Under the new rules, which took effect July 1, 2001, only the purchase method of accounting for business combinations is allowed. Intangible assets like contracts, patents, trademarks, and licensing agreements must be recognized, valued, and amortized. This doesn't include all intangible assets-only intangible assets that meet certain criteria according to SFAS No. 141. Goodwill will still be recorded, but under SFAS No. 142 it won't be amortized any longer. Instead, companies must test the dollar amount of goodwill on their books against its fair value at least once a year.

It makes a big difference to reported earnings whether or not an intangible asset is classified as goodwill. The way the FASB chose to define customer-related intangible assets actually results in most of them becoming goodwill. Acquirers welcome this because future charges to earnings will be lower. But readers of financial statements may not fully appreciate just what the buyer actually acquired.

In an economy as diverse as that of the United States, there is a tremendous range of customer relationships: long-standing relationships based on a handshake, shortterm relationships with multipage contracts drawn up by teams of lawyers, and all other kinds of contracts in between. The FASB was uncomfortable with noncontractual customer relationships, so it decided-for accounting purposes-that customer relationships either have to be based on legal contractual rights or have to be severable and marketable on a separate basis. This may make good accounting, but it's a poor basis for investing millions, or even billions, of dollars in an M&A transaction.

Let's look at how SFAS No. 141 impacts accounting for business combinations, contrasting the accounting approach with the business approach, which, of course, is the basis on which buyers make purchase decisions. Few M&A transactions would be undertaken if an acquiring company had no confidence that a significant portion of the target's customers would remain after the acquisition.

WHAT DOES SFAS NO. 141 SAY?

Paragraph 39 of SFAS No. 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 rights 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 acquired entity and sold, transferred, licensed, rented, or exchanged (regardless of whether there is an intent to do so)....

Paragraph A20 of SFAS No. 141 states:

If an entity establishes relationships with its customers through contracts, those customer relationships would arise from contractual rights. Therefore, customer contracts and the related customer relationships are intangible assets that meet the contractual-legal criterion....

Paragraph A21 of SFAS No. 141 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 noncontractual customer relationship and might also provide information about exchange prices that should be considered when estimating fair value....

Simply classifying customer relationships as either legally contractual or noncontractual or separable or nonseparable fails to provide a meaningful basis for classifying many long-established business relationships. At one end of the contract spectrum are long-term "take or pay" contracts, which are legally enforceable. At the other end, for example, are retail relationships, where all transactions are for cash and are anonymous. Overall, most customer relationships are informal and based on personal relationships.

In addition, a contract without enforceable rights doesn't generate an asset. Simply saying, "If I do the work, you will pay me" generates little value. But an argument can be made from the perspective of a buyer that nonlegal contracts of an acquired business are a small, nominal asset. The buyer is saving the selling expense on the engagements or work in progress, and this value represents the maximum amount that can be ascribed to that informal contract.

Now let's look at several examples of situations involving customer relationships. In each, I offer my firm's analysis, conclusions, and recommendations.

OIL COMPANY

An oil company has contracts with dealers of leased stores. The contracts commit the dealer to buy the company's brand at market prices. In this case the contract has value to the oil company because it "guarantees" sales of the product. On the other hand, given that gasoline is a commodity whose price changes daily, the company realizes 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 or she meets certain minimum volume requirements over a certain time period. But the commitment to pay these bonuses may be a liability, not an asset.

The valuation of the contract, in our opinion, is based on the costs foregone of obtaining 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 No. 141, would be developed from recent marketing experience. How much is spent in a year on dealer recruitment? How many dealers are obtained? If we used two or three years of historic experience to derive a supportable "cost per dealer obtained," that unit cost figure would be applied to all the existing number of 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 historic turnover, and this history can probably be safely applied to the value of the current dealer contracts as derived above.

MONEY MANAGER

A money manager's clients sign contracts 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 stipulating that as long as the client leaves his or her 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 a formula based on some factors of achieving success.

That there is a contract here is unquestioned. What isn't so dear is whether, from the perspective of the money management firm, the relationship 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": to get paid for the period of time he or she manages the assets. No more and no less.

Here we have a contract that allows you to get paid only through today, with no right to enforce future performance. While there's a piece of paper with two signatures, the contract itself provides no "contractual or other legal rights." Thus, we read SFAS No. 141 paragraph 39 that without enforceable "contractual or other legal rights" the customer relationship between the parties does not qualify for recognition as an asset apart from goodwill. And if you then go to the second factor, that of 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 anymore and have sold your contract to a new firm who 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 didn't mean to have this result. It may be an unintended consequence of the way SFAS No. 141 was drafted. On the other hand, there is an entire continuum of customer relationships, and the FASB had to make a decision somewhere along that spectrum. By putting the emphasis on contractual rights, it appears that a contract without enforceable rights simply precludes accounting recognition as an asset apart from goodwill.

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' product, but we maintain our market share because of our customer service and the personal relationships our people have with theirs." We don't believe that in these extremely prevalent situations the value of the relationships, whether contractual or not, falls within the rules. Because the relationships really aren't "separable," they fall outside the SFAS No. 141 guidelines.

PROFESSIONAL SERVICE FIRM

A professional service firm signs an engagement letter (contract) with a customer. My firm, Valuation Research Corporation (VRC), is a professional services company. For every engagement, we ask the client to sign our engagement letter, which essentially says we will perform certain work, and they will pay us. While it doesn't happen often, there have been numerous situations over a 25-year period when a client will call up and say, "Stop the work" because something unforeseen happened.

In such situations, what enforceable rights, if any, does VRC have? We can't go to the client and say, "You must let us finish the work!" Rather, all we can expect-and can go to court for-is to demand payment for the work performed to date.

If VRC were to be bought, what asset would the buyer have in terms of our customer relationships? While we do work for many firms more than once, each engagement stands on its own. We have no contracts with clients that say they must use us as their appraisers. Yes, there are many recurring relationships, but they aren't contractual. Our relationships also can't be separated and sold to someone else. If, in practice, we subcontract some specialized work, we take full responsibility for the final values. If we can't do the work, the client goes elsewhere. Period.

Finally, if VRC were bought, we believe that the only value ascribable to contracts in progress would be the work performed to date but not yet billed to clients. Inasmuch as any client can tell us to stop at any time, we essentially have no legal or contractual rights to future performance or future pay. In terms of revenue recognition, we earn money only when we put in the professional time. We have no right to demand that clients pay us for work we haven't performed, even though the current engagements in progress are likely to continue irrespective of form ownership.

A FINAL WORD

The FASB had to write some rules for which customer relationship assets had to be capitalized and which did not. Right or wrong, they wrote the rule using a legal contract/separability set of criteria. It's not the way my firm has traditionally valued customer relationships. It differs from the real economics of M&A transactions. But SPAS No. 141 is the rule and has to be followed as writ- ten. The results, while at times counterintuitive, may be favorable or unfavorable. This may be right; it may be wrong. Still, few of us could have done a better job of drafting the new statement, and we are all going to be held to it as written.

I can suggest the following:

When considering an acquisition, carefully examine the exact nature of the target's existing customer relationships. Just because there is a written piece of paper called "contract"-or some other word-you must carefully examine the rights and obligations of the party. A contract that essentially is executory in nature does not, in my opinion, generate significant value at the date of closing an M&A transaction. In addition, you should analyze the target's customer relationships in terms of SFAS No. 141 and No. 142 and project the effects they will have on your balance sheet and income statement. Some customer relationship assets will probably have to be recognized and amortized over relatively short periods of time. The Securities & Exchange Commission will be scrutinizing allocations to assure themselves that goodwill is not being overstated and that all identifiable intangible assets are captured and properly valued.

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