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Divorce in Ohio Series Part 12: Unique Aspects of Professional Practice Valuations in Divorce

Unique Aspects of Professional Practice Valuations in Divorce

By: Heather Deskins, CPA/ABV/CFF, CFE, CVA

Managing Member of P.D. Eye Forensics, LLC

Valuing a professional practice in a divorce setting has its own set of issues.  These issues include understanding the characteristics of a professional practice, the special financial statement adjustments to consider and issues in valuing goodwill.  Of course, each industry is different and there are certainly additional issues that can be addressed; however, this article will focus on several major valuation issues.

What makes a Professional Practice Unique?

Professional practices, such as medical, dental, accounting, legal, and architectural/engineering firms, have certain characteristics that distinguish them from other small businesses and make them unique:

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  1. They involve providing a service versus a product.
  2. There is a level of trust and respect between the professional and the client.
  3. The professional often relies on referrals to obtain business.
  4. A specific educational degree is usually required by the professions regulatory body.
  5. The professional holds a license from a governmental or regulatory agency and/or is certified by a professional organization.
  6. Successful professional practices typically have a high intangible value and a low tangible value.

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Valuing a professional practice is far different than valuing, say a manufacturing business.  Since professional practices focus on selling a service, they typically have little value in actual tangible assets (i.e., inventory, machinery & equipment) but have greater value and dependence on their earning capacity.  Some important factors to consider in valuing a professional practice include the following:

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  • Location: Is the practice located in an urban, high growth area or in a rural, declining market?
  • Referral sources: Is there a large referral base or is the practice reliant on one or a few referral sources?
  • Reputation: What is the professional’s reputation?
  • Age of Professional: Is the professional young and energetic or on the verge of retirement?
  • Employees: Are they dedicated and trained or on the verge of leaving?
  • Work habits: Does the practitioner delegate staff and, as a result,  have a light work load ?  Does the practitioner work excessively?

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In addition to reviewing these and other non-financial issues, various financial issues need to be addressed that also impact the fair market value of a professional practice.  Fair market value is defined as follows:

The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, and both parties have reasonable knowledge of the relevant facts.[i]

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The financial issues include adjusting the financial statements to market values (versus recorded book values) and valuing the goodwill of the practice.

Normalizing Adjustments

Normalizing adjustments are made to the income statement and balance sheet to bring the financial statements to an economic reality.  Typically, a professional practice prepares its financial statements on the cash-basis, meaning that whenever cash is received or paid out, it is then recorded on the books.  Therefore, cash-basis financial statements may not include accounts receivable, accounts payable, accrued vacation pay or accrued taxes on the balance sheet.  To bring the balance sheet to a more economic reality or to true market values, these types of accounts should be included.

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Balance Sheet

Determining the accounts receivable in a medical practice can be somewhat challenging because the amount the medical practice bills is not necessarily what they expect to be paid.  This is because the medical practice bills their normal rates to the patient’s insurance provider and the insurance provider has a predetermined amount they will pay for services.  When the medical practice receives payment from the insurance provider for services, the medical practice writes-off the difference as uncollectible.   Therefore, the normalizing adjustment to accounts receivable should only included the amount that is determined to be collectible, which can be a challenging process.

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A specific normalizing adjustment specific to practices that bill by the hour, like accountants and lawyers, is their work-in-process (WIP) or unbilled accounts receivable.  This is considered an asset of the practice and should be considered.  The value of WIP may be an estimate as it is difficult to determine the exact amount of WIP on a particular valuation date; however, it is important to understand the practice’s billing procedures in estimating the amount.

Office equipment can be a valuable asset for certain professional practices.  A dental practice would have far greater value in equipment than a mental health professional.  Depending on the age and condition of the equipment, it may be necessary to have a professional equipment appraiser value the necessary equipment in order to adjust the value to market levels.

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In addition to adjusting assets on the balance sheet, liabilities should also be considered.  Any unreported liabilities such as accounts payable, accrued liabilities, long-term liabilities and contingent liabilities, should be included on the balance sheet.

Income Statement

One of the most controversial adjustments made to the income statement is to Owners’ Compensation.  When a business owner has control to set his or her own compensation, the level of compensation paid may not be what the current market is paying.  Reviewing the owners’ responsibilities, education and experience will help determine an adequate market compensation.

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When valuing a business during a divorce proceeding, it is especially important to be consistent in using the same compensation of the business owner that is used in the business valuation and the compensation used in determining child and/or spousal support.  If a higher income is used in determining spousal support than what is used in valuing the business, the concept of double-dipping has occurred.  This is a topic for another day.

Goodwill

As stated previously, professional practices typically have little value in actual tangible assets (i.e., inventory, machinery & equipment) but have greater value and dependence on their earning capacity, which creates goodwill. Goodwill in a professional practice can be broken down into enterprise (or practice) goodwill or personal (or professional goodwill).

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Enterprise goodwill is the value of earnings or cash flow directly attributable to attributes of the enterprise that results in earnings from consumers that return because of the enterprise, in earnings from new consumers who seek out the enterprise, and in earnings from referrals made to the enterprise.[ii]

Personal goodwill is the value of earnings or cash flow attributable to attributes of the individual that results in earnings from consumers that return because of the individual, in earnings from new customers who seek out the individual, and in earnings from referrals made to the individual.[iii]

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Enterprise goodwill is typically transferable upon the sale of the practice, while personal goodwill is typically not transferable.  The question then arises, “is personal goodwill a martial asset?”

In the recent Ohio Appeals court case, Banchefsky v. Banchefsky, 2010 WL 3527578 (Ohio App.) (Sept. 9, 2010)[iv], the business owner sold his dental practice during the divorce and the divorce court limited personal goodwill to the value of the non-compete, which was $15,000 as his separate, non-divisible property.[v]

Heather Deskins CPA/ABV/CFF, CFE, CVA is appearing as a Guest Blogger on our site.  She does not work for the Law Offices of Virginia C. Cornwell, and is not being paid to write this article.

 


[i]Revenue Ruling 59-60.

[ii] Business Valuation Update, Still Hunting: In search of Consistent, Functional Definition for Personal Goodwill, David Wood, CPA/ABV. CVA, CFFA, April 2010.

[iii] Ibid.

[iv] Please note that the author does not provide any legal advice, and the case citation provided in this article is for illustration, general informational, and discussion purposes only.

[v] Business Valuation Update, December 2010.

Other Resources:

Pratt, Shannon P., Robert F Reilly, Robert P. Schweihs. Valuing Small Businesses & Professional Practices. 3rd ed.

New York: McGraw-Hill, 1998

You may also find these articles from our divorce series to be interesting:

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