Roll-up companies include--

* Cornerstone Professional Advisors. Cornerstone was established by BGL Capital Advisors to integrate accounting and related business and professional services. One of its founders is Robert Basten, a former president of American Express Tax and Business Services.

* Integrated Professional Services (IPS). IPS is in the process of establishing partnerships with professional service firms in regional markets prior to a roll up into a public offering. According to IPS, this strategy will allow the IPS professional service firm partner to achieve an operating history prior to being in the public marketplace. Hyperion Partners, a private equity fund, provided the initial funding to IPS.

* Allegis Group Inc. Financed by Parkway Capital, LLC, through a commitment of $50 million of equity capital from its sole member, Aerotek, Inc., Allegis intends to be a provider of business solutions, targeting primarily small to mid-sized business. Allegis' business plan calls for the acquisition of a "core group" of professional-services businesses, which will provide the platform for an initial public offering.

Franchisers

Franchisers, in exchange for a fee, offer a basket of services such as group advertising, a widely recognized name, and group purchasing. CPA firms offer tax services under the franchiser's banner, yet operate more or less autonomously. Franchise companies include--

* Jackson Hewitt (part of HFS Inc.). Hewitt is a tax preparation and business service franchiser. The acquisition by HFS will allow for cross-marketing opportunities with HFS brands such as Century 21, Avis Rent-A-Car, and Providian Auto and Home Insurance Companies and businesses such as fuel card and vehicle management, lodging, time-share services, mortgage services, relocation services, and mutual funds. Jackson Hewitt is ranked 16th in size in the 1998 Accounting Today Top 100 Tax and Accounting Firms.

* Padgett Business Services. Padgett is a network of locally owned and operated offices across North America specializing in accounting and tax services. Padgett is ranked 35th in the 1998 Accounting Today Top 100 Tax and Accounting Firms.

* Peoples Income Tax Inc. Based in Richmond, Va., and primarily in the tax preparation business, it formed a wholly owned subsidiary, Peoples Inc., to be a franchising company that eventually intends to go nationwide.

* Triple Check Income Tax Services. Triple Check is a privately held tax preparation and business service franchiser. It has franchise relationships with CPA firms, but the CPA firms remain independent of Triple Check.

Affiliations

There are a vast number of organizations seeking to affiliate with CPA firms to form strategic alliances. They come in all shapes and sizes, and there are wide-ranging differences in how each develops its relationship with CPA firms; the basic concept is one of referrals and fee sharing. See Exhibit 3 for a list of companies in this category.

Other Players

Neither a consolidator nor franchiser, Gilman+Ciocia is a publicly traded company, based on Long Island, N.Y., that specializes in offering income tax and financial planning services to primarily middle- and upper-income customers in 15 states. The company is ranked 49th in the 1998 Accounting Today Top 100 Tax and Accounting Firms.

In addition to the above structural models, there are a number of service companies that are merging and partnering to provide an array of services. Some of the recent combinations and affiliations are as follows:

* ADP's purchase of Staff Management Services (TotalSource)

* Paycheck's purchase of National Business Solutions

* Unisource's purchase of Interlogic Systems

* Liberty Mutual's partnership with Staff Leasing

* American Express's investment in Adminstaff.

Why is Consolidation Happening?

Consolidators see the trend for the delivery of services from fragmented markets with many providers into a few larger entities. Not unlike the banking, insurance, and office supply industries, consolidation in the accounting profession is natural. But, why is it happening in the accounting profession now? What is motivating accounting firms to sell out?

* Lack of succession planning. The management of many firms remains in the hands of the founding partners. When founding partners begin to think of retirement, they often see a paucity of capable management ready to take over and run the firm. Also, many CPA firms have not provided for or funded retirement benefits for the partners. As a result, retiring partners are dependent upon selling the practice to existing younger partners. Partners now see an opportunity to avoid placing their retirement in the hands of untested, younger partners by selling out to public companies with deep pockets.

* Loss of core business. Surveys reveal that traditional auditing and accounting services have been on an even keel over the last several years with prospects for declines in the near future. New markets and new relationships are being sought by firms to replace declining revenues.

* Human resource issues. According to an AICPA 1998 Top Five MAP Issues poll, the top issue for the last several years has been finding, hiring, and retaining quality staff. Consolidators have the potential to attract talent by offering greater benefits than are normally associated with public and highly capitalized entities.

* Technology and capital requirements. Firms increasingly need to have the latest hardware and software, and it is becoming more and more expensive to keep up.

* Outsourcing is becoming an acceptable way to operate functions previously done internally. This could lead to the expansion of CPA services and a formula to generate new revenues.

* Increasingly complex regulations.

How Much is a Firm Worth in the Mind of a Consolidator?

Consolidators value a firm based on various factors:

* Profitability. Consolidation candidates are generally firms that operate within a profitability range of 30­40% of revenues before partner compensation. Consolidators indicate that if the profitability range falls below 30%, it is difficult to put together an adequate compensation package for the partners of the firm.

* Growth potential. A firm should be able to develop a growth strategy of 7­8%.

* Management of the firm. Consolidators are looking to the CPA firm management to make the business work and grow. The nature of the arrangement would be affected if the managing partner is seeking a retirement strategy.

* The chemistry or the right mix of individuals.

* Is the firm a lead firm or a "tuck-in" firm? After acquiring a first-tier firm and establishing regional operations, consolidators look to smaller, niche market or tuck-in firms.

* Leverage. Formulas such as total revenue per employee, per partner, or total employees per partner are examined for possible leveraging.

* Margin. Net income before owners' compensation divided by net revenue is typically used as a measurement guide.

* Other intangible factors. Is the firm dominant in its markets?

Consolidators say that not all firms are candidates to become part of the consolidation family. Deals sometimes don't make it because of emotional issues, economics (not a win/win situation for everyone or unreasonable expectations), not sharing the same philosophy (i.e., long-term goals), and the inability of a firm to execute the consolidator's philosophy.

What's in It for the Consolidators? Consolidators seek to leverage the trust accounting firms have established with their clients to build a nationwide network of financial services. They wish to take advantage of and leverage--

* one-stop shopping

* shared resources (staff, etc.)

* best practices

* cost containment and economies of scale.

What's in It for the CPA Firm? For the firm that joins the consolidators group some perceived benefits are--

* an opportunity for the firm to grow nationally

* an ability to provide related and complementary services and strengthen ties to clients

* access to capital for technology needs

* elimination of partners' personal liability for bank loans, leases, retirement programs, and other personal guarantees

* enhancement of profitability through economies of scale

* ability to defer taxable gain on any stock portion of the merger transaction.

How Does it Work?

The consolidator formulates a contract price for the purchase of firm assets--its customer base and goodwill--with future payments that are contingent on the firm attaining certain financial goals. Cash or stock is paid to acquire assets (accounts receivable and work in progress) and goodwill, with the value of goodwill varying depending on the firm and circumstances.

According to HRB President Terrance E. Putney, "Asset transactions are generally worth about 20% more than stock transactions because the amortization is deductible." CBIZ's consolidation model uses a combination of cash and restricted stock, with more than 50% stock. CBIZ uses both purchase and pooling accounting, depending on the circumstances of the acquisition. Pension obligations of the acquired CPA firm are presumably funded from the purchase price.

When a firm is acquired, the CPA firm continues either in its present form or as a newly formed distinct legal entity, with the firm name generally remaining the same. The CPA partners are the sole owners of the CPA entity, which continues to provide all the attestation services. The owners of the CPA firm supervise the attest engagements and issue auditor's or accountant's reports in the name of the CPA firm. The CPA firm sets its fees, approves billings, and is responsible for the collection of its own fees. The CPA firm and the owners bear all risk of loss for services rendered.

According to Jeffrey L. Saltzer, senior managing director of Saltzer Lassar Piccinnini & Company LLC, CBIZ's first acquisition of a CPA firm in New York, "The thorny issues become what do you do with clients that are on an annual retainer and for which you are performing both attest and nonattest work, which is fairly typical." The attest firm will remain owned by its current members and all other services will be completed by a business services and consulting entity that is a wholly owned subsidiary of CBIZ.

"The economic checks and balances of the marketplace will help maintain the separation and distinction that both the industry and the State Education Department demand," Saltzer said. "The structure provides that the attest firm be profitable, which is the goal of the existing owners/members to whom those profits would belong. Likewise, Century wants a minimum percentage return on its investment in the nonattest activities. This arms-length goal of profitability by unrelated owners should function to help ensure that this dual system allocating one charge for both types of services is fair and justifiable."

Managing partner Jerome A. Harris, CPA, of Checkers Simon & Rosner (CSR), a firm that consolidated with TBS in 1997, said separate books of accounts are kept for both entities and funds are not commingled. Harris also stated that the attest practice under the new arrangement is no different than previous practice. The CPA firm "develops the audit programs, supervises the work, makes the judgment calls ... and issues its reports." Further, "CSR owns and controls the workpapers of the attest practice."

Under the consolidation arrangement, the partners (or owners) and employees of the CPA firm become employees of the nonattest entity. HRB's structure provides for some professional staff to remain employees of the CPA firm, while others become employees of the nonattest entity. HRB's rationale focuses on an employee's requirement to have working experience with a CPA firm in order to meet the regulatory experience requirements to become a CPA. The CPA owners make decisions regarding the organization of the CPA firm, including the form of entity, admittance or termination of owners, operating procedures, and other ongoing governance issues. That is not to say, however, that some consolidators don't have standardized procedures that their affiliated CPA firms use for performing attest engagements.

Nonattest services are provided through one or more subsidiaries of the acquiring firm, sometimes referred to as a management, consulting, or professional service company. Services typically rendered are tax compliance and planning for businesses and individuals, accounting, management consulting, and personal financial planning. When both the CPA firm and service company provide services to the same client, separate engagement letters are obtained. The two entities communicate their separate identities by using separate letterheads and logos and by marketing their products independently.

The CPA firm and the service company are connected through a management service agreement that defines the responsibilities each has to the other. The service company provides administrative management, infrastructure, capital, and facilities to the CPA firm and leases employees to the CPA firm to perform attest functions. The CPA firm has the right to hire its own personnel or lease employees from any outside firm. The CPA firm enters into a lease agreement for use of the service company's facilities (office space and equipment). The goal of the consolidators is to have the clients work with both entities simultaneously as seamlessly as possible, while maintaining separate legal identities.

Compensation of the CPA owner comes in two forms: salary and other compensation as an employee of the service company based on goals fixed by the local office, and a share of the profits of the CPA firm. According to the consolidators, the total compensation of the CPA firm owners is initially designed to maintain prior levels or may be adjusted downward by 20­25%. Owners are evaluated on a performance-based system, with high performers generally receiving higher compensation.

The consolidator's infrastructure backs up both entities by providing access to other services that the consolidator group as a whole would provide to all of its clients--investment services, life insurance, credit sources, and the like. Consolidators have indicated that there are no requirements to refer business and services to the consolidator's family of services. TBS has stated its policy is not to share client lists and records, require client referrals, or require CPAs to sell products. HRB has structured its organization to establish a council of partners (board of directors) to have policymaking and strategic initiative responsibilities within the organization on a permanent basis. But to the extent there is no prohibition in professional standards or the code of conduct, referrals within the group of companies are encouraged and expected. In New York, the Board of Regents rules prohibit the obtaining of clients (by the CPA firm) through any corporation or business used as a feeder.

Independence Implications

Now that some CPAs may be wearing two hats to serve the same clientele, is the CPA's independence, integrity, and objectivity compromised? The same individuals--employees of the service company--are doing both the attest and nonattest services, albeit in the name of two separate entities. A sizable portion of the fee that is charged by the the CPA firm for attest services ends up with the service company as payment for various services provided to the CPA firm. The issue of independence and the question of who in fact is practicing public accounting will ultimately be determined by the various jurisdictions in which the consolidators operate.

As a result of the CBIZ acquisition in 1996 of SMR & Company, an accounting firm headquartered in Cleveland, Ohio, the Ohio State Board of Accountancy set forth its interpretation of the statutes and rules that must be observed to permit licensees of the board to operate within the CBIZ framework. The Texas Society of CPAs recently requested an opinion of the Texas State Board of Public Accountancy regarding alternative business structures.

When TBS acquired the nonattest assets of Goldstein Golub Kessler & Company, P.C., its first acquisition of a New York­based CPA firm, the State Education Department of New York State (SED) wrote to TBS, setting out similar rules of practice. SED's letter stated that "to assure that the CPA firm has sufficient independence to provide attest services, TBS and its affiliated entities will agree that they will not enter into certain specified prohibited business relationships [as defined] with any of the attest clients of the CPA firm, provided that the CPA firm has notified TBS of its relationship with such client. The CPA firm will agree with TBS that it will inform all of its clients that it is not part of TBS." A full copy of that letter can be found on the website of the New York State Society of Certified Public Accountants at www.luca.com/sedtbs.htm.

The SEC, recognizing the potential problem with public companies, is investigating whether accounting firms that consolidate with a public company are in violation of existing independence rules. The SEC has turned the issue over to the Independence Standards Board for resolution. The ISB's Issues Committee took on the project and released an Issue Summary on Alternative Practice Structures (98-2), which is being used by the Issues Committee in formulating a recommendation to the ISB. The issue summary and an analysis of current rules are available on the ISB's website (www.cpaindependence.org).

The Future

As the new millennium approaches, the accounting profession faces major changes and decisions. The profession is entering a conglomerate atmosphere as the need to provide other types of services takes hold. The profession is in transition; but all is not doom and gloom.

Consolidators are beginning to go head-to-head in a major way. With HRB's latest acquisition, Chicago has become the first major market where HRB Business Services, American Express Tax and Business Services, and Century Business Services are competing against each other.

Is consolidation the only way to go? Many don't think so. Some firms will choose to stay autonomous and compete from their strengths, while others believe that the current pace of consolidation would finally result in 60% of the accounting profession being consolidated. What about the remaining 40%? Where will they be in the future?

Firms have admittedly done well in recent times and seem to have recovered from prior droughts. The grapevine has it that consolidators are offering from .85 to 1.5 times annual revenues to purchase a CPA firm practice. If firms are doing that well, why would they sell out for a few years of profit? For those 40% of firms that continue in their present structure, the rewards may very well be great. Whatever the choice, with innovation and adaptation, the CPA profession should be financially rewarding into the future. The opportunities are there. Firms must make the choice. *

Anthony J. Mancuso, CPA, is Director of Accounting and Auditing Services for the New York State Society of Certified Public Accountants and an editor of The CPA Journal. Prior to joining the Society, he was a partner in a national CPA firm.