NETTING IT OUT

We first published this Report in the Spring of 2002, and we re-present it here pretty much as originally written. As usual, we were ahead of the curve in our call to action. (The advantage to our clients of our early warnings is that they get a three-year lead on those who aren’t reading our advice!) So, this is your second wake-up call. Many of our clients have now embarked on customer scorecard efforts. As you focus on the “right” customer metrics to track, here’s some food for thought.

In this post-Enron era, every management team is scrambling to ensure that its financial reporting is as transparent as possible. The next round of Financial Accounting Standards Board (FASB) disclosure rules on reporting intangible assets will have a dramatic impact on everyone’s business. This is your [first] wake-up call!

Both the International and American Accounting Standards bodies are now calling for more disclosure in reporting intangible assets. These intangible assets include, among others, customer lists and brand value.

THE CURRENT SITUATION. In the past, these intangibles have only been recognized when they resulted from an acquisition. In that case, they were lumped into the category of “goodwill” and amortized over time. Today, companies are required to separate out customer lists, brands, patents, and other intangible assets from goodwill. And they are required to re-evaluate and periodically adjust these values. This re-assessment may result in write-offs, which may be a good thing from a taxation standpoint, but a bad thing from the standpoint of earnings.

THE NEW REGULATIONS. In the future, once these new regulations go into effect, we predict that companies will also be required to break out and report internally-generated assets, e.g., the value of their patent portfolio, the value of their customer lists, and the value of their brands. We believe that customer value and brand value are inextricably intertwined.

Most importantly, we believe that the new era of accounting transparency will require companies to disclose much more information about their customer assets. Here’s a primer on how you should begin getting ready for the inevitable.

You need to begin preparing to disclose the number of customers you have, your customer retention rate by customer segment, your current earnings by customer segment, and your Customer Lifetime Value calculations. After all, if your earnings are derived from your customers, how else can investors assess your company’s ability to generate future earnings?

THE TIME HAS COME TO START REPORTING THE VALUE OF YOUR CUSTOMERS!

These are treacherous times for CFOs, accountants, and auditors. Investors are demanding more visibility into our companies’ books. Accounting wizardry that used to be admired has now become witchcraft and is to be exorcised. For good reason! In the customer economy, investors demand transparency and visibility. Nothing can get swept under the rug.

In my ground-breaking book, “The Customer Revolution”, published in March 2001, I welcomed readers to the Customer Economy. I explained the forces behind the dawn of the Customer Economy and its impact on companies’ strategies and on their perceived value by investors. On page 79, in the chapter on customer value, I stated, “We predict that by 2005 most companies will be reporting their customer numbers using a consistent reporting standard. We’ll call it the Customer Value Index--an indicator of the future earnings potential of the company.” I go on to explain how you should calculate customer value (by adding together customer capital and customer momentum) and how to get started today.

THE FIRST STEP OF DISCLOSURE: REPORTING THE VALUE OF YOUR CUSTOMER ASSETS

New FASB Reporting Rules under Development re: Intangible Assets

On March 5th, 2002, an interesting column appeared in the Financial Times. Entitled, “Putting a Finger on Corporate Intangibles,”[1] Simon London reported that the “US Financial Accounting Standards Board (FASB) is working on rules that will require US companies to disclose, for the first time, information regarding intangible assets, such as brands, customer lists, and technology.” London didn’t say when the new rules will go into effect, but he implied that this reporting change would come within the next 12 to 18 months. He goes on to say “Regulations that make companies reveal more about their investment in intangible assets could have a greater impact, in the long run, than anything likely to emerge from the Enron saga.”

Later in his column, London explains that the FASB has already begun its tortuous path towards deciding how and what intangible assets need to be reported to investors. If we look at the changes to the reporting rules that have already been made by the FASB, we can see that there’s a lot more work to be done in determining how to report out customer assets. And that’s just a baby step in determining how to report out customer value.

THREE DIFFERENT TYPES OF CUSTOMER ASSETS

What’s the Value of a Customer List You Acquire When You Buy a Company?

Today, when one U.S.-based company acquires another, it must separate the value of the customer base it acquired from the rest of goodwill. “Under FASB 141 and 142,” London reports, “US companies are now obliged to identify separately from goodwill those intangible assets a) over which they have control and b) which can be identified separately.” The value of the customer base you acquire when you acquire a company is thought to meet both conditions. But does it?

DEFINING CUSTOMER ASSETS. The financial definition of an asset is “an economic resource owned by the firm.” In the Customer Economy, you don’t “own” your customers. They own themselves. You don’t have control over your customers. They control you.

Just because you acquire a customer base by buying it from a company or by acquiring a company, gives you no assurance that those customers will be willing to be your customers. How many of you have been “sold” to another company in a merger and have responded by saying, “hell no, I won’t go!” It happens every day. So customers or a customer base are not accounting assets.

A customer list, on the other hand, does meet the definition of an asset. However, the quality and value of that list will vary based on a number of factors: the relationship of the customer list to the brand with which those customers have chosen to relate, the current and future retention rate of the customers on the list, and the current and future projected earnings to be realized from the customers on the list.

The danger of customer defection is particularly acute when the brand with which the customer was used to associating is supplanted by another brand in which the customer has no trusted relationship. Here’s an example: When Fleet Bank merged with BankBoston, many BankBoston customers refused to go along with the merger. And when government regulators required Fleet to spin off part of its customer list to a smaller, regional bank, Sovereign Bank, many of those customers refused to be transferred.

So, a customer list may be part of an acquisition, but its value to the acquirer is often considerably less than its value was to the company that developed and nurtured those customer relationships. And financial executives realize that. That’s why the value of a customer list is always heavily discounted when it changes hands. “If we do a good job, maybe we’ll be able to retain 25 percent of those customers,” they say to themselves, “with a possible future earnings stream of $X per customer over the next three years.” So, one way to assess the value of a customer list is to calculate the net present value of the future earnings that can be conservatively assumed to be generated by the list.

What’s the Value of the Customer List You Already Own?

We’ve already stated the obvious: the customer list of an acquired company is worth far less to the acquirer than it was to the acquiree. But what if you’re not acquiring a company and its customer list. How do you determine the value of the customer list you’ve built up over the years within your own firm? What’s the value of your customer list(s) to your company? Since your company is now going to have to start reporting this out as a separate intangible asset, it’s time to think seriously about how to deal with this reporting issue...