Valuation of accounting practices--what's it worth?
What's It Worth?
Professional accounting practices are frequently subject to valuation. The question of the value of an accounting practice is important to the practice partners, their spouses and heirs, potential partners (including merger partners) and other interested parties.
This article will briefly discuss several of the more common reasons for valuing a professional accounting practiceas well as several of the most common approaches for the valuation of accounting practices. One approach, the asset accumulation approach, will be discussed in detail. This approach is generally considered the most rigorous, objective and substantiated practice valuation methodology. The various uses and benefits of this approach will be presented and a comprehensive illustrative example will be provided. Finally, several caveats regarding professional practice valuations will be discussed.
Reasons for an Accounting Practice Valuation
There are numerous reasons why an accounting practice may be subject to valuation. However, all of these reasons can typically be grouped into five categories: transaction, taxation, financing, litigation and management information. These reasons -- or motivations -- for an accounting practice valuation will be discussed briefly below.
The transaction pricing and structuring motivations include the purchase or sale of the entire practice, the purchase or sale of a partnership interest in the practice, the relative allocation of equity in a two-practice merger, the relative allocation of equity in the formation of the practice (between individual practitioners), and the equity or asset allocation during a practice dissolution.
Taxation motivations include estate tax planning, estate tax compliance, purchase price allocation and practice asset basis adjustment.
Financing collateralization and securitization motivations include practice acquisition financing (both asset based and cash flow based financing) and practice operations financing. Litigation support and dispute resolution motivations include marital dissolution of the partners, taxation disputes, partner squeeze-outs and claims of fraud or misrepresentation subsequent to a practice purchase or sale.
Management information and planning motivations include long-term estate planning, the formation and operation of partner buy/sell agreements, partnership formation and dissolution agreements, evaluation of practice purchase or merger offers, evaluation of the stewardship and effectiveness of practice management and the development and implementation of practice value enhancement techniques.
Accounting Practice Valuation Approaches
There are numerous formulas and techniques to determine the value of a professional accounting practice. However, all of these can typically be categorized into three general approaches: the market data comparison (or market multiple) approach, the discounted net cash flow (or earnings capacity) approach and the asset accumulation (or adjusted net worth) approach.
The market data comparison (or market multiple) approach is, frankly, the most commonly used methodology to value professional accounting practices. This approach, however, has several limitations. To be effective, this approach requires access to a substantial data base of confidential information regarding sales transactions of accounting practices. In order for the approach to be valid, the data base must be comprehensive and the data must be current. Even then, the appraiser must use considerable professional judgment in selecting the sample of comparable transactions -- and in adjusting the derived valuation multiples.
In using this approach, the appraiser first analyzes the subject accounting practice. The appraiser will analyze the practice by product line (e.g., a relative revenue and profit analysis by audit, accounting, taxation and management advisory service lines). Next, the appraiser will select comparability criteria. These criteria will be used in the sample selection and in the valuation multiple selection procedures. These comparability criteria may include: service mix, revenues per partner, profits per partner, industry or service line specializations, etc. Based on the comparability criteria, the appraiser will access the comprehensive data base and select a sample of "comparable" accounting firms that were actually sold recently. Based on an analysis of the sample, the appraiser selects valuation multiples. The most common multiple for an accounting practice is, of course, a multiple of gross revenues.
In addition to selecting the sample of comparable transactional data, the appraiser must exercise judgment in the adjustment of the valuation multiple. Adjustments of the valuation multiple may be made based upon the lack of exact comparability of the subject practice to the sample of comparable accounting firms.
Comparability, or lack thereof, is a function of the similarity of the historical returns of the practice and the nonsystematic risk features of the practice -- as compared to the same elements for the sample transactional firms. Accordingly, based upon the mix of client services, the growth of the practice, the profitability of the practice, etc., valuation multiples of 75% to 125% of annual gross revenues are not uncommon for accounting practices.
The discounted net cash flow (or earnings capacity) approach determines the value of the accounting practice as the present value of the prospective economic income that will be generated by the practice and distributed to the stakeholders of the firm.
For purposes of a practice valuation, economic income is defined as: net revenues less total operating expenses (excluding depreciation), less incremental investments in net working capital (receivables less payables), and less incremental investments for capital expenditures.
There are several features regarding an accounting practice that effect the traditional discounted net cash flow valuation approach. First, cash flow is projected to determine a return on the partners' ownership interest only. The cash flow model should recognize a hypothetical salary expense for the partners -- equal to what nonpartner staff members with equal experience and tenure would earn. Cash flow should be determined before any partner profit distributions. Second, the discounted net cash flow analysis should be performed on a before-tax basis, because most accounting firms are (nontaxpayer) partnerships. Of course, the present value discount rate should also be determined on a before-tax basis. Third, most accounting firms enjoy very little leverage in their capital structure. Therefore, the weighted-average cost of capital used to calculate the present value discount rate will approximate the cost of equity capital for the practice.
Using the discounted net cash flow approach, the value of the capital structure of the practice is the present value of the prospective economic generation over a finite period (typically between five and 10 years) plus the present value of the residual value of the practice at the conclusion of the finite forecast. The residual value is typically determined by capitalizing the discrete economic income projection in the terminal year by the present value discount rate. The value of the equity of the practice is the value of the capital structure less the current value of any long-term debt outstanding.
As with the market data transactional approach, the discounted net cash flow approach requires considerable professional judgment on the part of the appraiser. Certainly, professional judgement is required to prepare the projections of revenues, expenses, etc., used in the cash flow model. Professional judgment is required to determine the appropriate employee-equivalent compensation to be substituted for the partner's draw (i.e., base compensation) in the model. And, professional judgment is required to quantify the appropriate residual value of the practice at the end of the discrete forecast period.
Nonetheless, the discounted net cash flow approach is widely used and has many advantages. This approach does require a rigorous economic analysis of practice operations in order to prepare the required financial forecasts. Clearly, such an analysis should be performed in any event before the purchase or sale of an accounting practice.
The asset accumulation -- or adjusted net worth -- approach determines the value of an accounting practice as the fair market value of all of the firm's assets less the current value of all the firm's liabilities. Obviously, this appraisal approach closely follows the basic accounting premise that the firm's assets must equal the firm's equities. However, in using this approach, we create a valuation-based fair market value balance sheet -- as opposed to a GAAP-based historical cost balance sheet. Nonetheless, the basic accounting equation -- that total assets less total liabilities equals owner's equity -- still applies in our valuation-based balance sheet.
The total assets of an accounting practice typically can be grouped into three categories: 1) financial assets, 2) tangible personal property and real estate interests, and 3) intangible assets. The financial assets include cash, client receivables, prepaid expenses, etc. The tangible personal property and real estate interests include office furniture and fixtures, data processing equipment, leasehold improvements and leasehold interests. Intangible assets typically include client workpaper files (sometimes called the accounting plant), client relationships, a trained and assembled workforce, going-concern value and goodwill.
Accounting firm liabilities typically can be grouped into two categories: 1) current and 2) noncurrent. Current liabilities include accounts payable, salaries payable, accrued expenses, etc. Noncurrent liabilities include notes payable.
Using the asset accumulation approach, the value of an accounting practice is the fair market value of its assets less the current value of its liabilities.
Before Selecting a Valuation Approach
Before selecting the actual quantitative and qualitative approach to appraise an accounting practice, the appraiser must carefully define the accounting problem. This definition must encompass the following items:
1) purpose and objective of the appraisal, 2) definition of value, 3) premise of value, 4) business interest to be appraised, and 5) quantity and quality of available data. The objective of the appraisal answers the what and when questions -- e.g., the objective of the appraisal is to determine the fair market value of a 50% partnership interest as of December 31, 1989. The purpose of the appraisal answers the why question -- e.g., the purpose of the appraisal is to provide an independent valuation opinion for marital dissolution litigation support.
Various value definitions may be applied in the appraisal of an accounting practice. The most common definition is fair market value. However, depending upon the purpose of the appraisal, alternative definitions such as insurable value, acquisition value, investment value, liquidation value, etc., may be appropriate.
In an accounting practice appraisal, the premise of value in continued use (as a going-concern business) is the most common. However, depending upon the purpose of the appraisal, alternative premises of value in exchange -- such as orderly liquidation or forced liquidation value -- may be appropriate.
Obviously, the definition of the business interest subject to appraisal is an important part of the appraisal process. Of course, different valuation conclusions will result for the following business interests: the firm's entire asset structure, the firm's entire equity structure, a 50% controlling partnership interest or a 5% noncontrolling partnership interest.
After considering all of the above items, the appraiser must also consider the quantity and quality of available data regarding the firm. These data may be both financial and operational in nature as well as historical and prospective. Based upon a synthesis of all of these factors, the appraiser must ultimately rely upon experience and professional judgement to select the appropriate valuation approach.
The Benefits of the Asset Accumulation Approach
There are many benefits to the use of the asset accumulation (or adjusted net worth) approach, particularly in regard to the appraisal of an accounting practice.
First, the conclusion of the asset accumulation approach is presented in a typical balance sheet format. The format is a comparative presentation of the firm's historical cost-based balance sheet and the firm's valuation-based balance sheet. This format should be very familiar and comfortable to accountants. Second, because of the format, the approach can be used to present the conclusions of alternative definitions of value and premises of value. For example, the same format can present the historical cost-based balance sheet -- compared to a fair market value-based balance sheet -- compared to a liquidation value-based balance sheet.
Third, this approach explains the individual components of the value of an accounting practice. Valuation approaches that rely upon capitalized cash flow or a multiple of revenues may yield an appropriate valuation conclusion. However, these approaches yield only the conclusions. They do not explain why or how the firm has achieved a certain value. On the other hand, the asset accumulation approach concludes an overall value by building up the component values of each individual tangible and intangible asset. The componentization of the firm's value may be important to lenders, to partners buying in and to partners selling out.
Fourth, the asset accumulation approach has many dispute resolution and litigation support benefits. In a partnership dispute or marital dissolution, for example, the value of an individual partner's interest may be determined by appraising the individual intangible assets associated with that partner's contribution to the practice. For example, it is certainly possible to quantify the value of client workpapers, client relationships, a trained workforce, going concern and goodwill associated with most partners' individual practices.
Fifth, in the case of a practice merger or acquisition, the asset accumulation approach concludes a ready-made purchase price allocation. Such a purchase price allocation may have important asset basis considerations for federal income tax purposes.
Description of the Asset Accumulation Approach
The appraisal of an accounting practice's financial assets is usually very straightforward. The fair market value of these assets is typically the same as the net realizable value. Since most value definitions assume a purchase transaction (e.g., what a willing buyer would pay to a willing seller), special consideration should be paid to the current collectibility of client receivables. In addition, special consideration should be paid to the net realizable value of certain prepaids -- particularly if a practice liquidation premise is appropriate.
The three traditional approaches to asset appraisal should all be considered with regard to the valuation of accounting practice tangible personal property and real estate interests. The three traditional asset appraisal approaches are the cost approach, the market approach and the income approach. As with the overall practice valuation methodology, the selection of the appropriate asset appraisal approach is a function both of the purpose and objective of the appraisal and of the quantity and quality of available data.
Assuming the premise of value in continued use, the depreciated replacement cost approach is typically used to appraise office furniture and fixtures. Since there is an active secondary market, the market approach is often used to appraise data processing equipment. The depreciated replacement cost approach is typically used to appraise tangible leasehold improvements. And, the income approach (i.e., the capitalization of a hypothetical income stream from a rental rate advantage) is often used to appraise the intangible leasehold interests.
The identification, valuation and remaining useful life analysis of intangible assets is clearly the most important--and most complex--procedure within the asset accumulation approach to appraising accounting practices. Obviously, the identification of intangible assets is the first step in this process.
Unlike tangible assets which are typically purchased from a supplier, intangible assets is typically created by the owners of the accounting practice. And, of course, the creation or existence of these intangible assets are typically not recorded on historical cost-basis financial statements. The appraiser must first rigorously analyze the accounting practice operations in order to identify which intangible assets exist and which intangible assets have economic value. Accounting practices typically own the following types of intangible assets: leasehold interests, a trained and assembled workforce, client workpaper files, client relationships and goodwill.
As with all assets (tangible and intangible), appraisers may use either the cost approach, market approach or income approach to value accounting practice intangible assets. The cost approach is typically used to appraise intangible assets that are used in the production of other (typically income producing) intangible assets. The market approach is used to appraise intangible assets for which directly comparable assets are freely traded in a secondary market. The market approach is not often used to appraise accounting practice intangible assets, because such assets are unique to each individual practice and freely traded comparable assets typically do not exist. The income approach is used to appraise intangible assets that are associated with an identifiable income stream. This identifiable income stream may either be in the form of revenue increments (e.g., from client relationships) or cost decrements (e.g., from favorable lease or other supplier contracts).
The cost approach and the market approach intangible assets are usually appraised before the income approach intangible assets. This is because the income approach intangible assets must provide for a fair return on all of the assets (including the intangible assets) that are used in the production of the accounting practices income. Accordingly, the values of the cost approach and market approach intangible assets (and the value of all of the firm's tangible assets) must be known before the values of the income approach intangible assets can be finalized.
As mentioned above, the income approach is often used to appraise the value of an accounting practice's favorable leasehold interests. The cost approach is often used to appraise the value of the firm's trained and assembled workforce. The cost approach is often used to appraise an accounting practice's permanent client files and records. The income approach is typically used to determine the value of the firm's established client relationships. And the income approach (through the capitalized excess earnings methodology) is frequently used to appraise the value of the accounting practice's goodwill.
Comprehensive Illustrative Example
To illustrate the asset accumulation approach to accounting practice valuation, consider the hypothetical firm of Precise and Accurate, Accountants. Although hypothetical, the firm is representative of many small, two-partner accounting firms. The objective of this hypothetical appraisal is to determine the fair market value of 100% of the partners' equity capital as of December 31, 1989. The appraisal will proceed under the premise of value in continued use as a going-concern business enterprise.
Table I presents a summary of the asset accumulation approach valuation of Precise and Accurate. Table I also presents the historical cost basis balance sheet and the fair market value basis balance sheet of the firm, as of December 31, 1989. The value of the practice equity is based upon this fair market value basis balance sheet.
In Table I, the financial assets were appraised to net realizable value. This appraisal resulted in a slight devaluation in the client receivables and the client work in process. Also in Table I, each item of the firm's tangible real and personal property was appraised to fair market value in continued use. The appraisal of these assets was the result of a depreciated replacement cost analysis.
The next section of the hypothetical example illustrates the identification, valuation and remaining useful life analysis of the accounting practice intangible assets.
Table II presents the valuation of the practice leasehold interest. This asset represents the favorable economic element of the firm's leased office space.
Table III presents the valuation of the practice trained and assembled workforce. This asset represents the cost to recruit, hire, and train a replacement workforce of comparable experience and expertise of the firm's workforce.
Table IV presents the valuation of the practice client workpaper files. This asset represents the cost to recreate the workpaper files related to recurring audit, accounting and taxation clients. Since clients normally return to the accounting firm that maintains their historical and permanent accounting and tax files, these files represent an important intangible asset for the firm.
Table V presents the valuation of the practice client relationships. The first step in this valuation is the determination of the average remaining life of the client relationships in place as of the valuation date. There are various methods commonly used to determine the average remaining life of client relationships, including the turnover rate method, the original group method, the select and ultimate method and the retirement rate method. For Precise and Accurate's client relationships, the average remaining life is five years.
The second step in this valuation is a projection of the net fee revenues from the current client relationships. This projection requires consideration of expected changes in the levels of service provided, of the practice billing rates and of the practice allowance (or charge-off) rate.
The third step in this valuation is a projection of the contribution margin (or profit margin) associated with the current clients. This contribution margin is calculated after an allowance for basic partner compensation, but before consideration of any partner profit distributions. In other words, in order to calculate the contribution margin, partners are treated as highly compensated employees and not as owners of the firm.
The fourth step is to convert the projection of net earnings into a projection of economic income. This is accomplished by subtracting any increments in net financial assets due to the projected increase in net client fees. Net financial assets are typically defined as accounts receivable plus work in process less accounts payable. Also, the net earnings from the client relationships should be reduced by a fair return on the assets employed in the service of those clients. The fair return is often calculated as the practice-specific discount rate times the fair market value of the assets employed on the valuation date. The discount rate typically represents the firm's weighted average cost of capital. And the assets employed include both the tangible (e.g., office furniture and fixtures) and intangible (e.g., client workpaper files) of the practice.
The final step of this valuation is the determination of the present value of the economic income, over the average remaining life of the client relationships. Of course, this procedure requires the quantification of the appropriate present value discount rate. Typically, this discount rate is the weighted average cost of capital for the firm. The present value of the projected economic income represents the value of the recurring client relationships to the firm.
Table VI presents the statement of results of operations of the firm for the year ended December 31, 1989. This statement of operating results is used in the determination of the value of the goodwill of the accounting practice. It should be noted that partners are treated as employees in the preparation of this statement. In other words, the partners' basic compensation is treated as an operating expense, and the statement presents the amount of firm profits available for periodic distribution to the firm partners.
Table VII presents the determination of the value of the practice goodwill. For practice valuation purposes, goodwill is often calculated by a capitalized excess earnings approach.
The first step in the goodwill valuation is the determination of the fair market value of all of the identified assets of the practice. These assets include: financial assets, tangible real and personal property assets and specifically identified intangible assets. The sum of these values is the total fair market value of all identified assets. The second step is the determination of the current value of all identified liabilities of the practice. The third step is the determination of the fair market value of net assets of the practice (i.e., total identified tangible and intangible assets less liabilities). The next step is the determination of a fair return on the practice net assets. There are several methods for quantifying a fair return on net assets. One common method is to use the firm-specific present value discount rate. Since this discount rate is based upon a weighted average return on capital, it should provide for a weighted average fair return on net assets. This is the method illustrated in Table VII. It is important to note that the fair return is typically calculated based upon the appraised value of all of the practice assets, both tangible and intangible.
The fifth step is a comparison of the actual net income of the practice to the calculated fair return on net assets. If the actual return exceeds the fair return, then excess earnings exist. The capitalization of this fair return represents the value of the practice goodwill. If the actual return is less than the "fair" return, then economic obsolescence occurs. In that case, the value of the identified tangible and intangible assets may have to be reduced to equal the amount of economic support for those assets.
If excess earnings exist, the final step is to capitalize those earnings as an annuity in perpetuity. Again, the firm-specific discount rate is often used as the annuity capitalization factor. These capitalized excess earnings represent the fair market value of the firm's goodwill.
Using the asset accumulation approach, the value of the practice equity is the fair market value of the firm assets less the current value of the firm liabilities. Table I presents the fair market value of the firm assets (i.e., $1,410,000) and the current value of the firm liabilities (i.e., $200,000). Accordingly, the fair market value of the partners' equity in the firm is (rounded) $1,200,000.
Caveats Regarding Practice Valuations
Due to space constraints, our illustrative example did not consider all of the discounts and premia associated with professional practice valuation issues. For example, appropriate discounts should be applied for a minority interest (e.g., individual partner's interest), key partner dependence, key client dependence, etc. In addition, appropriate premia should be applied for majority control of a practice, for significant practice diversification, etc. While the asset accumulation approach can be modified to accommodate many of the issues, the consideration of minority discounts, control premia, etc., are beyond the scope of this analysis.
There are various reasons to perform a valuation of an accounting practice, including transaction, financing, taxation, litigation and management information motivations. Several approaches are commonly used in the valuation of accounting practices, including market data comparison, discounted net cash flow and asset accumulation. Of these approaches, the asset accumulation approach is the structured, most rigorous and substantiated methodology. A comprehensive illustrative example of this methodology has been provided. The asset accumulation approach not only concludes an overall practice valuation, it componentizes the elements of that valuation into the individual tangible and intangible assets of the accounting practice. [Tabular Data 1 to 7 Omitted]
Robert F. Reilly is a national partner in the Deloitte & Touche Valuation Group. He specializes in the valuation of closely held corporations and professional practices. He is an accredited senior appraiser, a certified real estate appraiser and a certified public accountant. Robert P. Schweihs is managing director of Valuation Economics Associates, a firm specializing in the valuation of business entities and business interests. He is an accredited senior appraiser and a certified real estate appraiser.
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|Author:||Reilly, Robert F.; Schweihs, Robert P.|
|Publication:||The National Public Accountant|
|Date:||Feb 1, 1991|
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