Preparing for transition
AICPA Supports the Cost Approach to Valuing Health Care Businesses
There has been significant debate among health care appraisers over the use of the cost approach to value health care businesses in cases where the business does not show earnings (e.g., professional practices where owners generally take out all of the earnings as compensation).
But a newly published white paper from the American Institute of Certified Public Accountants (AICPA) attempts to settle the debate by endorsing the cost approach method for this specialized situation.
The AICPA’s business valuation committee issued Intangible Asset Valuation — Cost Approach Methods and Procedures in March 2014 after putting out a draft two years earlier. It primarily addresses intangible asset valuation for the health care industry.
According to the authors of the document:
Health care is an example of an industry in which intangible asset valuations are particularly common. This may be due to the fact that there are so many transactions between for-profit entities and not-for-profit entities in the health care industry. Such transactions typically involve regulatory compliance issues. This may also be due to the fact that health care entities are intangible asset intensive.
Background for the debate
In general, the debate among health care appraisers divides into two camps. Those who believe that using the cost approach to value intangible assets is incorrect argue that neither the intangible assets nor the business enterprise, beyond its tangible assets, can have value if the business does not generate adequate earnings (known as the “residual method”).
Specifically, the residual method states that if you completed an income approach and then subtracted the value of the business determined using the cost approach (the asset accumulation method), you would have to reduce the value by any resulting negative amount. Consequently, the final value calculated under the cost approach would always equal the value calculated under the income approach. For businesses with no earnings, the value would be zero, or it would be limited to the value of property, equipment, and other tangible assets.
In contrast, appraisers supporting the cost approach to value intangible assets say that these assets exist and have economic value in the marketplace, similar to tangible assets (such as property and equipment), and can be valued independently of business earnings. The issue is especially complicated by health care’s regulatory environment, which prohibits nonprofit organizations, and any health care providers receiving payment under federal programs such as Medicare and Medicaid, from entering into transactions that are not at fair market value.
Whether or not it is consistent with valuation theory, taking the position that the cost approach cannot be used, unless there are sufficient business earnings, is the most conservative approach. In most instances it is unlikely that a regulator would take issue with paying only for the tangible assets, or less-than-fair market value — though paying less-than-fair market value might also technically violate health care regulations.
Arguments for the cost approach
According the white paper, the common reasons to value a commercial intangible asset are:
- Regulatory compliance and corporate governance: estimating the fair market value of the intangible asset sale, license, or other transfer between a for-profit and a nonprofit entity
- Performing the fair market value (asset-based approach) valuation of a going concern business enterprise to be sold between a for-profit and a nonprofit entity
Because sections of the document are subject to interpretation, we contacted contributing author Robert F. Reilly for clarification on whether the cost approach could be used as the primary method to value either individual intangible assets or a business enterprise without also relying on an income approach. His response below refutes the residual method.
… there are at least two reasons not to calculate economic obsolescence based on the residual method (i.e., income approach value – cost approach value = economic obsolescence). First, each valuation approach should be performed independently. That is, an analyst should be able to complete a cost approach analysis independently from, and without ever having to perform, an income approach analysis. Second, if the analyst uses the residual method, there is no reason to ever perform a cost approach analysis. In the residual method, the cost approach value is “forced” to equal the income approach value. Therefore, there is no reason to pretend to perform replacement cost new less depreciation (RCNLD) procedures when the final adjustment will “force” the RCNLD value to be exactly the same as the income approach value.
Neither Reilly nor many of the AICPA members who reviewed the white paper spend most of their time in the health care industry. As a result, they may not be actively involved in the debate among full-time health care appraisers, and most likely have not developed firm positions on the subject as it relates to health care. To that extent, they act as a neutral party to the debate.
You could also argue that because they do not spend most of their time in the health care industry, they do not understand the nuances that would prohibit the use of the cost approach. Nevertheless, it would appear that, based on Reilly’s credentials and review of the white paper by AICPA committee members, use of the cost approach is appropriate for all industries, even if some appraisers would not use it as a primary method in the health care industry.
Cost approach and the potential for abuse
Whether or not an appraiser uses the cost approach when valuing health care transactions, and physician practices in particular, it does not end there. Concurrent with the appraisal of the business, the fair market value of physician compensation must also be determined. Under health care regulations, physician compensation must be at fair market value whether or not it results from the acquisition of a practice, if doctors are otherwise in a position to refer patients to federally funded government programs.
The potential for abuse is real for hospitals, health systems, and other providers desperate for the patient referrals these physicians and their businesses can provide. As a result, it is understandable why some attorneys and appraisers would chose to take a conservative position and not use a cost approach.
The white paper is an exclusive AICPA member benefit, but anyone can purchase the Guide to Intangible Asset Valuation by Reilly and Robert P. Schweihs, which includes a chapter that covers substantially the same information as the white paper. In addition, appraisers at CliftonLarsonAllen who specialize in health care can also help you understand your unique valuation situation.