Community Benefit and the Cost Approach

May 27th, 2011 | Cost Approach | Income Approach & Methods | Regulatory Matters | Valuing Goodwill

Another no go. I thought looking at recent IRS EO Division discussions of the Community Benefit Standard in physician practice valuation and acquisition would be helpful in resolving the abuse of the Cost Approach. The White Paper at http://www.cpa.net/2011/02/white-paper-on-the-cost-approach/ was just published by the AHLA Hospitals and Health Systems section.

The 2004 EO Text available at http://www.irs.gov/pub/irs-tege/eotopicc04.pdf contains a discussion entitled Meeting the Community Benefit Standard. A subset of that discussion is Hospital Purchase of Physician Practices. That section states as follows:

“When the purchase involves significant amounts of money, the organization should be in a position to justify the terms of the purchase through, for example, timely valuation of the assets purchased. Such valuations help ensure the hospital has not overpaid. See Article Q, Valuation of Medical Practices, in the FY 1996 CPE text for a discussion of acceptable valuation methods.”

Thus, the 1996 text on valuation was still the standard in 2004. The 1996 text is available at http://www.irs.gov/pub/irs-tege/eotopicq96.pdf. It discusses in considerable detail the approaches to valuation. The discussion of the Cost Approach states as follows:

“B. How Is BEV Determined?
A valuation appraisal should include all recognized approaches for estimating BEV, including the market approach, cost approach, and income approach. The income approach is generally employed in IDS cases, because it includes the “excess earnings method” described in Rev. Rul. 68-609, 1968-2 C.B. 327, and approved for the valuation of intangible assets acquired by exempt organizations in Rev. Rul. 76-91, 1976-1 C.B. 149. Valuation analysts general favor the income approach in appraising physician practices.”

“While BEV may appropriately be measured using the income approach, it is important to note that the approach (which includes a number of different methodologies) frequently depends on assumptions made about future events; information upon which the assumptions are based is under the control of the parties – who may not be dealing at arm’s-length – and is often difficult to verify. Different assumptions can result in different values. Thus, the factual assumptions upon which such a valuation is based should be reviewed carefully to ensure that they are realistic, and if the valuation uses the income approach, it should be confirmed, if possible, by the cost and market approaches. Requiring that multiple approaches be used is consistent with the statement in Rev. Rul. 68-609, supra, that “[t]he formula [income] approach may be used for determining the fair market value of intangible assets of a business only if there is no better basis therefor available.”

“The value of intangible assets is particularly difficult to measure, and it is with respect to valuation of intangibles that inflation of value is most likely to occur. Valuation of intangibles is made even more complicated by the fact, referred to in Part 2-B, above, that valuation analysts are constrained from assigning value to the anticipated indirect revenues from referrals. Often, the same value is assigned to other intangible assets.

C. “Allocation” Valuation
Once arrived at, BEV is allocated among the assets comprising the business enterprise. The individual assets are valued, using appropriate methodologies; the aggregate value of the individual assets thus arrived at should equal the BEV.”

Thus, for purposes of measuring Community Benefit the IRS division charged with that task specifies use of the Cost Approach only to ALLOCATE intangible value determined under the Income Approach and as a safeguard against valuing indirect referrals; it even suggests that the value of those referrals is often ascribed to other intangible assets.

There is also the following statement:

“Retained Rights A review of the underlying documents is necessary to determine if there is retained authority over the use of the assets by the seller. For example, the right to direct future affiliations with other medical practices, the right to hire additional physicians, or the right to repurchase a medical practice (other than a right of first refusal) may effectively limit the ability of a hospital to utilize its assets to further exclusively charitable purposes and also reduces the value of the assets.”

“Retained rights can usually be found in the asset purchase agreement, but they can also be in a professional service agreement or employment contract.”

Simply stated “terms make the deal.” You cannot do a valuation without looking at the transaction documents, a principal clearly enunciated in Derby.

Here is the document: eotopicq96

Once again, there is no authoritative support for sole reliance on the Cost Approach and that applies to Community Benefit as well.

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