What Are Contributory Asset Charges in Valuation?

Contributory asset charges (CACs) are a component of business valuation, arising during a purchase price allocation (PPA) as outlined in Accounting Standards Codification (ASC) 805. When one company acquires another, the buyer must allocate the purchase price to all acquired assets and liabilities based on their fair values. CACs represent a charge for the use of supporting assets that help the primary asset being valued generate income.

For an intangible asset, such as a customer relationship list, to generate revenue, it relies on other parts of the business like computers, delivery trucks, and working capital. The charges are hypothetical deductions from an asset’s projected income stream. This process is designed to isolate the earnings that are truly attributable only to that specific asset.

The Role of Contributory Assets in Valuation

The principle behind contributory asset charges is that no single asset generates income in isolation. To determine the fair value of a primary intangible asset, an appraiser must first strip away the earnings attributable to all the other assets supporting it. This step is necessary to avoid overstating the value of the primary asset and to ensure the total value of all identified assets does not exceed the company’s purchase price.

This concept is most prominently applied within the Multi-Period Excess Earnings Method (MPEEM), a valuation approach for significant intangible assets like customer relationships or proprietary technology. The MPEEM begins with a forecast of revenue from the primary asset and then subtracts charges for any other asset that contributes to generating that cash flow. This isolates the “excess” earnings that can be solely credited to the intangible asset being valued.

Consider a restaurant’s secret recipe. The recipe itself is valuable, but it cannot generate income without a kitchen (fixed assets), trained chefs (assembled workforce), and cash to buy ingredients (working capital). To find the true value of the recipe, one must account for the cost of using these other components. CACs are the financial equivalent of these costs, ensuring the final valuation reflects only the economic benefit of the recipe itself.

Identifying Key Contributory Assets

A key step in the valuation process is the identification of all assets that contribute to the cash flows of the primary asset being analyzed. These contributory assets can be tangible or intangible. Failing to identify a supporting asset means its contribution is not charged for, leading to an overstatement of the primary asset’s value.

Net Working Capital

Net working capital is the difference between a company’s current operating assets, like accounts receivable, and its current operating liabilities, like accounts payable. A business requires a certain level of working capital to function smoothly, managing the gap between paying suppliers and receiving cash from customers. This required investment is a contributory asset because, without it, daily operations would cease, and the primary asset could not generate revenue.

Fixed Assets

Fixed assets are the tangible, long-term assets used in the operation of a business, such as property, plant, and equipment (PP&E). This category includes everything from office buildings and manufacturing facilities to computer hardware and delivery vehicles. Because they provide the infrastructure for a company to produce goods or deliver services, a charge for their use is required.

Assembled Workforce

An assembled workforce is an intangible asset that represents the value of having a trained and experienced group of employees in place. While not recognized as a separate asset on the balance sheet under U.S. Generally Accepted Accounting Principles (GAAP) and instead subsumed into goodwill, it is a contributory asset. The value is derived from the cost that would be incurred to recruit, hire, and train a replacement workforce to the same level of proficiency.

Other Intangibles (Technology, Trade Names)

Often, a business has multiple intangible assets that work together. For example, when valuing a customer relationship intangible, the company’s trade name or its proprietary software might also contribute to securing and maintaining those relationships. A portion of the income generated is due to the brand recognition or the technology. Therefore, a charge for the use of these other intangible assets must be calculated to isolate the earnings of the primary asset.

Calculating Contributory Asset Charges

The calculation of CACs quantifies the economic rent of each supporting asset. The general formula involves multiplying the fair value of the contributory asset by an appropriate rate of return for that asset. This process requires consideration of the risk and economic life of each asset category.

Return “on” and Return “of” Capital

A distinction in these calculations is between a “return on” capital and a “return of” capital. The return on capital is the required profit or yield an investor would expect for deploying that asset, reflecting its risk. The return of capital represents the consumption or depreciation of the asset over its useful life. For some assets, both charges are necessary, while for others, only one is applicable.

Calculation for Each Asset Type

For fixed assets like machinery, the contributory charge typically includes both a return on the fair value of the assets and a return of the assets. The return of capital is captured through a charge equivalent to depreciation, reflecting that these assets are consumed over time. The return on capital is the profit required to justify the investment in those fixed assets.

The charge for net working capital is usually just a return on the required investment. This is because working capital is treated as a revolving fund that is maintained but not consumed. Unlike a machine that wears out, the level of working capital is assumed to be recoverable at the end of the project, so no return of capital is required.

Calculating the charge for an assembled workforce involves estimating the cost to recreate that workforce from scratch, including expenses for recruiting, hiring, and training. The contributory charge is then a return on this estimated recreation cost, representing the economic benefit of having a skilled team already in place.

Determining the Rate of Return

The rate of return applied to each contributory asset is not a one-size-fits-all number. It must be selected based on the specific risks associated with that individual asset or asset class. For instance, the required return on a stable, low-risk asset like land would be much lower than the return required on a more volatile asset like specialized technology.

Impact on Goodwill and Intangible Asset Value

The application of contributory asset charges directly impacts the valuation of the primary intangible asset and the resulting goodwill. After calculating the charges for all supporting assets, their sum is deducted from the projected cash flows of the primary intangible asset. This step leaves only the “excess earnings” that are attributable solely to that primary asset.

These isolated, net cash flows are then discounted back to their present value using a discount rate that reflects the specific risks of the primary intangible asset. The resulting figure is the calculated fair value of that intangible, which is then recorded on the acquirer’s balance sheet.

Goodwill is the residual amount left after the acquirer has allocated the purchase price to all identified tangible and intangible assets and assumed liabilities at their fair value. By accurately valuing the primary intangible asset after deducting all contributory asset charges, the calculation helps ensure that goodwill is not overstated. The more value that can be precisely attributed to specific intangibles, the less value is allocated to the non-specific, residual category of goodwill.