Customer Relationship or Goodwill?
An acquirer buys a services firm for $50M. Identifiable net assets at fair value (working capital, PP&E, assembled workforce excluded) total $20M. The acquirer's valuation team proposes recognizing a $22M customer-relationship intangible with a 10-year life, leaving $8M as goodwill. The customer list shows: 60% of revenue from contracts terminable on 30 days' notice; 25% from multi-year contracts with auto-renewal; 15% from one at-will anchor client that has stated it may insource. The team used a multi-period excess-earnings method but applied a single 10-year life to all customers and assumed 100% retention. The auditor questions both the life and the retention assumption.
1. Is the $22M customer-relationship value supportable as constructed? What must change?
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Not as constructed. Two assumptions are unsupported.
Retention: assuming 100% retention for a base where 60% of revenue is terminable on 30 days' notice and 15% may insource is indefensible. The MPEEM explicitly charges for customer attrition; a 100% assumption removes the very risk the method is meant to capture. The analyst must apply segment-specific attrition (e.g., higher churn on terminable contracts, lower on auto-renewing, explicit scenario for the anchor client).
Life: a single 10-year life across heterogeneous customer groups is arbitrary. Useful life should reflect the period over which the entity expects to benefit - shorter for terminable relationships, longer for contracted ones.
Result: the $22M is likely overstated, which means goodwill is understated. Re-run with segmented attrition and lives, and let the residual fall to goodwill. Do not force the split to hit a target.
2. The CFO says: 'If we shorten the life, amortization rises and reported earnings fall - can we just keep 10 years?' How should the analyst respond?
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No. Useful life is a measurement judgment driven by expected benefit period, not an earnings-management lever.
Response points:
- Amortization is non-cash; a shorter life raises amortization but does not change cash flows or the purchase price allocation total. It shifts value between the intangible and goodwill.
- Goodwill is not amortized but is tested for impairment; a larger goodwill balance carries future impairment risk. Choosing a longer life to smooth earnings may simply defer a write-down.
- Auditors and regulators treat unsupported lives as a red flag. Documenting a life inconsistent with the contract mix invites restatement.
The analyst should quantify the effect: show amortization under the segmented lives versus 10 years, and note the goodwill difference. Transparency beats smoothing.
3. What is the auditor's likely concern about the assembled-workforce exclusion, and how does it interact with the customer intangible?
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Under most standards, an assembled workforce is not recognized separately as an intangible (it fails the separability/contractual-legal criterion), so its value is subsumed into goodwill. That is correct treatment.
Interaction: the customer relationships depend on the workforce that services them. If the MPEEM attributes all contributory-asset returns to customer relationships but ignores the workforce's role, it may over-attribute value to customers. The analyst should ensure the MPEEM deducts a fair return on all contributory assets, including a notional workforce charge, before assigning residual earnings to the customer intangible. Otherwise the customer intangible absorbs value properly belonging to goodwill.