How to Value a Professional Practice and What Discovery will be Necessary
A Global Reach with a Local PerspectiveHow to Value a Professional Practice www.decosimo.comand What Discovery will be NecessaryMIKE COSTELLO, CPA, ABV, ASA, CFE, CFFPRINCIPAL
D. Michael CostelloCPA, ABV, ASA, CFE, CFFPrincipal | email@example.comMike Costellos experience includes extensive consulting workand testimony in tax, accounting, financial, economic, andbusiness issues of commercial litigation, with emphasis onbusiness valuation, economic damage and forensic accountingissues in the healthcare industry. Mike has been retained inhealthcare litigation involving a physician practice breakup, abreach of contract case involving a hospital chain, a wrongfultermination suit involving a hospital, an economic damagescase involving a lease of an image-guided radiotherapy systemand a breach of contract case involving a home health agency.His business valuations have been used and upheld in variouscourts, including the Tennessee Court of Appeals, and inconnection with buy-and-sell transactions.
VALUING THE PROFESSIONAL PRACTICE1. Adjusting the Professional Practice Balance Sheet2. Professional vs. Practice Goodwill3. Determining the Value of the Practice (case study)4. Initial Information Request5. Initial Information Request List (expanded)
VALUING THE PROFESSIONAL PRACTICETHE PRACTICE BALANCE SHEET ASSETS In the following slides, there is a discussion of the most common types of assets that the appraiser can find in professional practices. The list is not all-inclusive and the appraiser should use his/her judgment as to which assets are applicable to the business being appraised.
VALUING THE PROFESSIONAL PRACTICECASH Are the financials audited or were they compiled by an office manager or bookkeeping service? If they are thought to be wrong, bank statements should be requested to obtain an accurate balance. Cash is generally considered an operating asset, but if a reduction in cash wouldn’t affect the operation of the practice then the practice has excess cash and the balance sheet should be adjusted.
VALUING THE PROFESSIONAL PRACTICEACCOUNTS RECEIVABLE If a company uses the cash basis of accounting it is necessary to determine the value of accounts receivable in order to include them in the value of the practice. Day sheets, accounts receivable journals, or a card system (cards that are kept in the client’s file showing a debt or credit balance) may be totaled to determine total receivables. Included in receivables are those which have been turned over to a collection agency. The value of these receivables should be included in the overall accounts receivable amount. Once the gross value of AR has been established, the appraiser must adjust for uncollectible and slow-pay accounts. These amounts can be obtained from an accounts receivable aging schedule and the actual payment history.
VALUING THE PROFESSIONAL PRACTICEWORK-IN-PROGRESS INVENTORY This asset might also be called unbilled accounts receivable and is an asset typically found in practices that charge hourly for professional or staff time, such as CPA firms, consulting practices, and law firms. It is important to remember that practices using cash basis accounting probably have already recorded all expenses associated with the work-in-process inventory. For practices on the accrual basis, work-in-process should be listed as an asset on the practice’s financial statements and, except for minor adjustments, the appraiser can use the figures shown on the financials for the value of the work-in-process.
VALUING THE PROFESSIONAL PRACTICEINVENTORY OF SUPPLIES Inventory will vary greatly depending on the type of business. Though the appraiser can usually accurately estimate the value of inventory for those practices that do not have substantial value in inventory, the appraiser should still tour the facility and at least check the level of supplies kept.
VALUING THE PROFESSIONAL PRACTICEPREPAID EXPENSES Two typical expenses are prepaid rent and insurance. Since an appraiser is concerned with a specific valuation date, prepaid expenses must be reclassified into their appropriate categories on the balance sheet to recognize the fact that future expenses have already been paid.
VALUING THE PROFESSIONAL PRACTICEEQUIPMENT As with inventory, the amount of equipment required by a practice depends on what type of practice it is. The appraiser must determine if the equipment should be appraised by a professional equipment appraiser. The value obtained by the equipment appraiser must use the same standard of value used in the valuation of the practice (i.e. market value, liquidation value) An appraiser must inquire about any equipment that might not be listed on the depreciation schedule.
VALUING THE PROFESSIONAL PRACTICELIABILITIES There may be several categories of liabilities not reflected on the books of the average professional practice. On the other hand, from a valuation standpoint some may appear there that are not real debt (such as deferred rent).
VALUING THE PROFESSIONAL PRACTICE ACCOUNTS PAYABLE Cash basis financials typically do not show accounts payable. There are two basic methods for estimating accounts payable: The appraiser reviews all unpaid invoices at the valuation date. If field work is done substantially after the appraisal date, the appraiser should request all canceled checks written during a reasonable period of time after the valuation date, along with the corresponding invoices. The appraiser begins with the total expenses shown on the practice’s income statement. From this amount he subtracts expenses that do not belong with accounts payable. The appraiser considers the practice’s regular bill-paying procedures to calculate the estimated accounts payable at the valuation date.
VALUING THE PROFESSIONAL PRACTICEACCRUED LIABILITIES Accrued liabilities are expenses, such as payroll, payroll taxes, or interest that are allocated to a prior period but not yet due. One liability often overlooked is accrued employee vacation time. If there is a significant amount of vacation time pending, this liability should be reflected on the balance sheet or disclosed on the appraisal report.
VALUING THE PROFESSIONAL PRACTICEDEFERRED LIABILITIES Deferred liabilities are broken into three categories: Deferred Revenues Deferred Expenses Deferred Taxes Deferred revenues are amounts that have been received from services not yet performed. Deferred revenues may need to be considered in law firms and consulting firms that receive retainers before beginning work on the case. Deferred expenses are relatively unusual. An example of this might be deferred rent. The purpose of deferred income tax appearing on financial statements is to match income tax expense with the related financial accounting income for the appropriate accounting period. Deferred income taxes usually occur because of the difference in timing between recognition of income or expense for two different accounting systems of the same practice.
VALUING THE PROFESSIONAL PRACTICELONG-TERM DEBT Long term debt is usually associated with equipment purchases. The appraiser should also check to see if the debt is related to amounts due to the former owner of the practice who sold it to the current owner. If the amount is thought to be incorrect, copies of the debt instruments and payment records should be obtained.
VALUING THE PROFESSIONAL PRACTICELEASE OBLIGATIONS The appraiser should always obtain copies of all leases of the practice whether the practice is a lessor or a lessee. Future lease payments may be treated as long-term debt, after separating imputed interest payable.
VALUING THE PROFESSIONAL PRACTICECONTINGENT LIABILITIES Contingent obligations are liabilities for which there is insufficient information about the outcome to know how to account for them on the financial statements.
VALUING THE PROFESSIONAL PRACTICE The three approaches to business valuation - Asset Approach Market Approach Income Approach
VALUING THE PROFESSIONAL PRACTICE Professional vs. Practice Goodwill – “…the expectation of continued public patronage…” Personal Goodwill is the goodwill associated with the individual Practice Goodwill is the goodwill associated with the enterprise
VALUING THE PROFESSIONAL PRACTICE Blasingame v. American Materials – Important primarily because lots of other cases refer to it Basically says that an appraiser should consider all three approaches to value and choose a result from among them (Delaware Block)
VALUING THE PROFESSIONAL PRACTICE Bertuca v. Bertuca – H owned 90% of a partnership that operated 7 McDonald’s franchises Ignores a BSA because it “does not affect the value of his interest in the partnership determined on an earnings basis”
VALUING THE PROFESSIONAL PRACTICE Inzer v. Inzer – Great discussion of the valuation issues Both H and W had signed BSAs related to his interest in a Sonic franchise Appeals Court found that BSA value controlled since both parties had signed it
VALUING THE PROFESSIONAL PRACTICE York v. York – Multi-specialty medical practice 11 physicians 10 nurses 1 psychologist 1 optometrist Owned a building and leased space to others Appeals Court did not remand due to inclusion of goodwill
VALUING THE PROFESSIONAL PRACTICE Cunningham v. Cunningham – Appealed twice; first appeal is the one with the valuation issue Professional goodwill should not be included in the value
VALUING THE PROFESSIONAL PRACTICE Hazard v. Hazard – Medical practice value = $43K or $629K? TC said $200K Court of Appeals said $43K “…professional good will is not a marital asset…”
VALUING THE PROFESSIONAL PRACTICE Smith v. Smith – Good discussion of whether a law practice is marital property Concludes that “professional good will is not a marital asset…”
VALUING THE PROFESSIONAL PRACTICE Alsup v. Alsup – Ties the goodwill of a daycare to the presence of its operator Therefore goodwill not a marital asset subject to distribution
VALUING THE PROFESSIONAL PRACTICE Harmon v. Harmon – Parties stipulated to net asset value of H’s interest in a clinic and a building H had a BSA that set a lower value on exit Trial Court found that W entitled to ½ of what H would receive if he left Remanded for consideration of “all relevant evidence” regarding value Great description of previous cases
VALUING THE PROFESSIONAL PRACTICE Wright v. Quillen – Mentions RR 59-60 Valuation evidence admitted despite the fact that practitioner Used a method he created himself Was not familiar with RR 59-60 Was not familiar with Delaware Block
VALUING THE PROFESSIONAL PRACTICEINITIAL INFORMATION REQUEST (AS OF THE VALUATION DATE)1. Financial information a) Annual financial statements for the last five years, b) Interim financial statements for the most recent year to date and for the same interim period for the prior year, c) Tax returns for the last five years, d) Detailed depreciation schedules, e) Any financial budgets and/or projections, f) List of affiliated companies, partnerships, or proprietorships and their financial statements for the last five years,
VALUING THE PROFESSIONAL PRACTICE g) Plans for capital expenditures for the next fiscal year and beyond, and h) Accounts payable and accounts receivable aging schedules as of (valuation date).2. Product and market information a) Samples of trade publications regularly received by the company, b) Names of trade associations of which the company is a member, and c) Newspaper or magazine articles regarding company products, services, or key employees.
VALUING THE PROFESSIONAL PRACTICE3) Operating information a) Level of operating leverage employed including loan details and amortization schedules, and b) Cost control measures in place or planned.4) Personnel information a) List of current officers and directors, including background, experience, age, and compensation including all company paid benefits (including company paid auto, country club, life, disability, or other insurance, travel and entertainment expense, or any other item for which the owners receive benefits of a personal nature),
VALUING THE PROFESSIONAL PRACTICE b) List of other key management personnel, including job title, background, experience, responsibilities, compensation and age of each, c) Schedule of life insurance polices owned by the company, d) Organization chart, e) Summary of pension and profit sharing plans, and f) Employee handbook.
VALUING THE PROFESSIONAL PRACTICE5) Other information (if applicable) a) Articles of Incorporation, b) Minutes of shareholders and board of directors meetings for the last five years, c) Major contracts and other agreements, including loan agreements, buy-sell agreements, employment agreements, franchise agreements, leases, etc., d) Current ownership list and list of any transactions in owner’s interests since inception,
VALUING THE PROFESSIONAL PRACTICE e) Description of physical facilities, f) Previous appraisal of real estate, personal property or the business, and g) Previous offers to purchase company assets or corporate interests.
VALUING THE PROFESSIONAL PRACTICE INITIAL DOCUMENT REQUEST LIST (EXPANDED)1) Business Interests – for (business name) for fiscal years ended (as of valuation date) a) Corporate Tax Returns b) Partnership tax Returns c) All Schedules and Attachments to Tax Returns d) All Financial Statements – Interims and Year-Ends e) All books, Journals, Ledgers and Accountants’ Work Papers f) All payroll Tax Returns, Payroll Records and W-2s. g) All bank Statements, Check Stubs, Cancelled Checks, Deposit Records and Paid Bills. h) Copies of insurance policies – Casualty, Liability, Life, Group, Workmen’s Compensation, Disability, Medical and Cash Values.
VALUING THE PROFESSIONAL PRACTICE BUSINESS INTERESTS CONTINUED i) All Shareholders, Partners, Buy-Sell and Employment Agreements. j) All Other Legal Agreements including Leases, Purchases of Fixed Assets, Purchase of Business of Investment Interests k) All Depreciation Schedules l) Detailed Schedules of all Receivables and Payables. m) Notes, Mortgages and any other Evidences of Indebtedness or Receivables. n) Copies of all Prospectuses and Documentation for tax Shelter Investments. o) Schedules of all Accounts Receivables, Accounts Payable and Inventories as of the valuation date. p) All Contingent Assets and Liabilities
VALUING THE PROFESSIONAL PRACTICE2) Retirement Plans for fiscal years ended (as of valuation date) a) Copies of all Retirement Plans and Trust Agreements b) Annual Statements and Reports for any Pension Plan, Profit-Sharing Plan, Keogh Plan or IRA Plan reflecting Contributions, Earnings, Investments, and Fund Balances
VALUING THE PROFESSIONAL PRACTICE3) Professional Practice for years ended (as of valuation date) a) Patient Records, Appointment Books and Daily Sheets b) Current and Prior Procedural Fee Schedules. c) Hospital and Other Procedural Records. d) Schedules of all Accounts Receivable and Accounts Payable as of (valuation date)
VALUING THE PROFESSIONAL PRACTICEe) Copies of all Agreements or Contracts for Professional Services, Professional Affiliations or Fee Reimbursement.4) Personal Interest for (company name) for years ended (as of the valuation date) a) All 1040s’ and State Income Tax Returns b) All Interim and Year-End Personal Financial Statements. c) Schedule of all Personal Assets and Liabilities.
VALUING THE PROFESSIONAL PRACTICE d) Schedules of all Insurance, Cash and Brokerage Accounts, Investments, Real Estate and Other Assets. e) Schedules Detailing all Notes, Mortgages and Loans and Cash Values of Life Insurance. f) Broker’s Statements for all Accounts. g) Check Stubs, Cancelled Checks, Bank Statements and Deposit Records.
VALUING THE PROFESSIONAL PRACTICE h) All Paid Bills and Receipts. i) Schedule of Ownership Interests in all Business and Investments. j) List of all Safe Deposit Boxes. k) Schedule of all Tax Free Investments and Tax Shelter Investments.
VALUING THE PROFESSIONAL PRACTICE l) All Purchases and Sales of Real Estate and Other Assets Exceeding $1000 during the period m) All Contingent Assets and Liabilities n) All lawsuits involving the Parties and all Guarantees by the Parties
CONTACT ME MIKE COSTELLO firstname.lastname@example.org 800-782-8382 DISCLAIMER: The contents and opinions contained in this presentation are for informational purposes only. The information is not intended to be a substitute for professional accounting counsel. Always seek the advice of your accountant or other financial planner with any questions you may have regarding your financial goals.