New Wrinkles in Accounting for Customer Relationships: Accounting rules regarding these intangible assets often clash with business reality.

When buying a company, acquirers spend a significant amount of time on due diligence, valuation, financing, and planning for integration. Yet, despite a substantial discrepancy between how acquirers evaluate acquisition targets and how the FASB wants buyers to account for their acquired values, buyers generally review the transaction’s accounting requirements after completing the deal. Inasmuch as accounting is artificial, while business deals with real values and real cash flows, readers should realize that artificial accounting rules should not drive real business decisions. However, in order to avoid any unpleasant surprises, buyers should pay attention up front to the required accounting for intangible assets. This may involve a preliminary valuation exercise as part of the due diligence process. This article discusses the key differences between business reality and financial accounting, with an emphasis on complying with the rules regarding customer relationships set forth recently in SFAS 141 – the new approach to business combinations that superseded APB 16. In many ways SFAS 141 is a great improvement in accounting. The FASB eliminated pooling-of-interests accounting and told buyers that goodwill no longer had to be amortized. These are the pluses. The price that had to be paid was two-fold. Goodwill, while not amortized every quarter, must be tested annually for impairment. Second, the Board insisted that so-called identifiable intangible assets had to be recognized, valued, and amortized. Since the intangibles identified by the FASB for separate recognition include marketing, customer, and technology-based assets, and buyers already were interested in these aspects of the target, at first glance the Board seemed to have made the right decisions. However, the definitions the FASB outlined in SFAS 141 do not fully track what those in the m&a business use in their decisionmaking process. Listed below are several examples that show that the way the Board initially chose to define customer-related intangible assets actually resulted in most of these assets being included in goodwill. Buyers welcomed this, since future charges to earnings would be less. Nonetheless, it meant that readers of financial statements might not fully appreciate what the buyer really acquired. A good example of this is what is often referred to as the value of an assembled workforce, which is explicitly disregarded under SFAS 141. Virtually every public company, in its chairman’s letter to shareholders, has an obligatory statement to the effect that “our employees are one of our most valuable assets…” And it is probably a true statement. If all the employees of an advertising agency, or a law firm or a management consulting firm were to quit, what would the company be worth? Very little. Yet the FASB, claiming that the value of a workforce is hard to measure, said to disregard this asset for accounting purposes. Appraisal companies have been valuing assembled workforces for years, with little difficulty. So here is the first example of how SFAS 141 puts accounting purity ahead of economic reality. Now let’s look at the important area of customer relationships, since, in many cases, they represent a big asset in an acquisition. Unless a company had confidence that a significant portion of the target’s customers were likely to remain loyal, few m&a transactions would be undertaken. What would it profit a buyer to acquire lots of plants, products, and warehouses if customers left in droves the day after the purchase? Yet, with few exceptions, most customer relationships are informal and based on personal relationships, which is why an assembled workforce is so important. Sales representatives and customer service employees do bring in business! And they are likely to remain as employees, even with a new management team from the new owner of the firm. The FASB was uncomfortable with the concept of customer relationships based on habit and tradition. In issuing SFAS 141 the Board decided that, for accounting purposes, customer relationships either had to be based on legal rights in a contract or had to be severable and marketable on a separate basis. While this may make good accounting sense, it is a poor basis for investing millions, or even billions, of dollars in a merger or acquisition. Let’s look at how the FASB initially drafted SFAS 141, and the impact on accounting for business combinations. I will contrast the accounting approach with the business approach – the basis on which buyers make purchase decisions. Because this approach really did not work, the FASB, through its Emerging Issues Task Force (EITF), recently modified part of SFAS 141. Unfortunately, in the eyes of many observers, the new EITF rules are far from a good solution. What Does SFAS 141 Say? Paragraph 39 of SFAS 141 states: “An intangible asset shall be recognized as an asset apart from goodwill if it arises from contractual or other legal rights [emphasis added] (regardless of whether those rights are transferable or separable from the acquired entity or from other right and obligations). If an intangible asset does not arise from contractual or other legal rights, it shall be recognized as an asset apart from goodwill only [emphasis added] if it is separable, that is, it is capable of being separated or divided from the acquire entity and sold, transferred, licensed, rented or exchanged (regardless of whether there is an intent to do so)….For purposes of this Statement, an assembled workforce shall not be recognized as an intangible asset apart from goodwill.” Paragraph A20 states: “If an entity establishes relationships with its customers through contracts, those customer relationships would arise from contractual right. Therefore, customer contracts and the related customer relationships are intangible assets that meet the contractual-legal criterion.” Paragraph A21 states: “If a customer relationship does not arise from a contract, this Statement requires that the relationship be recognized as an intangible asset apart from goodwill if it meets the separability criterion. Exchange transactions for the same asset or a similar type of asset provide evidence of separability of a non-contractual customer relationship and might also provide information about exchange prices that should be considered when estimating fair value.” Many clients of Valuation Research Corp. have had issues interpreting the FASB’s intent with regard to customer relationships. In the real world there is a broad spectrum of customer/vendor relationships. Simply classifying them as either legally contractual or non-contractual, or separable or nonseparable, fails to provide a meaningful basis for understanding many long-established business relationships. At one end of the customer relationship spectrum would be long-term “take or pay” contracts, which are legally enforceable. At the other end would be a retail store, perhaps a greeting card store in a large mall, where all transactions are for cash and are totally anonymous. Consider the following examples of customer relationships: Coal company owns mineral reserves and has contracts with contract miners (customers) who also pay a royalty based on production. In this case, the owner of the reserves has neither the resources, nor the desire, to do the actual mining of the underground coal seams by itself. However, there are many contract-mining firms that do not own coal properties but do have the machinery and staff to mine coal. The contract calls for the miner to pay a royalty per ton mined, with a minimum royalty if there is no production (in order to force the miner to produce and hence pay royalties based on production and selling prices). With coal at present high-price levels, the likelihood of collecting revenue based on the minimums is negligible. The royalty rate is essentially a market rate, and the coal company can always find someone else willing to mine for the same royalty rate. In this instance, our firm valued the reserves, based on the present value of the expected future cash flows. In turn, the expected future cash flows considered the existing contracts, and the high probability that the other reserves, which have not yet been leased out, will in fact generate comparable amounts of cash as and when mined. In our professional opinion, the value was in the reserves, not in the contracts with the specific operators. This conclusion was based on the substantial number of operators available at any one time, plus the fact that the contracts called for market royalty rates. By valuing the reserves, we arrived at essentially the same value we would have if we had valued the existing contracts plus the high degree of certainty that the remaining reserves could be contracted out. We could not double-count both the reserves and the contracts, and it was our opinion that from an investor’s perspective, they would be more interested in the reserve quantities and values than in the specific contracts. Oil company has contract with dealers of leased stores; contract commits dealer to purchase company’s brand at market prices. In this example, the contract has value to the oil company in terms of “guaranteeing” sales of the product. On the other hand, given that gasoline is a commodity, whose price changes literally on a daily basis, there is no incremental profit over and above the normal margin obtained on sales of gasoline to any spot buyer. An oil company may, in practice, provide a bonus payment to the branded dealer if he meets certain minimum volume requirements over a certain time period. The commitment to pay these bonuses may in fact be a liability, not an asset. The valuation of the contract would be based on the costs foregone in developing dealers. In other words, the existing dealer contract means that the company can avoid trying to obtain a replacement. Therefore, the value to the buyer, relative to an allocation under SFAS 141, would be developed from recent marketing experience. How much is spent in a year on dealer recruitment? How many dealers are obtained? If one used two or three years’ historical experience, a supportable “cost per dealer obtained” could be derived. That unit cost figure, in turn, would be applied to all of the existing dealers as the value of the customer contracts. The life of the asset is probably limited because dealers do turn over. A relatively simple statistical or actuarial analysis can be performed on historical turnover; this history can probably be safely applied to the value of the current dealer contracts as derived above. Beverage company places a glass-front cooler in convenience stores in exchange for a commitment on the part of the storeowner to buy and display the brand in the cooler. There may or may not be a written contract, but assuming there is a contract, then the guarantee of sales through that store has value to the beverage company. Two major cola companies pay substantial sums to colleges to become the “official” drink supplier, and then only that firm’s dispensers are allowed on campus. Because beverages are not a commodity, as is gasoline, there is an operating profit that the guaranteed outlet provides. The difference is that if the oil company does not sell 10,000 gallons to one of its own stations, the same 10,000 gallons can be sold on the spot market. In the case of a beverage company, if Store A does not buy 15 cases of Brand A cola, it will buy Brand B cola instead. The 15 unsold cases of Brand A cannot be sold on any spot market, and the lost revenue and margin cannot be made up. For this reason, we would tend to place a significantly higher value on the customer relationship of the beverage company than we would on the gasoline dealer customer. At the marketing level, the margins on beverages are higher than on gasoline and there is no spot market on which to offload unsold product. The life of the customer asset, for the beverage company, would again have to be derived from historical experience. One would anticipate relatively long lives, essentially limited by the life of the business itself, e.g., the convenience store, since switching from one major supplier to another is probably relatively infrequent. Interestingly, the more usual relationship of a beverage company with its customer, say a major grocery chain, is not likely to be under a contract (no cooler is provided) and thus would not be captured as an “asset apart from goodwill.” This is discussed below with reference to a cookie manufacturer. TV station has advertisers who have advertising contracts. There is a contractual relationship between the station and the advertiser (or advertising agency), stating what will be charged for sponsoring a program or running spot ads at a certain time period. The more frequent the ads, the lower the rate. So, the contract essentially is a price schedule (for the station) and a cost schedule (for the advertiser). To the extent that the prices in the contract are essentially market prices, it would not appear that the contracts have a particularly high value. From the station’s perspective, they have saved on a certain amount of selling expense, but a typical contract would probably not force the advertiser to buy time if it chose not to. Only if the contract were on a “take-or-pay” basis would real value be ascribed to it. In the usual case, however, the advertiser can essentially void the contract simply by not requesting any more advertising time and not supplying the ad in a format suitable for transmission over the airwaves. The critical issue here is just what rights the television station can enjoy as a result of having a contract with the advertiser. Can the station take the advertiser to court, and obtain a judgment, if the advertiser stops advertising? Without an enforceable right, the contract has little value, other than possible savings in selling expense. Depending on how the contract is written, if it is little more than a price (cost) schedule previously agreed to by the parties, then the valuation for purposes of complying with SFAS 141 would, in our opinion, be nominal. Further, the life would be quite short because advertising plans shift quickly and there are very few long-term advertising relationships. Looked at another way, what is the likelihood that Procter & Gamble will be advertising on television over the next 10 years? It is a very high probability, but there are no 10-year contracts in television land. Cookie manufacturer has grocery store customers who place product on their shelves. A well-known brand, Oreo, has been sold for many years, is No. 1 in its category, and is likely to continue for many years to come. From the perspective of the owner of the brand, one of its greatest attributes is the shelf space that Oreo commands in almost every grocery and convenience store in America. It is truly a mega-brand. The customer relationship that the owner of the Oreo brand has with every grocery chain is that of vendor and customer, but with no contract requiring either the store to buy or Kraft to sell. Because it is mutually profitable, the relationship is likely to continue indefinitely. Does the relationship that Kraft has with a grocery chain have value? Is the availability of shelf space (the most valuable asset that a grocery store has) for Oreo valuable? Would a buyer of the Oreo brand consider that shelf space, and the overall relationship with the chain(s), something to consider in any purchase decision? In my opinion, that customer relationship is extremely valuable. But, according to the requirements of SFAS 141, the relationship that Kraft has with a grocery chain does not qualify for recognition as an “identifiable intangible apart from goodwill.” The reason is that there are no written contracts. A 50-year ongoing relationship is undoubtedly more valuable than the contractual relationship the beverage company has as a consequence of putting in a $2,000 cooler. Yet the latter is recognized as an asset and the former is not! Let us look very carefully at the FASB’s definition. In effect, in order to be recognized in financial statements, the intangible asset has to be contractual and/or separable. This definition now incorporated into GAAP may be good accounting but it is poor valuation practice. Consumer product manufacturers virtually never have contracts with their store customers, other than perhaps a short-term purchase order. A store can stop buying Oreo cookies any time it wants to. Kraft, in turn, cannot go to court and enforce any “legal rights.” It is these “legal rights” that are referred to in the first sentence of Paragraph 39, quoted above. But as long as a store is in business, the probability that it will continue to buy Oreo cookies is very high – virtually a certainty. But with the definition as written, we do not value the customer relationship under the first of the two tests. The second test, whether the relationship is separable, certainly does not apply. A grocery chain can always stop buying Oreo cookies but it cannot go to any other supplier and obtain Oreos, because Oreo is a trade name or brand owned by Kraft. Kraft cannot go to a store and say, “You now have to buy Oreo cookies from your new supplier, Nestle,” assuming for the sake of argument that Nestle bought Oreo from Kraft. In point of fact, when Kraft bought Nabisco, the owner of Oreo, most customers continued to buy, but they did that because of the strength of the brand not because of any contractual relationship with Nabisco. Finally, it is absurd to think that Kraft could go to a grocery chain and tell them that the shelf space for Oreos has been sold by Kraft and that it now has to stock apple pies in that location. It appears that the only type of customer-relationship asset that is truly separable would be a mailing list owned by L.L. Bean, for example. L.L. Bean can rent its mailing list to Lands’ End, and vice versa. So if one were valuing L.L. Bean under the SFAS 141 definition, the L.L. Bean mailing list would qualify as an “identifiable asset apart from goodwill.” A company can rent out its mailing list, obtain rental income, and still have the list for its own internal purposes. In short, the FASB’s definition of customer relationships that must be recognized, contrasted with those relationships that cannot be recognized, is arbitrary. Fortunately, or unfortunately, (depending on your position) some very valuable customer relationships will end up in unamortizable goodwill, and some less valuable relationships will have to be quantified, recognized, and then amortized. Accounting value here does not equal economic value. Money manager’s clients sign contacts to have their funds managed. Here we have a situation in which, as an example, a pension fund places its assets with a money manager, perhaps a bank trust company or an independent firm. There is a contract that says that as long as the client leaves his money with the firm the money manager will handle the investments (perhaps within predetermined parameters). In exchange, the client will pay the money manager a fee, either a percentage of assets managed or based on some sort of success factors. That there is a contract here is unquestioned. What is not so clear is whether the relationship, from the perspective of the money management firm, has any value. The issue is the fact that virtually all such contracts permit the client to withdraw the money at any time and place it under management elsewhere. The money manager has only one legal right. That right is to get paid for the period of time it was managing the assets. No more and no less. The contract only allows you to get paid through today, with no right to enforce future performance. While there is a piece of paper with two signatures, the contract itself provides no contractual or other legal rights. Thus, we read in Paragraph 39 that without enforceable “contractual or other legal rights” the customer relationship between the parties does not qualify for recognition. And if you then go to the second factor, separability, there is no question that a money manager cannot go to the client and tell him the following: “By the way, we are not managing your money any more and have sold your contract to a new firm that now is your new money manager! Please pay them from now on.” The client would undoubtedly say, “Fine, but we will make our own decisions, thank you very much.” In short, if the test of accounting recognition is an asset that arises from contractual or other legal rights, then if there are no rights, there should be no asset. If the asset resides in the rights, and the rights are worth zero, then the asset is worth zero. Perhaps the FASB did not mean to have this result. It may be an unintended consequence of the way SFAS 141 was drafted. On the other hand, as discussed above, there is a continuum of customer relationships and they had to make a decision somewhere along that spectrum. By putting the emphasis on contractual rights, it appears that a contract without rights (rights that are enforceable in some way) simply precludes accounting recognition. Finally, the concept of separability severely limits accounting recognition of customer relationships. In the final analysis, all customer relationships are people-based. People relationships are very hard to separate from the firm that employs those people. In industry after industry we hear, “Our product is [virtually] identical to our competitors’ products but we maintain our market share because of our customer service and the personal relationships our people have with the customers.” In these situations, the value of the relationships, whether contractual or not, is subject to the rules. Because they are really not separable, they fall outside of the SFAS 141 guidelines. Recent EITF Decisions The FASB’s definition of customer relationships, putting the emphasis on contractual relationships that are separable, has led to unintended consequences. Most companies that were acquired showed little, if any, amounts assigned to customer relationships and much more than expected assigned to goodwill. While CFOs may be pleased with the impact on future financial statements – goodwill not having to be amortized while customer relationships represented future charges to expense – the FASB wanted just the opposite. The FASB wanted to minimize goodwill and maximize the dollars assigned to identifiable intangibles, the major category of which is customer relationships. If the wording of SFAS 141 led to unanticipated consequences, there was only one thing to do: change the words! Because the FASB’s decisionmaking process is very time-consuming, it determined it would be easier to have the EITF issue an “interpretation” of SFAS 141, rather than issue a brand new Standard that would supersede SFAS 141. In October 2002, EITF 02-17: “Recognition of Customer Relationship Intangible Assets Acquired in a Business Combination” was issued. The EITF decided that renewals and other benefits associated with a customer relationship should be considered regardless of whether it meets contractual, legal, or separable criteria. In addition, the EITF decided that as long as a company had even a single purchase order from a customer on the closing date of the acquisition, then that met the “test” of a contractual relationship. Further, the value of the relationship would not be just the single order covered by the purchase order but all expected future orders. In other words, a single purchase order was enough to sweep in all future business, whether contractual or not. Application of this new rule seemingly changes some of the decisions discussed in this article. For example, for a money management firm, while the 60-day cancellation clause in the contract means that the firm cannot force its clients to continue to do business with it, the new rule forces companies to change the evaluation process of just what the relationship is and how long it will last. It will take probably another year before appraisers and accountants can sort through the impact of the new EITF rule. I will bring readers up to date at that time, using the same six examples, to provide continuity. Further, while EITF 02-17 deals with whether or not there is a customer relationship that must be measured, it does not provide guidance on how to value that relationship. The next article will discuss just what approaches appraisers are using. Suffice it to say that at this point I am finding that the value of the customer relationships may be less than feared, thus minimizing the impact on future expense charges. Nonetheless, readers should not underestimate the financial impact of EITF 02-17. There is now less goodwill and more dollars charged to customer relationships, amounts that must be written off over the first few years. Recommendations The FASB was faced with a difficult decision in writing SFAS 141. By not amortizing goodwill it wanted to ensure that companies followed the rules that all along have been in APB 16 and 17, but were not usually followed, with respect to intangible assets. It makes a big difference to reported earnings whether or not an intangible asset is recognized under SFAS 141 or is classified as goodwill. So the Board had to write rules for recognizing and valuing customer relationships, among other intangible assets. There is a tremendous range of customer relationships in an economy as diverse as that of the United States. There are long-standing relationships based on a handshake. There are short-term relationships with multi-page contracts drawn up by teams of lawyers, and everything in between. The FASB had to write some rules for which customer relationship assets had to be capitalized and which did not. Right or wrong, it wrote the SFAS 141 rule set forth in Paragraph 39, and explained in Appendix paragraphs A20 and A21. It chose to use a legal contract/separability set of criteria. This may have been right. Obviously, on second thought, the FASB thought that it had gotten it wrong, and then modified the rules with EITF 02-17. Whether we like the result or not, we are all being held to the Standard and EITF interpretation as written. It seems clear to us that a contract without enforceable rights does not generate an asset. Simply saying, “If I do the work, you will pay me” generates very little value. And saying that the agreement brings into the valuation equation all future work is not fully logical. An argument can be made that from the perspective of a buyer of a business with such contracts there is a small, but nominal, asset. The buyer is saving the selling expense that now does not have to be incurred on the engagements or work in progress; this, however, represents the maximum value that can be ascribed to the contract. The way SFAS 141 is drafted, and EITF 02-17 interprets it, gives a result that differs from the way companies were valuing customer relationships for taxes, prior to adoption of IRS Code Section 197. It differs from the real economics of m&a transactions. But SFAS 141, as modified, is the rule and has to be followed as written. The results, while at times counterintuitive, may be favorable or unfavorable. All I can suggest is: * In the initial due diligence for any acquisition, carefully examine the exact nature of existing customer relationships. Just because there is a written piece of paper that is headed “contract,” or some other word, you still must examine the rights and obligations of the party. A contract that essentially is executory in nature does not generate value at the date of closing of a merger or acquisition. * In the initial implementation and adoption of the new SFAS 142, dealing with goodwill impairment, the value of customer relationships may be critical in testing for impairment. Essentially, the greater the amount ascribed to such an intangible asset, the greater possibility of a goodwill impairment charge there will be. This is because the test involves determining the value of the reporting unit and subtracting the value of all tangible and identifiable assets to leave the residual as “implied goodwill.”‘ The greater the amount ascribed to customer relationships, the lower the amount of implied goodwill, given that the envelope is based on income and cash flows. The lower the implied goodwill, the greater the write-down. * In trying to project the balance sheet and income statement effects in future deals, close scrutiny of the target’s customer relationships may be highly worthwhile. Some customer relationship assets probably will have to be recognized and amortized over relatively short periods of time. The SEC is going to be scrutinizing allocations to ensure that goodwill is not being overstated and that all identifiable intangible assets are captured and properly valued. Alfred M. King is Vice Chairman of Valuation Research Corporation. Copyright 2003 Thomson Media Inc. All Rights Reserved. (http://www.thomsonmedia.com)