Deferred Compensation and the Valuation of Professional Practices

By Kyle Garcia

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For 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.

Background

A common 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 as follows:

Generally 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 books.

The 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.

Applying the Adjusted Book Value Method

Most 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.

The 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.)

The 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.

The 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 is made.
• 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.

These 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 are rendered.

As 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.

Risk 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 3. The 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.

The 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.