Compensation and the Valuation of Professional Practices
2005 - Business appraisers adjust cash-basis financial statements
to an accrual basis in order to evaluate economic income and
economic assets. In evaluating an asset-based approach, they
also adjust balance sheets to fair market value. Adjustments
typically include the addition of accounts receivable and
accounts payable. Professional practices often exhibit a large
difference between accounts receivable and accounts payable,
which generally leads to a fair market value balance sheet
with a relatively high equity value. Asset value generally
serves as a floor to the business’ value, with income
and market approaches generally reflecting a larger market
value. Sometimes, however, the net asset approach produces
the highest value, after adjusting for accrual accounts.
professional practices, unrecorded deferred compensation
is often a missing component of value. Nonowner salaried
employees perform their services in the creation of the
practice’s accounts receivable. Unlike employees,
however, professional practice owners generally take compensation
from their firms only after receivables are collected. This
obligation for the services owners performed to create their
practice’s accounts receivable is typically not recorded.
This future expense reflects a genuine claim against accounts
receivable and serves to decrease net asset value.
valuation technique in valuing professional practices, the
adjusted book value method–net asset value method,
calculates the value of a professional practice by subtracting
the economic value of the business’ liabilities from
the total value of its assets, resulting in the value of
its equity, or partners’ capital. Valuations of partnerships
prepared for divorces in New Jersey often reference Stern
v. Stern (66 N.J. 340; A.2d 257), which describes this methodology
speaking the monetary worth of this type of professional
partnership is worth the total value of the partners’
capital accounts, accounts receivable, the value of work
in progress, any appreciation in the true worth of tangible
personalty over and above book value, together with goodwill,
should there in fact be any; the total so arrived at to
be diminished by the amount of accounts payable as well
as any other liabilities not reflected on the partnership
value of a professional practice may also be the subject
of a partnership or shareholder agreement, which often uses
adjusted book value, or a book value–based formula,
to determine the value for the transfer of interests. This
becomes an issue in owner disputes as well as in gift and
estate tax matters. Whether this valuation methodology should
be considered is usually not in question, but its proper
application is regularly contested.
the Adjusted Book Value Method
professional practices maintain accounting records on a
cash basis, reporting revenues when received from patients
or clients and expenses when paid. Exhibit
1 presents a typical cash-basis balance sheet.
cash-basis balance sheet reflects the tangible assets and
cash-basis equity of the business entity. In adjusting a
balance sheet to reflect the current value of assets, appraisers
typically make accrual adjustments, such as accounts receivable
and payable, to the cash-basis balance sheet. In this example,
the cash-basis balance sheet is adjusted assuming that the
business entity had $100,000 in accounts receivable and
$10,000 in accounts payable, as shown in Exhibit
2. (Although it is often debated in court proceedings,
for the purposes of this example, income taxes are not considered.)
adjustments made above to the cash-basis balance sheet increased
equity by $90,000. This reflects a 130% increase in the
book value of the business. Although somewhat simplified,
this analysis reflects the standard analysis of a typical
expert. The problem with this analysis is that the adjusted
book value leads to an artificially high equity value in
comparison to income- and market-approach calculations.
author analyzed the financial characteristics of professional
practices that report financial statements on a cash basis
in an attempt to understand this seeming discrepancy. The
following were considered:
A professional performs a service, and clients or patients
are billed for services rendered.
The practice pays for overhead expenses that relate directly
to providing that service, usually before the collection
The client pays the bill, and the practice records gross
income (on a cash basis).
The practice pays the professional for services rendered,
in the form of salary.
characteristics were considered from the perspective of
the accrual-basis balance sheet. From an accrual perspective,
the creation of accounts receivable requires that revenues
be recorded even though no cash has been collected. The
practice incurs overhead associated with the services provided,
and the balance sheet reflects this as accounts payable.
Both economics and accounting principles require that the
professional services rendered in the creation of those
services billed be recorded at the time that the services
of the valuation date, the practice had not paid compensation
to the professional owner. From an economics perspective,
there was a real expense payable, and it was determined
that adding a deferred compensation liability to the accrual-basis
balance sheet must be considered. In any market- or income-approach
calculation, the appraiser routinely takes reasonable replacement
compensation into account. In a typical asset-approach calculation,
however, the appraiser does not. This omission is inconsistent,
and a “reasonable replacement compensation”
liability must be created in calculating a value based on
an asset approach.
Management Associates’ Annual Statement Studies
2002–2003 reported that average officers’
compensation for small professional practices was approximately
30% of revenues. Assuming that the compensation liability
was calculated similarly to the percentage of accounts receivable,
the example was adjusted as shown in Exhibit
estimate of stockholders’ equity decreased dollar
for dollar with the deferred compensation adjustment, and
the equity value of the practice decreased by approximately
20%—a very significant amount.
idea of adjusting the balance sheet for deferred compensation
is not new and reflects the reality of how professional
practices operate. Professionals are both the salesmen and
the production workers for their practices, but their compensation
is often deferred until cash flow permits them to take it.
Appraisers must understand the reality of professional practices
and apply that reality in their valuations. Adding accounts
receivable and not accounting for the expected salary overestimates
the value of a business.
Garcia, CBA, ASA, is a senior associate in the Business
Valuation Group at RosenfarbWinters, LLC, in Roseland, N.J.