Journalof Accounting Education, Vol. 8. pp. 31 l-319, 1990 Printed in the USA. All rights reserved. Copyright 0 1991P er&mm Press plc Case THE VALUATION OF AN ACCOUNTING PRACTICE AND GOODWILL William Cenker Robert Bloom JOHN CARROLL UNIVERSITY OVERVIEW This casei s written to encourage students to apply accounting and finance concepts to a situation that they may eventually need to address in practice. There is no single correct approach for the student to take. Rather, emphasis should be placed on the quality of the analysis. This case involves the valuation of goodwill and would most likely be appropriate for an advanced accounting course. Valuation theory has receivedr ecent attention in the accounting literature under the rubric of management advisory services, litigation support ser- vices, and practice management. A critical element of the valuation process is the establishment of a value for goodwill. CASE David Lawyer and John Count are partners in a practice that combines law and accounting. Although both partners are certified public account- ants, Lawyer has had little to do with the accounting end of the practice in recent years. For personal reasons, John Count left the partnership in the fall of 1984. Although Count took a portion of the practice with him, Lawyer was left with an accounting practice having annual gross billings of $300,000. Even though three staff accountants remained with Lawyer, the firm would not be able to adequately service, and thus would probably lose, the remaining clients. William Balance, a partner at ., a competing local firm in the same midsize Illinois city, was apprised of the situation between Lawyer and Count through mutual Rotary Club activities. Balance approached Lawyer with the suggestion that . service the accounts in the coming busy season. . assisted Lawyer through the first busy season by servicing the accounts and billing Lawyer for the services performed. The work was kept separateb y proper coding of Lawyer’s accounts. A local firm with a quality practice, . has a professional staff of 45. . has been a member of the Private Companies Practice Section 311
312 W. Cenkera nd R. Bloom (PCPS) of the AmericanI nstituteo f Certified Public Accountants( AICPA) since PCPS’s n the samel ocation since 1916,t he firm is the leadingl ocal CPA firm in the city. In contrastt o Lawyer, . offers comprehensivsee rvicesr angingf rom traditionala uditinga ndt ax servicest o computerc onsultinga nd personalf inancial hile servicingt he accounts,t he . partnersd eterminedth at Lawyer’sp racticec onsisted of the followings ervicese xpresseads a percentagoef grossb illings: Audit and Review 10% BookkeepingS ervices 30 Tax 60 100% The practicei ncludedt he servicingm ainly of smallerc lientsw ith several medical and dental iven the relativelyh igh percentageo f tax clients,t he averagec lientb illing was$ 800. . offered, and Lawyer accepteda, purchasep rice of 20% of gross billings paid over a five-yearp eriod. “Gross billings” is definedi n the pur- chasea greemenat s the annualb illingsf or all servicesp erformedf or clients relatedt o the initial client list. The paymentsa re being madeu nder a con- sulting agreemenbt etweent he two parties. . did not acquire any receivableso r tangiblea he three accountingp ersonnel,w ho were particularly important during the transition period, had been hired by . undern ormale mploymenct onditions. Under the agreementto acquiret he practice,n o cashw asp aid up front. The consultingf ees payablet o Lawyer were determinedb asedo n . billings for the actualc lientsp urchasedu nder the agreemenat s well as for additionalc lientso btainedt hroughr .. billingsf or the Lawyer accountsin creased4 0% overt he first threet ax seasonsT. hesei ncreasews ere generallyt he resulto f providings uperiors ervicesa nd increasedc omplexity in servicingt he accountsd ue to enactedt ax fter considering referralsa nd extendeds ervices,t he total increasei n billings amountedt o approximately6 0%. After the third year,b asedo n the 20% annualg rowth trend, Balancee stimatedth at Lawyer would be paid nearly $450,000o ver the five-year acquisitionp herefore, . will pay a price ap- ITherea ret wo sectionso f the AICPA division for memberfi rms. The first section,t he SEC, consistsm ainlyo f largerf irms servicingp ubliclyt radedc he seconds ection,t he PCPS, consistsm ainlyo f local and regionalf irms that servicep rivatelyh eldc ompaniesM. embership in the PCPS is purelyv o maintaina quality practice,t herei s a requiremenfto r mandatoryp eriodicp eerr eviewo f eachm embeirn this section. 2Givena n estimateda nnuali ncreaseo f 20% over the base year,B alance’se stimatec an be approximated:
Valuation of an Accounting Practice and Goodwill 313 proximating1 50% of the revenuesin the acquisitiony ear. This price is reasonablec, onsideringt hat accountingp racticesh aveb eens uggestetdo be worth a value rangingf rom 75 to 150% of the revenuesin the latesty ear (Kuttner,1 989,p . 146;P ratt, 1986,p . 314). . booked no goodwill relativet o its acquisitiono f Lawyer’s ac- ach of the paymentsto Lawyeri s expensedo n the . partner- ship books. This treatmenwt asb asedo n the following reasoning: 1. Although the partnershipa greemendt oes not specificallya ddressa c- quisitions,t he agreemendt oesa llow for “retired” partnerst o continue to services electeda n essenceL, awyer is consideredt o be a retired partner of the . herefore, expensingt he paymentsto Lawyer is appropriate. 2. Lawyer’sf irm was in distressa fter the loss of Count, the accounting he . partnersm aintaint hat little, if any, goodwill is attributablet o the ven if therew ereg oodwill attributablet o Lawyer, it would be meaninglestso book it becauseL awyer was not admittedt o the . partnership, 3. Lawyer’sp racticec onsistedm ainly of tax and write-ups ith the departureo f Count from the partnership,m ost of the clientsw ere expectedto leaveL ecauseA .. is the leadingf irm in town, a significantp ortion of the clientsw ould likely switcht o . should Lawyer liquidate. 4. No cashw asp aid initially. The practicew asp urchaseda s a percentage of future receiptsA. ssumingt hat a valuew eret o be establishedfo r the debitt o goodwill, the questionw ould arise:“ What accounts hould be credited?”L iabilities,a s definedb y the FASB in Statemenot f Financial Accounting Concepts No. 6, “Elements of Financial Statements” (1985),a re: Probable future sacrifices of economic benefits arising from presento bligationso f a particulare ntity to transfera ssetso r pro- vide servicest o other entitiesi n the future as a result of past transactionso r events. In view of the definition of a liability as a presento bligationr esulting from paste ventst, he substanceo f the contractw ith Lawyeri s not clear. Year Billings Lawyer’s 20 Percent 1986 $300,000 $ 60,000 1987 360,000 72,000 1988 432,000 86,400 1989 518,000 103,600 1990 622,000 L 124 400 $446,400
314 W. Cenkera nd R. Bloom Becausen o paymentis due Lawyer until futurew ork is performed,t he agreemenat ppearst o be fully executoryi n nature. Accordingly, the partnersc ontendt hat no accountingli ability exists. 5. The relationshipb etweenA .. and Lawyer can be vieweda s similart o a contract for “royalties” or production he contract is fully executoryi n the senset hat no performanceh ad been made by either party at the time the partiesa greedt o the fully executoryc ontracti s not recordedi n the accountsb ecauseth e contract representsm utual promisest o an exchangeo f hen the ex- changea ctually occurs, the contracti s executedt o the extento f the exchangeF. or example,i f one party agreest o furnish a servicet o a secondp arty,a nd the secondp arty makesp aymentp rior to performing the service,t he contracti s partly executedW. ith the subsequenftu ll performanceo f the service, the contract is wholly he . partnersc ontendt hat the paymentsm adet o Lawyer shouldb e treateda s royaltyp aymentsR. oyaltyc ontracts,w hich are usuallyf ully executorya, re not recordedi n the he royaltyp aymentsr ep- resente xpensesto . for the servicesp rovidedb y Lawyer under circumstancesi milart o a licensingc ontract. Required 1. What is goodwill? Should the natureo f Lawyer’sp racticei nfluencet he calculationo f goodwill? 2. Distinguishb etween“p ractice” goodwill and “professional” goodwill. 3. Specifically addresst he . partners’j udgmento n both goodwill and the resultingl iability. 4. Discusst he rationalef or the accountingt reatmento f fully executory oes the agreemenbt etweent he . partnersa nd Law- yer constitutea fully executoryc ontract? TEACHING NOTES 1. Goodwill is an assett hat is difficult to define and thus difficult to value. According to APB Opinion No. 17 (AccountingP rinciples Board, 1970): The excesso f the cost of an acquired enterprise over the sum of the identifiable net assets,u sually called goodwill, is the most common unidentifiable intangi- ble asset (paragraph 1). In this case,n o identifiablen et assetsw erea ll the receivables and property and equipmenta s well as other assetso f Lawyer’s practice 3Wea rei ndebtedt o an anonymousre fereefo r this idea.
Valuation of an Accounting Practice and Goodwill 315 remained with him. In Accounting ResearchS tudyN o. IO (Catlett & Olson, 1968),g oodwill is generally associated with superior management, effective advertising, and high community standing. Lawyer’s practice did not qualify in terms of superior management. In fact, based on the “stress” imposed by Count’s departure from the firm, the viability of the firm was questionable. In the preparation of this case, the authors approached severala ccounting practitioners for their views on practice valuation and goodwill. Their views on the measurement of goodwill differed significantly, ranging from the notion that goodwill may exist but simply cannot be measured reliably for a personal service business to the use of a sophisticated analysis of projections of free cash flows. The diversity of opinions relative to professional goodwill is paralleled on an historical basis. In the late 1940sa nd early 195Os,a number of writers argued that goodwill did not attach to a professional practice (seeN ielsen & Hudson, 1987). On the other hand, several current writers suggest that goodwill is the most significant asset in the purchase of a professional practice (., Kuttner, 1989; Mastracchio, 1985; Pratt, 1985; Wright, 1982). From an income and estate tax standpoint, there has also been a general shift towards the recognition of goodwill in a professional practice (Nielsen & Hudson, 1987). The most comprehensive and often-quoted definition of goodwill from a tax standpoint is contained in Revenue Ruling 59-60: In the final analysis,g oodwill is basedu pon earningc apacityT. he presence of goodwill and its value,t hereforer, estsu pon the excesso f net earningso ver and above a fair return on the net tangible hile the elemento f goodwill may be basedp rimarily on earnings,s uch factorsa s the prestigea nd renowno f the business,t he ownershipo f a tradeo r brand name,a nd a record of successfuol perationso ver a prolongedp eriod in a particularl ocality, also may furnish supportf or the inclusion of intangiblev alue . . . The enterprise has a valuea s an The nature of the practice would certainly influence the purchase price and therefore goodwill. In Valuationo f a CloselyH eld Business( AICPA, 1987, p. 21), a recommendation is made to apply multipliers of 130% of gross billings for audit clients and 75 and 50% of gross billings for corporate and individual tax clients, respectively. In addition to the nature of the engagement, client “quality” factors also include industry classification, 4In light of the valuation requirements for estatet ax purposes, Thorton (1984) suggestst hat the . is the chief architect in this area. This conclusion is also supported by the AICPA MAS Small Business Consulting Subcommittee (1987). The two principal documents that essentially view goodwill as based on earnings are Appeals and Review Memorandum (ARM) 34 and RevenueR uling 59-60 (Kuttner, 1989). Both documents suggest that a formula approach ought to be the consideration of last resort. Should a formula approach be required, goodwill is viewed as a capitalized value of excess earnings. Generally, excess earnings for five years is considered appropriate.
316 IV. Cenkera nd R. Bloom geographicd istribution,m aturity,a nd collectionr he transferability of the practicei n questiont o the new accountantsw asf acilitatedb y retain- ing three key hese employees,a lthough not partners, were certainly partly responsiblef or .‘s retentiono f most accountsa c- quiredf rom Lawyer. In this case,t herew eren o tangiblea ssetsp onethelessp, ay- mentsa ret o be madet o Lawyeri n amountst hat exceedt he fair valueo f his consultings value for goodwill should be establishedb y . basedo n the client list it receivedf rom Lawyer. One approach,c onsistent with generalp racticea nd tax courts, would be to capitalizet he expected earningsf rom the existingc lient rostera t time of purchaseA. high capitali- zation rate, and thereforea low goodwill value, is suggestedb y the low percentageo f audit servicesin the Lawyer-clients ervicem ix. The “stress” componentc an also be factoredi nto the capitalizationr ate,o r the resulting valuem ayb e reduceds ubjectively. 2. Practiceg oodwill, which is often referredt o as businessg oodwill, re- lates to the goodwill associatedd irectly with the n this case, practiceg oodwill consistso f the client list and the recommendationms ade to the clients. The recommendationrse latet o the retentiono f . as the clients’a ccountingf irm. Professionalg oodwill pertainst o the personal attributeso f the accountantp roviding the ince Lawyer was not directlyi nvolvedi n accounting,li ttle, if any,g oodwill is attributablet o him. 3. . failed to differentiateb etweenp racticea nd professionagl ood- will. The partners’r easoningc oncerningp rofessionalg oodwill was sound: Lawyer was not capableo f servicinga ccountingc here is, however, good reasont o book goodwill basedo n the value of the client base( ., practiceg oodwill). The paymentsm adet o Lawyer are not consistenwt ith the provisionsf or retiringp artnersi n the . partnershipa the . part- nershipa greementr,e tiringp artnersr eceivep aymentsb asedo n a percentage of the feesg eneratedb y their continuingt o servicea ccountsa s well as on their capitalb alancesU, nlike paymentsm adet o a retiringp artneri n accord- ancew ith this agreementt,h e paymentsa re not the resulto f personals er- viceso r capitalb alancese xtinguishedo vert ime. Lawyer wasn ot personally servicingt he accounts. That Lawyer wasi n distress houldc ertainlyi nfluencet he decisiont o sell as well as the termso f istressc an be factoredi nto professionapl rac- tice valuationsi n differentw ays,i ncluding( 1) as a negotiatedfa ctor in the termso f the salesa greement(,2 ) as a factor in the capitalizationr atet o be appliedt o earningso r cash flows, (3) as a discount factor appliedt o the overallc alculations. The argument hat a specificp ercentageo f Lawyer’sa ccountsw ould be . accountsi f Lawyer weret o fail does not havem erit. It is unlikely that Lawyer would have allowedt he firm to liquidatei f . had not
Valuationo f an AccountingP racticea nd Goodwill 317 purchased the practice. Lawyer would have attempted to sell to another firm. The recording of purchased goodwill without an initial payment requires that a liability be booked. This liability would be recorded as a contingency. According to FASB Statemento f Financial Accounting StandardsN o. 5, “Accounting for Contingencies” (1973, a contingency is: an existing condition, situation, or set of circumstancesi nvolving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future eventso ccur or fail to occur (paragraph 1). Although not technically a gain or loss contingency, a liability is justified on the grounds that payments will be made to Lawyer in the future. The amounts payable to Lawyer are both probable and reasonably estimated, even though they are based on future services. The arguments presented by the partners for nonrecognition of goodwill lack merit. First, the payments to Lawyer are not related to his continuation as a consultant. Treatment as a retired partner is equally unjustified. Dis- tress can be factored into the valuation of goodwill in various ways. The client service mix, though principally involving tax and writeup work, has value. Admittedly, however,t his value would probably be larger for a prac- tice that is more audit Liability recognition is warranted as a contingency. Assuming that the resulting value is material, an asset and a liability should be recorded as a highly discounted estimate of either the future earnings or cash flows. The asset should be amortized for accounting purposes on a straight-line basis over a reasonable period of time, not to exceed4 0 years (Accounting Principles Board Opinion No. 17, 1970).T he liability should be reduced by the payments made to Lawyer with interest recognized using the effective interest method (Accounting Principles Board Opinion No. 21, 1971). 4. A fully executory contract is illustrated by an agreement to purchase products or services in the future. The underlying rationale for the practice of not recording fully executory contracts in the accounting records is based on the uncertainty underlying performance in accordance with the terms of the contract. At the time the contract is established, neither party has per- formed. Accounting for fully executory contracts is fundamentally in con- formity with the Uniform Commercial Code (.). Under the ., should one party to such a contract repudiate its contractual obligation, the 5Pratt( 1986c) omments“:G enerally,a n accountanwt ill be willing to paym oref or a continuing auditc liento r a write-upc lientt han for numerousin dividualt ax returnc lients” (p. 315).T his samec onclusioni s supportedb y the AICPA (1987)a s well as by Kuttner( 1989)A. pparently, audita nd accountinge ngagemenltesa dt o longerc lientr etentionsth ane ithert ax or consulting the other hand, Istvan (1984)s uggeststh at becauseo f increasingc ompeti- tion, thef uturem ayb eb righterf or then ewern, ontraditionaMl AS andc omputesr ystemd esign services.
318 W. Cenkera nd R. Bloom other party is not requiredt o perform ,F’ urthermore,t he aggrieved party is usually severelyl imited in recoveringd amagesa rising from the breacho f pecific performancei n accordancew ith a contracti s generallyu nenforceableu nlesst he contractd ealsw ith a uniquep roduct or everthelesss, uch contractsa re expectedt o be carried out in the normal courseo f business. There is a difference,h oweveri,n the circumstancessu rroundingt het rans- fer of accountsb etweenfi rms and a fully executoryc n a licenseo r royaltyc ontract,t he asseti nvolved,w hethert angibleo r intangible,r emains with the owner-licenserT. he actualr ightso f ownershipa re not transferred. If ownershipr ightsw eret o be transferreda, si n thec aseo f a capitall ease,a n assetw ould be recordedb y the one party (Le., a licensee)i s payinga notherp arty (., a licenser)f or useo f a productivea sset,t hent he contractw ould be fully executorya, nd no asseto r liability shouldb e booked by the licenseef or the ownershipo f the productivea sset8 Kontractual performancere quirementosf one party subsequentto the performanceo f con- tractualo bligationsb y the other party appeari n Sections2 -507a nd 2-511o f the . Contractuarl emedieas rec overedin Sections2 -711t hrough2 -714a nd Sections2 -703,2 -706,2- 708,a ndZ -710A. lthought heU .. dealsw ith thec ontractuarle quirementrse sultingfr om the saleo f goods, performancere quirementasn d remediesfo r servicec ontractsc an be drawnb y analogyS. ection2 A of the . for examplec, overst he leaseo f goodsi n a mannerp arailef to the sectionsc oncernedw ith the saleo f goods. We are gratefult o H. E. Mallue, Jr. of The Collegeo f William and Mary for assistancein locatings pecifics ectionso f the . dealing with contractuaol bligations. ‘Although fully executoryco ntractsa reg enerallyn ot recordedt,h e contractsm ustb e disclosed if they represenut nconditionalo ng-termo ccordingt o FASB Sta@~~eNnot . 47, “Disclosure of Long-Term Obligations” (1981), these obligations have the following characteristics: (a) They are essentially noncancellable or canceltableo n occurrence of a remote contingency. (b) They constitutep art of the projectf inancinga rrangemenotf a supplierf or the facilities thatw ill providet he contractedse rviceo r goods. (c) Theya rel ong termi n nature. sPeriodicp aymenttsh ata rem adef or the right to usea secretf ormula,c opyrightedm ateriaol r traden ame,o r to exploitm ineraid epositsa reo rdinarilyd eductiblea s businesse xpenseus nder Section1 62(a)(lo) f the . The royaltyp aymentas red eductiblea s businesse xpenseus nder mucht he samec onditionst hatr entp aid for businesso r income-producinpgu rposesis deducti- ble. Similar to rent, royaltyp aymentsa re treateda s capital~ penditures,n ot as deductible expensesi,f the paymentsa re madea s part of the purchasep rice of the underlyingp roperty rathert hanf or useo f the propertyW. hene xclusiveo r perpetuarli ghtsa ret ransferredsu cht hat the transferord oesn ot retaina n economici nterest,t he tax courtsh avec onsistentlyh eld that the paymentsa re capitali nvestmentas nd thereforen ot currentlyd eductiblee xpensesS. ee,a s examplesM, agee-HaleP ark-O-MeterC o., 15T CM 254,a nd SeattleB rewinga nd MaltingC o., 6 TC 856. As the . agreemenwt ith Lawyerg rantsi ndefinite rights to ., with Lawyern ot retaininga n economicin terestin the clientl ist, taxd eductibilityo f the paymentsa s royaltiesis doubtful.
Valuation of an Accounting Practice and Goodwill 319 Lawyer is not, however, retaining rights to the client list transferred to . In fact, most sales agreementsa nd employment contracts with ac- countants and other professionals contain agreementsn ot to compete within a specified geographic area for a specified time period. Such agreementsa re necessaryt o protect the interests of the purchaser. The . partners have acquired the rights to service Lawyer’s accounts for an indefinite period. As such rights are expectedt o generaten et cash inflows, recording an asset for the estimated value of these rights is warranted at least in theory. In practice, estimateso f the value of such rights are likely to be subjective. To the extent that this value could be estimated in terms of the amounts and timing of the net cash inflows involved, then the inflows should be discounted using an appropriate interest rate for the firm. REFERENCES Accounting Principles Board. (1970). Intangible Assets. OpinionN o. 17. New York: AICPA. Accounting Principles Board. (1971). Interest on receivables and payables. OpinionN o. 21. New York: AICPA. AICPA MAS Small Business Consulting Practices Subcommittee. (1987). Valuationo f a closely heldb usinessN. ew York: AICPA. Catlett, G. R., &Olson, N. 0. (1968). Accounting for goodwill. Accountingre searcsht udyN o. ew York: AICPA. Crandall, A. L. (1985, March). A practical approach to valuing a closely held business. The PracticalA ccountant. Financial Accounting Standards Board. (1975). Recognition and measurement in financial statementso f business enterprises. Statemenotf financiala ccountincgo nceptNs o. 5. Stam- ford, CT: FASB. Financial Accounting Standards Board. (1985). Elements of financial fatement of financiala ccountingco nceptNs o. 6. Stamford, CT: FASB. Financial Accounting Standards Board. (1975). Accounting for contingencies. Statemenot f financiala ccountinsgt andardNs o. 5. Stamford, CT FASB. Financial Accounting Standards Board. (1981). Disclosure of long-term obligations. Statement offinancialaccountinsgt andardNs o. tamford, CT: FASB. Internal RevenueS ervice. Appeals and review memorandum number 34. Internal RevenueS ervice. Revenuer uling 59-60. Istvan, D. F. (1984, April). The future of the accounting profession: Will your firm survive until 1990? TheP racticalA ccountant. Kuttner, M. S. (1989, November). Business valuation: An important management advisory service. TheJ ournal of Accountancy. Mastracchio, N. J. (1985, December). How to value a professional practice. The Practical Accountant. Nielsen, G. (1984, February). The purchase of an accounting practice: Making the right choice. TheJ ournal of Accountancy. Nielsen, G., & Hudson, D. (1987, February). How to value an accounting practice. TheN ation- al Public Accountant. Pearson, C. M. (1987, September). Managing your practice. TheP racticalA ccountant. Pratt, S. (1986). Valuings mallb usinesseasn ewood, IL: Irwin. Thorton, R. C. (1984, November). What’s a business worth? TheP racticalAccountant. Wright, J. E. (1982, January). On buying and selling a practice. Journal of Accountancy.
