection of assets isn't the only answer. What CPAs really want is to leave to their surviving spouses or heirs something from all the hard years of work it took to build the practice. To accomplish this end, selling the practice at a buyer-friendly price may be necessary. As mentioned earlier, practices can disintegrated very quickly, so timing is vital.

Each client must be listed in the contract and assigned individual values that equal the total valuation agreed on for the practice. Payment for each is made to the CPA's heirs from cash received by the successor firm from billings to these clients for future services. The agreed-on percentage of current collections to be paid depends on the contract's term. If the term is 10 years, then 10% of each collected amount would be paid; a 5-year term would require 20% payments each year. Payments are usually made by the 20th of the month after the cash is received. The maximum amount to be paid for any client is its agreed-on value. If the client terminates the successor firm's services, payments for that client cease.

The surviving spouse or heirs don't participate in any future client growth once the practice continuation agreement takes effect. Usually, interest is not a factor in practice payments. CPAs should be extremely cautious about entering into an agreement that involves a note payable. This could be a trap, because it fixes the price for consideration and prevents payments that correspond with cash flow. It is inflexible to client loss. The buyer could end up paying for a client it may not keep.

Valuation considerations. Although this article does not discuss the different valuation methods, CPAs should keep in mind that there are no hard rules on valuing an accounting practice. All practice units are unique, and a different set of criteria must be used for each. Many intangibles can affect the valuation. There are a number of factors that contribute to the realization of agreed-on value, including

1. Practice size by annual fee volume.

2. Historical net income generated by the practice.

3. Nature and type of practice involved (client matrix).

4. Seller's ability to assist in transfer of the practice and solidify relationships with the successor firm.

5. Purchaser's competency to manage additional practice.

6. Purchaser's interest in acquiring the practice.

7. Agreed payout period.

8. Growth potential of the predecessor's practice.

The factors are more fully discussed in the American Institute of CPAs Management of an Accounting Practice Handbook.

The valuation method must be agreed to by both parties to the contract and be an integral part of the agreement. It's a good idea to cover compensation for the arbitrator or hired professionals needed in final valuation determinations.

IMPORTANT ISSUES

Noncomplete clause. The agreement must address competition. If the selling CPA is disabled, he may continue to work with clients, and this relationship should be defined in the agreement. In the case of temporary disability, the successor firm should be penalized if it takes away a client as a result of the temporary disability engagement. The penalty generally is no less than 150% of the last year's annual cash fees collected from the client in question.

Termination of the agreement. Most agreements allow for a termination by either party with a 30-day written notice. This provision is protection in case a practitioner finds financial or other problems that make the agreement unfavorable or uncovers facts that would be concerns for the firm's clients.

Arbitration. The firms involved generally agree that any dispute or claim concerning the agreement is to be settled by arbitration, accomplished by CPAs who aren't parties to the contract. The costs of the arbitration usually are split between the firms involved.

Notification. The predecessor firm should notify all clients of the agreement and assure them there will be no interruption of services when the practice changes hands. The practitioner should stress that an effort has been made to find a suitable successor firm that provides compatible services at comparable rates. Even though not stipulated in the contract, it is extremely important to ensure the surviving spouse or heirs are aware of the existence of the practice continuation agreement and understand its provisions. In addition, the attorney for the predecessor CPA's estate should be familiar with agreement terms, if he or she did not draft and negotiate the agreement.

A WORTHWHILE INVESTMENT

CPAs must invest time and effort to find suitable successors for their firms and to create useful, equitable practice continuation agreements. The investment is a good one, however, because these agreements ensure that if a CPA is unable to continue managing the practice, the value he has built over the years will not be lost. An orderly transfer of a practice to another CPA is a substantial financial benefit to the CPA's family. At the same time, through the handpicked successor, the CPA fulfills his professional responsibility to his clients. CPAs who don't have these agreements should consult their attorneys or state CPA societies to learn more about preserving the value they've created.

JOHN A. EADS, CPA, is president and managing shareholder--director of Eads, Hunter & Company in Dallas. He is a member of the American Institute of CPAs and treasurer of the Texas Society of CPAs. His book on practice continuation agreements is to be published soon by the AICPA.