Accounting Practice Valuations for Bankruptcy-related Purposes
The public accounting profession has experienced several structural changes in the last few years. To differing degrees, these structural changes have impacted accounting firms ranging from sole practitioners to the "Big Five." The changes have influenced the value of accounting firms and of practitioners' ownership interests in accounting firms. This article presents an update on the significant issues affecting accounting firms. In addition, this article will discuss how these issues may be integrated into professional practice valuation approaches, methods and procedures.
Accounting Industry Trends
There are three current trends principally affecting accounting firm valuations. Each of these industry trends became obvious three or four years ago. However, these trends have become even more prominent in 2001. These three industry-wide trends are:
- consolidation of practices,
- separation of accounting and consulting services, and
- diversification of specialized professional services.
The Consolidation Trend
The consolidation trend is affecting firms of all sizes—from the largest national firms to the smallest local practices. According to an article in the March 19, 2001, issue of Accounting Today: "Consolidation reinforced its position as a key issue among the accounting industry's elite."1 This article reports that 26 of the largest 100 U.S. accounting firms participated in at least one merger-and-acquisition (M&A) transaction in 2000. Most often in these M&A transactions, one of the largest 100 firms acquired one or more smaller firms. However, there were also several instances where the top 100 firms themselves merged. And there were several instances where firms that were on the Accounting Today "top 100" list in prior years were dropped from the list in 2000 because that "top 100" firm was acquired by one of the national consolidators.
This continuing accounting firm consolidation contributed to the 17.6 percent revenue growth rate experienced by the non-Big Five "top 100" firms in the year 2000. Big Five firm revenue growth was still a respectable 12.6 percent in 2000. But because of their massive size, M&A transactions have a smaller impact on Big Five firm growth rates than they do on other large firm growth rates.
Many of the larger firms that have not acquired (or been acquired) have entered into some type of a collaboration or similar networking agreement. During the last year or so, The Leading Edge and Capital Professional Advisors have been the most active collaborative groups. Accounting firms that enter into collaboration agreements maintain their independent ownership. However, based on various royalty arrangements, they share common trademarks and trade names, business development materials, technical resources and client/engagement leads.
While these networking/affiliation arrangements have provided a valuable strategic alternative to many large accounting firms, they have not had anywhere near the impact on large firms as the direct consolidation transactions. For example, the Accounting Today article referenced above reported that consolidator Centerprise Advisors acquired five very large accounting firms in 2000, including three "top 100" firms. These acquisitions allowed Centerprise Advisors to achieve the number 16 ranking in the 100 largest U.S. accounting firms. In addition, these transactions imply market valuations for other large firms. And these transactions indicate that even the largest U.S. firms are potential candidates for M&A consolidation transactions.
Of course, Centerprise Advisors is not the only acquisitive national consolidator. Consolidators RSM McGladrey, E-Partners and American Express continue to pursue large and small firm acquisitions. Additionally, Jackson Hewitt (while not a consolidator per se) has publicly announced intentions to make one or more significant accounting firm acquisitions. The acquisitive activities of the national consolidators are expected to continue because the underlying reasons that accounting firms are interested in consolidations continue. These reasons are summarized in a recent Accounting Today article entitled "Consolidation and the Medium-size Firm." The article reports, "The underlying reasons for consolidation are still the same—a fragmented industry, no existing strong brand name, a rising requirement for capital, too many unfounded retirement plans and poorly thought-out succession plans, to name a few."2
The most recent influence on the industry-wide consolidation trend is called mini-consolidation. This influence is most apparent in small- to medium-size accounting firms. In a mini-consolidation, a local firm (as opposed to a national consolidator) acquires several other local firms, usually in the same city. These mini-consolidations eliminate local competitors, augment the competitive position of the acquisitive firm, expand the professional service offerings of the acquisitive firms, and provide liquidity and an exit device for retiring partners. These local accounting firm M&A transactions also allow the acquiror to remain independent from the national consolidators—at least temporarily. And to the extent that the mini-consolidator firm ultimately does sell to a national consolidator, it is a much more valuable target (resulting in greater proceeds to the mini-consolidator partners).
The influence of mini-consolidations is expected to increase in the near term. This is because many small-firm partners have realized that even the small-firm component of the industry is operating in an "acquire or be acquired" environment. From a valuation perspective, these mini-consolidation transactions (1) provide market-derived pricing evidence of firms' values, (2) increase the liquidity (and therefore, the value) of even the smallest accounting practices, and (3) put virtually all sizes of accounting firms "in play."
The Separation Trend
Perhaps the most noteworthy trend in the accounting profession is the ongoing separation of the Big Five firms into (1) traditional accounting services business units and (2) consulting practice business units. During the last year, Arthur Andersen and Andersen Consulting (now known as Accenture) finalized their organizational separation. Likewise, both KPMG and Ernst & Young finalized the spin-off of their consulting businesses.
While this separation trend directly affects only Big Five firms, it indirectly affects the values and marketability of other accounting firms. Clearly, the "separated" Big Five firms will attempt to recoup the revenue dollars and the revenue growth rate contributions of their divested consulting businesses. This attempt will be actualized by aggressive competition for traditional attestation and taxation services. In addition, traditional accounting and tax services revenues can increase through the acquisition of medium to large size accounting firms. Accordingly, the more traditional accounting firms may present themselves as M&A targets for Big Five firms.
The divestitures of Big Five consulting businesses—particularly those separations that contemplated either business sales or IPOs—resulted in market-derived pricing multiples for consulting practices. Accounting firm buyers and sellers will be aware of the actual or implied pricing multiples related to these separations. M&A participants may infer that the consulting business divestiture transactions would imply even greater pricing multiples for traditional accounting firms. This is because historically, accounting and tax practices have sold at higher pricing multiples than consulting practices; unlike consulting practices, accounting and tax practices typically have annuity-type client relationships.
Therefore, medium- to large-size accounting firm valuations may be positively impacted by two factors. The first factor is the perceived demand on the part of some Big Five firms to compensate for divested consulting business unit revenues. The second factor is the perceived implication that Big Five consulting business unit divestiture pricing multiples would set lower bounds on traditional accounting firm pricing multiples.
The Diversification Trend
Even though several Big Five firms divested their consulting practices in 2000, most accounting firms continue to diversify and specialize their service lines. This is true for firms of all sizes, from the smallest local firms to the largest national firms. The diversification component of this trend represents the offering of specialized accounting, tax or consulting services in addition to traditional attestation services. The specialization component of this trend could involve either (1) industry specialization (e.g., providing services exclusively to the construction industry) or (2) product-line specialization (e.g., providing exclusively insolvency-related services).
These two components of the diversification trend allow practitioners to compete more successfully in the selected niche market—particularly against consolidators or affiliated firms. In addition, these two components of the diversification trend allow practitioners to offer more value-added services (e.g., services at premium billing rates or at premium fixed/performance fees).
Many accounting firms have diversified to exploit perceived growth areas. In its Oct. 1, 2000, issue, Accounting Today reported: "Developing new specialized services is a theme throughout the Top 100."3 The same article went on to identify several of the growth services in which practitioners are specializing: "New growth areas that were cited include some arcane categories, such as data security, long-term health care facilities consulting, licensing and royalties, and arbitrage services."4
Even the Big Five firms are participating in the diversification trend, at least in terms of how they market their professional services. "More than any other entity, Big Five firms have assumed completely new roles, no longer referring to themselves as accounting firms, but as professional services firms" reports Accounting Today.5 However, the diversification trend has had the greatest impact on non-Big Five firms. Reports Accounting Today: "Non-Big Five CPA firms have revised the types of services they offer, too. Tax, audit and write-up services have given ground to personal financial planning, fraud auditing, human resources, various non-audit attest services, information systems and business advising services."6
Accounting firms that have successfully recognized and participated in these industry trends have become more valuable. In particular, the consolidation trend has made many accounting firms more marketable (and practitioners' equity in their firms more liquid) than ever before. The remaining discussion will focus on the application of the generally accepted practice valuation approaches within the current state of the public accounting industry and in particular will identify the practice valuation (1) methods and procedures and (2) analytical variables that are particularly sensitive to the impacts of these industry trends.
Accounting Practice Valuation Approaches
There are numerous methods and procedures to estimate the value of an accounting firm. All of these methods and procedures are typically grouped into three "approaches" to professional practice valuation, namely:
- the market approach
- the income approach
- the asset-based approach.
Each of these valuation approaches can be adapted to conclude (1) alternative standards (or definitions) of value and (2) alternative premises of value (based on the highest and best use of the practice assets). Also, each of these valuation approaches can be adapted to conclude alternative levels of value, such as (1) the value of 100 percent of the firm assets, (2) the value of 100 percent of the firm equity, (3) the value of an individual partner's unrestricted ownership interest, and (4) the value of an individual partner's ownership interest subject to contractual transferability restrictions.
Before applying the practice valuation approaches, the analyst should understand what is the appropriate (1) standard of value, (2) premise of value, (3) practice ownership interest and (4) level of value (related to elements of ownership control and marketability) for the bankruptcy-related valuation assignment.
The Market Approach
Within the market approach, the guideline merged and acquired practice method is commonly used. However, this valuation method has several practical limitations.
This method requires analyzing substantial information regarding actual sale or merger transactions of accounting practices. In addition, the analyst should exercise considerable professional judgment in (1) selecting the most appropriate guideline transactions and (2) adjusting the market-derived valuation pricing multiples to make them applicable to the subject practice. The selected pricing multiples are based on comparing the operating results/attributes of the guideline merged/acquired firms to the operating results/attributes of the subject firm.
In this method, the analyst first analyzes the subject firm by professional service line. This analysis will include performing a multi-period revenue and profit analysis for each significant service line. These service lines would include audit, accounting, taxation, management advisory services and other specialized services (such as estate planning or litigation support services).
Second, the analyst determines the most appropriate comparability criteria for selecting a sample of guideline firm sale/merger transactions from among the entire population of recent accounting firm transactions. These comparability criteria may include service mix, revenues per partner, profits per partner, partner/staff ratios, billing rate levels, partner/staff utilization levels and industry or service line specializations.
Third, the analyst performs as comprehensive an analysis as possible of the selected guideline M&A transactions (given that a great deal of information regarding the merged or acquired firms remains confidential). In this analysis, the analyst is considering the primary factors of (1) historical profitability, (2) expected growth, (3) risk and (4) expected partner return on investment for the guideline firms vis-à-vis the subject firm.
From the analysis of the market-derived transactional pricing data, the analyst extracts valuation pricing multiples that are applicable to the subject firm. The most common pricing multiple is a multiple of gross or net revenues. However, pricing multiples related to other measures of economic income (such as net operating income, net income and net cash flow) or to other measures of operating statistics (such as number of professional staff or total billed/billable hours) may also be relevant.
In addition to selecting which pricing multiples to consider, the analyst should exercise judgment when adjusting the market-derived pricing multiples for a lack of perfect comparability of the guideline firms to the subject firm. Comparability, or the lack thereof, is a function of the similarity of the guideline firm's (1) historical and (2) expected risk, and return characteristics compared to the subject firm's (1) historical and (2) expected risk and return characteristics.
The Income Approach
A common income approach valuation method is the discounted economic income, or discounted cash flow, method. The value of the subject firm is estimated as the present value of the prospective economic income (1) expected to be generated by the firm and (2) available for distribution to the firm equity-holders. This economic income may be defined many different ways. However, a common measure of economic income is cash flow defined as net revenue, less total operating expenses (excluding depreciation), less incremental investments for working capital and capital expenditures.
An accounting firm has special features that affect the discounted economic income method. First, economic income is projected to estimate a return on the equity-holders' ownership interest only. Therefore, the valuation should typically recognize a market-derived salary expense for the equity-holders, equal to what non-partner staff members with equal experience and expertise would earn. Also, cash flow is typically estimated before any partner profit distributions.
Second, because most accounting firms are partnerships (or similar pass-through entities) the analysis is often performed on a before-tax basis. In a before-tax valuation analysis, the present value discount rate should be estimated on a before-tax basis.
Third, most accounting firms operate with little leverage in their capital structures. Therefore, the weighted-average cost of capital used to calculate the present value discount rate will typically approximate the cost of equity capital for the subject firm.
Using this valuation method, the value of the firm's total net assets equals (1) the present value of the prospective economic income generated over a finite projection period (typically between 5 and 10 years) plus (2) the present value of a firm's "residual value" at the end of the discrete projection period. The "residual value" is typically estimated by capitalizing the discrete economic income projection in the terminal year by a direct capitalization rate. The direct capitalization rate is typically calculated as (1) the present value discount rate less (2) the long-term expected firm growth rate. Using the discounted economic income method, the value of the firm equity is the value of the capital structure (i.e., total net assets) less the value of any long-term debt outstanding.
The Asset-based Approach
A common asset-based approach method is the asset-accumulation method. This method estimates the value of the accounting firm as the current value of all the firm's assets (both tangible and intangible) less the current value of all its liabilities. This method follows the basic accounting principle that the firm's total assets must equal its total equities. However, in this method, the analyst prepares a valuation-based balance sheet instead of a historical cost-based balance sheet.
Accounting firm assets typically can be grouped into four categories: financial assets, tangible personal property, real estate and intangible assets. Financial assets include cash, client receivables and pre-paid expenses. Tangible personal property includes office furniture and fixtures, data processing equipment, etc. Real estate includes owned and leased land and buildings. Intangible assets typically include the firm's trademarks and trade names (if any), client workpaper files (sometimes called the accounting plant), client relationships, a trained and assembled workforce, going-concern value and practice goodwill.
Accounting firm liabilities typically can be categorized as current or non-current. Current liabilities include accounts payable, salaries payable and accrued expenses. Non-current liabilities include notes payable and other long-term obligations. In addition, the "value" of the accounting firm's contingent liabilities—if any—should be considered in an asset-based valuation. Using the asset-based approach, the value of the accounting firm equity is the value of both the firm tangible and intangible assets, less the value of both the firm recorded and contingent liabilities.
Each of the above-described valuation approaches should consider the value influences of current trends in the public accounting industry. In the market approach, the transactional prices and terms of recent accounting firm sales and mergers will reflect the positive and negative value influences of current industry trends. However, the analyst should be mindful of how the subject firm is affected by industry trends (1) in the selection of guideline sale or merger transactions and (2) in the selection of the valuation pricing multiples extracted from market-derived transactional pricing evidence.
In the income approach, current industry trends should influence the analyst's selection of projected (1) revenue growth rates, (2) practice profit margins, (3) required investments in human capital and property capital, (4) investor/owner's expected present value discount rate and (5) investor/ owner's expected terminal value capitalization rate. In fact, all of the valuation variables used in the income approach should reflect the subject firm's position with respect to current industry trends.
The value influences of current industry trends on the subject firm will affect the asset-based approach most directly in the valuation of the practice intangible assets. The value of several practice intangible assets (such as client relationships, staff and partner employment agreements, etc.) will be directly affected by the expected risk and rate of owner/investor return of the subject firm. These expected risk and return factors are influenced by current industry conditions.
It is often important to identify and quantify the various adjustments (i.e., discounts and premiums) associated with the valuation of an individual equity-holder's fractional ownership interest. While the following list is not exhaustive, some typical non-systematic risk factors that affect accounting firm valuation adjustments include the following:
- illiquidity (of the overall accounting firm)
- lack of marketability (of the subject fractional ownership interest)
- blockage (associated with the size of the subject ownership interest)
- dependence on a key employee such as the firm founder, the managing partner or a key "rainmaker"
- dependence on a key client
- lack of industry diversification
- lack of any defined firm specializations
- lack of service-line diversification
- lack of service-line innovation
- obsolescence of productive capacity
- lack of geographic diversification
- inappropriate capital structure (such as an unfavorable debt-to-equity mix)
- unfavorable contractual agreements (such as onerous lease agreements)
- excess non-productive assets (for example, computer equipment not currently used in firm operations)
- restrictions on ownership disposition (such as holding period restrictions or buy-sell agreement restrictions)
- minority (or lack of control) ownership interest
- majority (or controlling) ownership interest
- superior service-line diversification
- superior geographic diversification
- excess income-producing assets
- favorable capital structure
- favorable cost of capital components
- favorable contractual agreements
- service-line technological innovation
- ready marketability of security interest
- favorable industry specialization
- favorable service-line specialization
In the valuation of an equity-holder's fractional ownership interest, the analyst should consider the current trends in accounting when both (1) selecting the appropriate discounts and premiums and (2) quantifying those discounts and premiums.
Summary and Conclusion
Accounting firm values are influenced by current industry trends. Significant recent industry trends relate to (1) consolidation, (2) separation and (3) diversification. The market-indicated effects of each of these trends should be reflected in the various valuation variables used in the (1) market approach, (2) income approach and (3) asset-based approach valuation analyses.
In addition, the analyst should judgmentally consider the position of the subject firm vis-à-vis industry trends in the valuation synthesis and conclusion. Finally, the analyst should consider all quantitative and qualitative value influences in light of the standard of value, premise of value and level of value appropriate for the particular bankruptcy-related valuation assignment.