In a Business Combinations, this is a intangible asset and is therefore recognised separately from goodwill, provided that its fair value can be measured reliably. This customer-related intangible asset does not arise from contractual or other legal rights, but meets the definition of an intangible asset because it is separable.
If a customer relationship acquired in a business combination does not arise from a contract, the relationship is an intangible asset if it meets the separability criterion. Exchange transactions for the same asset or a similar asset provide evidence of separability of a non-contractual customer relationship and might also provide information about exchange prices that should be considered when estimating fair value.
There are valuation models to value customer contracts and the related customer relationship and the non-contractual customer relationships, as per IFRS 3 Business Combinations.
What are the inputs? IAS 38 Non-contractual customer relationships
Revenue – represents revenue from existing customer relationships for existing products. Includes contractual and non-contractual relationships (even those without current backlog or commitments). Separate valuation of a backlog revenue intangible asset can be considered if and when such backlog exists.
The model assumes a “market participant” point of view, therefore revenue/earnings assumptions should not include the impact of synergies specific to Acquirer Co., rather only those synergies that would be realized by any market participant.
Revenue growth on a stand-alone basis, i.e. without Acquirer Co.-specific Synergies
Turnover/Attrition IAS 38 Non-contractual customer relationships
Terminal value IAS 38 Non-contractual customer relationships
Net margin IAS 38 Non-contractual customer relationships
Inventory write-up – represents purchase accounting write-up of Inventory, if any. Amount should be deducted herein to avoid overvaluing the customer intangible asset. It is deducted completely in year 1.
Contributory asset charge IAS 38 Non-contractual customer relationships
Charge for tradenames – Tradenames can be valued using a benchmarked revenue stream from a tradename branded product. Revenue and growth rates should only be reflective of “market participant” synergies, not synergies specific only to Acquirer Co. The royalty tradename rate should correspond to the estimated rate that would be required by a 3rd party to utilize the subject tradename.
Charge for other technology – Represents revenue relating to patented/unpatented proprietary technology. It may be a subset of total business revenue. Revenue and growth rates should only be reflective of “market participant” synergies, not synergies specific only to Acquirer Co. The royalty technology rate should correspond to the estimated rate that would be required by a 3rd party to utilize the subject technology.
If and when other technology items are separately valued as intangible assets, this income stream has to be eliminated from the customer relationships valuation component by using this line as costs in this part of the model.
Income tax rate – this should reflect the estimated effective tax rate for the acquired business (the rate would not be revised for any benefits that would be specific to Acquirer Co.).
Unit of measurement – the functional currency of the acquired business in units or ‘000 units, so for example EUR ‘000 or USD ‘000.
Partial first year factor – when the first year is not a full year, the factor has to be for example 10/12 if first time inclusion is beginning March of the year under review. Here the first year is a full year or 12/12 = 1.
Present Value Factor/Discount Rate – takes into consideration the Weighted Average Cost of Capital (WACC), Internal Rate of Return (IRR), and the Weighted Average Return on Assets (WARA). Note that the discount rate used for the intangible asset valuations should generally reflect a premium of 100 to 300 basis points over the WACC determined for the overall acquisition.
The present value factor is then calculated as follows: 1 / ((1 + i%)^n), i is the discount factor, 14.0% and n is year 1, year 2, …….. year 16, so year 1 = 1 / ((1.14)^1) = 0.8772 and year 16 = 1 / ((1.14^16) = 0.1229.
Reference is made to Customer relationships valuation IAS 38 Non-contractual customer relationships