Customer relationships form a key intangible asset for firms operating in many industries. Firms devote significant human and financial resources in developing, maintaining and upgrading customer relationships. In some instances, supply or customer contracts give rise to identifiable intangible assets. More broadly, however, customer related intangible assets consist of the information gleaned from repeat transactions, with or without underlying contracts. Firms can and do lease, sell, buy or otherwise trade such information, which are generally organized as customer lists.
The Appraisal Practices Board of The Appraisal Foundation originally released a discussion draft of a document entitled “The Valuation of Customer-Related Assets” in June 2012. The draft, authored by the Working Group on Customer-Related Assets, provides best practices guidance on the valuation of customer-related intangible assets. A subsequent exposure draft was released in December 2013. A final version of the document is pending. This article, drawing in part from these documents, examines attributes of customer-related intangible assets and their valuation.
Three key attributes are important in considering the value of customer-related intangible assets:
- The expectation of repeat patronage creates value for customer-related intangible assets. Contractual customer relationships formally codify the expectation of future transactions. Even in the absence of contracts, firms look to build on past interactions with customers to sell products and services in the future. Two aspects of repeat patronage are important in evaluating customer relationships. First, not all customer contact leads to an expectation of repeat patronage. The quality of interaction with walk-up retail customers, for instance, is generally considered inadequate to reliably lead to expectations of recurring business. Second, even in the presence of adequate information, not all expected repeat business may be attributable to customer-related intangible assets. Some firms operate in monopolistic or near-monopolistic industries where repeat patronage is directly attributable to a dearth of acceptable alternatives available to customers. In other cases, it may be more appropriate to attribute recurring business to the strength of the trade names or brands.
- Customer-related intangible assets create value over a finite period. Without efforts geared towards continual reinforcement, customer lists dwindle over time due to customer mortality, the ravages of competition, or the emergence of alternate products and services. The mechanics of present value mathematics further erode the economic benefits of sales to current customers in the distant future. Customer relationships are wasting assets whose economic value deteriorates with the passage of time.
- Customer-related intangible assets depend on the existence of other assets to provide value to the firm. Most assets, including fixed assets and intellectual property, are essential in creating products or providing services. The act of selling these products and services enable firms to develop relationships and collect information from customers. In turn, the value of these relationships depends on the firms’ ability to sell additional products and services in the future. Consequently, for firms to extract value from customer related assets, a number of other assets need to be in place.
Why Value Customer-Related Assets?
The need for the valuation of customer-related intangible assets for financial reporting purposes may arise in primarily two contexts:
- Acquisition accounting. Following business or asset acquisitions, ASC 805 Business Combinations requires firms to recognize and measure the fair value of acquired identifiable assets, including any customer-related intangible asset. Certain exceptions for private companies may be available.
- Impairment testing. ASC 350 Intangibles – Goodwill and Other currently mandates a multi-step goodwill impairment test to be conducted (at least) annually. Under Step 1, firms measure the fair value of the reporting units being tested. If the carrying amount of a reporting unit exceeds its fair value, Step 2 of the test is triggered. Step 2 requires firms to measure the fair value of all identifiable assets, including any customer-related intangible asset, of the reporting units. However, the FASB is considering the elimination of the Step 2 requirement.
Additionally, ASC 360 Property, Plant, and Equipment sets forth the procedures for impairment testing of long-lived assets (including any customer-related intangible asset) held and used, or assets held for sale or disposal.
Fair value, for the purposes of both acquisition accounting and impairment testing, is defined in ASC 820 Fair Value Measurement as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
In particular, fair value is defined from the perspective of market participants rather than a specific party. Accordingly, valuation of customer-related intangible assets should be based on market participant assumptions.
Valuation methods generally fall into one of three approaches: cost, market or income.
- Valuation under the cost approach requires estimation of the cost to replace the subject asset, as well as opportunity costs in the form of cash flows foregone as the replacement is sought or recreated. The cost approach may not be feasible when replacement or recreation periods are long. Therefore, the cost approach is used infrequently in valuing customer-related assets.
- Use of the market approach in valuing customer-related assets is generally untenable because transactional data on sufficiently comparable assets are not likely to be available.
- Under the income approach, fair value estimates are based on cash flows that an asset is expected to generate in the future. In practice, customer-related assets are valued most commonly using the multi period excess earnings method (MPEEM) under the income approach. Other techniques include the distributor method, the with-and-without method, and the differential cash flows method.
Applying the Multi-Period Excess Earnings Method
MPEEM involves estimation of the cash flow stream attributable to a particular asset. The cash flow stream is discounted to the present to obtain an indication of fair value. The most common starting point in estimating future cash flows is the prospective financial information prepared by (or in close consultation with) the management of the subject business.
In applying the MPEEM to customer-related assets, valuation professionals first identify the portion of prospective revenues that is expected to be generated through repeat business from customers existing at the valuation date. It is often useful to examine estimated future revenue as the product of revenue per customer and the number of retained customers. Fair value measurement requires that valuation professionals consider prospective revenue from a market participant perspective and exclude any firm-specific synergies that may be embedded in the prospective financial information prepared by management.
As discussed earlier, customer-related assets derive value within a finite period as the numbers of customers that provide repeat business can be expected to decline over time. Good estimates of expected attrition can be obtained by conducting statistical analyses of historical customer turnover and revenue growth rates. When historical customer data of sufficient quality is not available, it may be necessary to rely on management estimates or an examination of industry characteristics in developing customer attrition rates.
After the identification of prospective revenues attributable to the base of customers existing at the valuation date, valuation professionals estimate earnings based on expected profitability of the business. It is important to consider only the operating costs relevant to the base of existing customers from a market participant perspective. Marketing costs that are expected to be necessary in finding new customers and firm specific cost synergies, for instance, are not relevant in projecting earnings on expected revenue from existing customers.
Cash flow attributable to the customer-related asset is isolated from the estimated earnings by assessing contributory charges for other assets of the subject business. As discussed earlier, a number of other assets need to be in place for firms to extract value from customer related assets. The contributory charges represent economic rent equivalent to returns on and returns of assets necessary to produce goods or services marketed to the customers.
Mercer Capital has valued customer-related assets to the satisfaction of clients and their auditors across a multitude of industries. Please contact us to explore how we can help you with acquisition accounting or impairment tests.
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