February 7, 2023
In an almost unnoticed motion in March 2022, the FASB took position against counting customer relations as intangible assets, but rather subsuming them into goodwill. CFODIVE and Thomson Reuters reported. In my view, this is not a very good idea, for a number or reasons. Thinning out purchase price allocations for customer relations would leave not more than a stump.
Customer relations are the single most important class of intangible assets of businesses by far, and in all different aspects – their size, their frequency, and their growing importance. 87% of all business combinations report a customer relation asset, which accounts for 25% of enterprise value on average, much more than for any other class of intangible assets. It is fair to say that a major part of corporate acquisitions is made for the customer relations of the target. For more information, read this article.
FASBs concerns involve the question whether customer relations involve contractual rights to a future economic benefit. According to FASB members, non-contractual “hoped-for future sales” are not tangible enough to qualify as a separable intangible asset and would better be subsumed under goodwill.
Customer relations do not constitute an owner’s right – any customer is free to terminate and to choose another supplier -, and they almost never do guarantee future sales. In essence, the question is about risk, and all future business is risky. Looking at all different intangible assets, there is only one which meets FASBs requirements: order backlog. Here, there is a both a contract and a contracted volume at a fixed price; both seller and buyer are bound to this future transaction. It is a guaranteed business. (Still, it can fail, i.e. if the buyer goes bankrupt).
Beyond backlog, all other intangible assets do not meet FASBs requirements. Looking for example at contractual customer relations, and the “guarantees” contained in them, which FASB seems to favor. Any customer contract involves a volume – which can be fixed, open or contain a minimum. Also, it involves a term – which again can be fix, automatic renewal or explicit renewal. In any case, a contract can be terminated or not renewed, its remaining life is “at risk”. In almost all cases, the guaranteed future volume of a customer contract is rather small, compared to its “hoped-for” future volume.
I can’t see much difference between contractual and non-contractual customer relations. For both, their value depends on an accurate and reliable projection of historic customer behavior (volumes and renewals) into the future. For both, the prerequisite for valuation is that data on such historic customer behavior is available for projection. Regarding separability, I can’t see much difference either. Both – contractual and non-contractual – customer portfolios are bought and sold. In both cases, the acquirer has no guarantee that an acquired customer relation will persist; even for contractual relations, the customer typically has an (extraordinary) right to terminate. Valuation must provide accurate assumptions regarding the churn rate caused by the transfer, for both groups.
FASBs concern involves all other intangible assets, too, i.e. registered and enforceable IP rights like trademarks, patents, copyrights, and industrial designs. These are generally accepted as separable intangible assets, which are transferred, sold or licensed. But very similar to customer relations, they offer little guarantee of future economic benefits. Admittedly, they constitute a right – at least when registered. But substantial parts of such IP assets are basically unregistered. Technology is often unpatented, trade names are often non-registered, as are most copyrights, content assets, libraries or databases. If unregistered, they are “somehow” protected by trade secrets, confidentiality clauses, non-competes, or unfair competition law. But all these do not constitute enforceable rights, let alone contracts. Valuing and reporting such IP assets means making assumptions regarding their asset-specific future returns and useful life. In my view, the lack of projectable history causes a higher level of uncertainty and risk, compared to the valuation of customer relations.
Almost one year passed since FASBs ideas about how to treat customer relations. Since, FASB has revoked its plans to redesign the accounting for goodwill, and its amortization. However, it is not clear how this withdrawal affected FASBs view on customer relations.
In my view, not counting customer relations as separable intangible asset would be a serious loss of quality in financial reporting information. Customer relations are not only the most important, but also the most accurately valued and meaningful class of intangible assets. Subsuming them into goodwill would leave most PPAs as a stump, and would evoke additional intangibles to follow the same route.
Instead of dumping them, we should think about improving the accounting and reporting of customer relations. An important improvement of informational content to readers and investors would be to group them into four different subcategories:
– Contracts (without business beyond the contract term)
– Renewal business from existing contracts
– Non-contractual customer relations
and outline assumptions regarding useful life and risk differences.