Bookkeeping question. Introduction

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1 Bookkeeping question Introduction This example considers the valuation of a small bookkeeping company and illustrates that blind adherence to a formula-based approach will often lead to incorrect results. In this instance, for example, the valuator chose to rely primarily on a secondary method of valuation instead of one of the more traditional income-based calculations. Business Valuators must be flexible in their approach, and rigid adherence to a "template" type calculation is not recommended. Students are cautioned to note that this example is for illustrative purposes only and does not necessarily reflect all of the steps undertaken in an actual valuation engagement or a precise valuation conclusion. General Ledger Inc. ( Ledger Inc. ) is a small bookkeeping company operated by Gail Debit. Gail does not have any accounting or other professional accreditation, but she is well-known in her community and is an active member of the local Chamber of Commerce. Gail started the business in White Rock, B.C. in 1984 serving the local business community and has managed to develop a successful niche business. Gail believes that she understands her market and their needs well. Most of her clients, for example, are the typical small business with perhaps 10 or fewer employees. These businesses don t always require the sophistication of service provided by several Chartered Accountant and Certified General Accounting firms located near her office. Ledger Inc. provides a variety of services including typical manual bookkeeping, payroll, and computerized accounting services. Simple tax preparation services can also be provided, but there never has been more than only a minimal demand for this. Gail started the business on her own, but in the last several years has added additional staff, including a full-time receptionist / office clerk and two other part-time staff. Both of the part-time staff are young accounting students who are primarily interested in obtaining some experience in the industry. For many years White Rock was primarily a residential neighbourhood with a large retired community. In more recent times, however, the local business community has really taken off. Several professional accountants looking to establish a new practice have also recognized this and asked Gail if she was interested in selling her company. Gail had never really considered this, and at age 45 was definitely not yet considering retirement. To Gail, her company was primarily a way of earning her living and she wasn t that interested in the bottom line profit after earning a reasonable salary for herself. For prospective purchasers, Ledger Inc. offered a quick entry into the business with an established client list that they hoped could be built and expanded upon. To a professional accountant, for example, there was considerable value in obtaining an existing client that they could upsell with tax planning, audit, and other services. Bookkeeping Case Study Page 1

2 Gail is now considering selling Ledger Inc. but has no idea on what it might be worth. She has heard that companies similar to Ledger Inc. often are valued according to certain rules of thumb, but again, she doesn t know what types of factors are considered if this method is applied. Financial results for Ledger Inc. during the last five fiscal periods are as follows: (000s) Fee revenue $350 $333 $275 $290 $280 Expenses Gail s salary Other expenses Total expenses Net income (loss) $ 20 $ 8 $(30) $(11) $ 0 Fee revenues had been growing fairly steadily in the last several years with only a small dip in 2002 when some road construction in the area disrupted some of her business. The most significant cost was her office lease, which was at a fixed cost per month and not scheduled to expire for several more years. Ledger Inc. has a typical office with front street access in a fairly busy business area. Although there is some walk-in business, most of the new clients are established by word of mouth. Valuation Analysis Gail decides to contact a Chartered Business Valuator ( CBV ) for some help in placing a value on her business. Since Gail has not yet decided for certain to sell her business and only wants some general assistance at this point, the CBV and Gail both agree that he would prepare an estimate of fair market value for her rather than a complete formal valuation opinion which would entail a much larger fee. The first step of the CBV is to meet with Gail and discuss the specific terms of his engagement and obtain a better understanding of her business. During the meeting the following terms of reference are agreed: Date of valuation current date Definition of value generally accepted definition of fair market value Time frame the valuation estimate and report was to be completed in two weeks time. An engagement letter is completed and the CBV commences his fact-finding and information gathering. The CBV asks Gail if any prior valuations had been completed and she said no. Also, her discussions with the prospective purchasers were only general in nature and did not include any proposed purchase prices, etc. Bookkeeping Case Study Page 2

3 During the course of his review, the CBV is careful to ensure that he meets the professional standards prescribed by the Canadian Institute of Chartered Business Valuators (CICBV). In particular, Valuation Standard 120 details a number of requirements pertaining to the scope of work that must be completed when a valuation report is prepared, as well as Valuation Standard 130 dealing with File Documentation. For example, according to Standard 120 the CBV is required to: - obtain sufficient evidence to support the report with consideration to its intended use; - obtain sufficient understanding of the subject of the valuation and the underlying business operations; and - consider the key valuation components and assumptions. Some of the financial documents obtained by the CBV included detailed financial statements of Ledger Inc. for the last five years and the most recently prepared budget, which essentially forecasted similar operating results in 2005 as reported in the previous 12 months. Gail never finds the time to prepare a detailed business plan and didn t find it useful to project beyond the next 12 months. The CBV also obtains the basic corporate documents such as the articles of incorporation and bylaws. Gail was the sole 100% shareholder of the company since inception. The CBV then decides to complete an economic and industry review. He finds that general economic conditions are favourable with low interest rates, historically low inflation, and improving stock markets. A closer examination of Ledger Inc. s market and competitors confirms what Gail had told him Ledger Inc. did not have any significant direct competition to the market it served, but is somewhat limited in its growth long-term if it starts to pursue those businesses currently served by professional accounting practices. The CBV also considers potential purchasers in the industry who might perceive certain post-acquisition net economic value added by acquiring Ledger Inc. together with an existing business. The CBV then considers the employees of Ledger Inc., but concludes that they are not a critical component of the final valuation conclusion. They all appear capable and trustworthy, but the ultimate success or failure of Ledger Inc. didn t heavily rely on any of them. The CBV also contacts the company s lawyer and finds that there were no contingent liabilities, contractual obligations or litigation, pending at the valuation date. Once the CBV has finished all of his preliminary work and analysis he has to decide on what valuation approach and methods to adopt. There is minimal profitability in the company after Gail had deducts her salary and for several years in the past there was even a bottom-line loss. There are also only minimal assets held by the company, so an asset-based method would not result in a significant value. Most critically, the CBV had to decide on the nature of the goodwill, if any, residing in Ledger Inc. Was it personal goodwill that does not have any commercial value, or was it more accurately individual goodwill which can, depending on the circumstances, have commercial value? 1 The 1 Personal goodwill represents the unique advantages enjoyed by a given individual which arises from his or her particular abilities, good name, and reputation, and which is not transferable by contract or otherwise. Individual goodwill accrues to a business by virtue of its employment of an individual (or more than one individual) who has abilities, business contacts, good name and reputation that could be, or would, be harmful to the economic well-being of the business Bookkeeping Case Study Page 3

4 CBV also realizes that apart from the goodwill consideration, there may be separate value in the client list of Ledger Inc. itself as an identifiable intangible asset. After careful review and discussions with both Gail and some of her clients, the CBV concludes that most of the value resides in the client list as a separate intangible asset. The CBV also determines that the most likely purchaser would be either an existing accounting practice or a newly accredited professional looking to quick-start a new practice. In terms of determining a fair market value for Ledger Inc. s client list, the CBV understands that the more purchasers, who believe they are capable of enjoying postacquisition economies of scale and/or strategic advantages, the greater the likelihood that one or more of them would be prepared to pay for this component. The CBV reviews the historical operating results of Ledger Inc. to determine if a normalized amount of indicated after-tax earnings (or cash flow) can be calculated. The starting point is usually the reported results (according to Canadian generally accepted accounting principles) to which a number of potential adjustments are considered. 2 In this instance, however, the CBV confirms that Gail has been drawing a market equivalent wage for herself (according to online references such as and the annual salary guide published by Robert Half Inc.). There are also no other applicable adjustments in estimating a reasonable expectation of the future performance of the firm. Because the company has historically reported intermittent profits and losses during the last several years, sole reliance on one of the traditional valuation methods did not seem appropriate. Although not normally adopted as a primary valuation technique, the CBV concludes that he would place the most reliance on the rules of thumb technique (also referred to as industry specific activity ratios) in this instance. Gail has essentially developed a job for herself by developing Ledger Inc. s business, and although there was minimal profitability beyond that, there was a market for this kind of company. Similar to valuation of some insurance agencies, larger companies are often interested in smaller local firms by effectively purchasing a customer list. With very little incremental cost the cash flow to the acquirer is enhanced and the CBV confirms that the rate of return relative to the purchase price did reflect economic reality. The CBV decides to complete additional research on the rules of thumb technique by consulting a number of different sources, such as a text authored by Mr. James Horvath, entitled "Valuing Professional Practices". He also researches various sites on the internet, such as those for the various professional accounting associations. He determines that the most commonly used methods of valuing public accounting practices are as follows: should that individual leave and compete with the business. In an open market context, it is noncompetition agreements that result in individual goodwill having commercial value. 2 Usually on account of such items as compensation, non-recurring items, redundant assets, etc. Bookkeeping Case Study Page 4

5 Net tangible asset value plus an amount for goodwill equal to a percentage of gross revenue for the latest 12 month period. This method is used in the majority of sales of both large and small accounting practices. Net tangible asset value plus a variable amount for goodwill. Using this method the goodwill value is usually a function of the retained revenue base and is calculated as a percentage of the average gross revenue during a certain period subsequent to the closing date. The primary factors considered in concluding on a final value include the following: 3 Revenue composition: A practice which earns fees from recurring work such as audit and tax services will generally have a greater value than a practice which depends more on non-recurring work such as receiverships or litigation support. Size and location: The demand for practices of different sizes and locations is also an important aspect in determining the fair market value of a particular practice. Revenue multiples applied in the purchase of an established client base of a sole practitioner may, for example, exceed the amount paid for medium-sized multi-practitioner practices. This can occur when there is excess demand for one-owner practices from young qualified accountants. Practice profitability: In analyzing the profitability of a practice, the average number of hours a year worked by the current owner should be reviewed and compared to the fee structure of its competitors. Client base: Practices that are dependent on only a few key industries or clients are generally worth less than those with a broader base because of the lack of diversification risk. The likelihood of selling additional work to the client base is also a significant factor. As part of his research noted previously, the CBV also determines that the percentage paid for goodwill and/or client lists has generally ranged between 50% to 150% of annual gross fees, with higher percentages usually being paid in larger urban centres. In the case of a change of ownership in the largest accounting firms, however, they are generally never sold and instead merge with another firm. 3 Source: Valuing Professional Practices, James Horvath, CA. CCH. Bookkeeping Case Study Page 5

6 After having completed all of his necessary work CBV concludes on a final valuation estimate range of $90,000 to $120,000 calculated as follows: Estimated maintainable annual fee revenue of $300,000 Low end of range calculated at 30% $90,000 High end of range calculated at 40% $120,000 The CBV decides to use the lower end of the generally adopted percentages based in part, on the following factors: the limited long-term growth potential of Ledger Inc.; only minimal to moderate diversity in the client base; and slightly higher than average hours that Gail spends in managing her business. Bookkeeping Case Study Page 6

Bike Store Question. Introduction

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