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When
buying a company, acquirers spend a significant amount of time on financing, due
diligence, and planning for integration. Yet, despite a substantial discrepancy
between how acquirers evaluate acquisition targets and how the Financial
Accounting Standards Board (FASB) wants buyers to account for their acquired
values, buyers generally review the transaction's accounting requirements after
completing the deal. In order to avoid any unpleasant surprises, buyers should
be paying attention up front to the required accounting for intangible assets,
in particular, customer-related intangibles. This may involve a preliminary
valuation exercise as part of the due diligence process.
Impact of SFAS 141
In Statement of Financial Accounting Standards (SFAS) No. 141, Business
Combinations, the FASB stated that the following categories of intangible
assets have to be recognized apart from goodwill: marketing-related,
customer-related, artistic-related, contract-based and technology-based.
Intangible assets that are identified must then be measured at fair value. The
following intangibles are included in the category of customer-related
intangibles: customer lists, order backlog, customer contracts and related
customer relationships, and noncontractual customer relationships.
SFAS
141 defines the term "customer relationship" as the following:
For purposes of this Statement, a customer relationship exists
between an entity and its customer if (a) the entity
has
information
about the customer and has regular contact with
the customer and (b) the customer has the ability to
make
direct contact with the entity. Relationships may
arise from
contracts (such as supplier contracts and service
contracts).
However, customer relationships may arise through
means
other
than contracts, such as through regular contact by sales
or
service representatives.
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-related intangibles either had to be based on legal rights in
a contract or had to be severable and marketable on a separate basis. While the
FASB had to come up with criteria for which intangibles should be recognized
apart from goodwill, the separability or contractual criteria fails to capture
the complete spectrum of customer/vendor relationships.
The
way the Board initially chose to define customer-related intangible assets has
resulted in most of these assets being included in goodwill. While buyers may be
pleased with this result since future charges to earnings will be less, readers
of financial statements might not fully appreciate what the buyer really
acquired. After the issuance of SFAS 141, the FASB decided to issue an
"interpretation" of SFAS 141 to address questions concerning the
application of paragraphs 19-21 to customer-related intangibles including order
or production backlog, customer contracts and related customer relationships,
and noncontractual customer relationships. In October 2002, the Emerging Issues
Task Force (EITF) issued EITF 02-17, "Recognition of Customer Relationship
Assets Acquired in a Business Combination."
Decisions From the EITF
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 meets the "test" of a contractual
relationship. Further, the value of a 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.
The
EITF determined that although customer lists do not arise from contractual or
legal rights, they can be rented or sold and therefore fit the separability
criteria for recognition apart from goodwill. If there is a restrictive
agreement as part of an acquisition which prohibits the company from selling or
renting the lists, the lists would not qualify as being separable. In the case
of customer contracts, regardless of whether there is a restrictive agreement as
part of an acquisition which prohibits the company from selling or renting the
lists, they should still be valued. The valuation method should be based upon
facts and circumstances, and the income and cost approaches were recognized by the
EITF as the most common approaches to use.
SEC
Scrutiny
One
final note about intangible assets, we have been finding in recent engagements
that the SEC is scrutinizing intangibles with indefinite lives. One of our
clients had a distributor network classified as having an indefinite life. We
had calculated for the client the cost to replace the distributor network. The
SEC went back to the client and asked for opportunity costs in addition to the
replacement costs previously provided. We then determined the cost to recreate
lost business opportunities.
In
conclusion, most transactions will have customer relationships that need to be
valued. Our recommendation is for the company to obtain an estimate of the value
of the intangible assets and goodwill prior to an acquisition. As
a buyer, knowing the value of the underlying assets will allow you to determine
whether or not a proposed acquisition will be accretive to earnings per share.
For further information regarding customer-related intangibles, contact your Valuation Research representative or PJ Patel at (609)
243-7015. VR
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