Customer Loyalty

Question: When one company buys another, payment amounts will likely be negotiated to compensate the seller

for intangibles where contractual or legal rights are held or where the asset can be separated and then sold.

Thus, parent companies who buy subsidiaries (especially in industries such as technology) will likely recognize

significant intangible asset balances on the subsequently consolidated balance sheet.

However, some intangibles have value but fail to meet either of these two criteria. Customer loyalty, for example,

is vitally important to the future profitability of a company, but neither contractual nor legal rights are present and

loyalty cannot be separated from a company and sold. Hence, customer loyalty is not reported as an intangible

asset despite its value. Much the same can be said for brilliant and creative employees. A value exists but neither

rule for recognition is met.

The owners of a company that is being acquired will argue for a higher price if attributes such as these are

in place because they provide for higher profitability in the future. The amount paid to obtain the subsidiary

is impacted although these intangibles do not meet the criteria for separate reporting as assets. How is this

additional acquisition cost reported by the parent in producing consolidated financial statements?

Assume Giant Corporation pays $16 million to acquire Tiny Corporation. The subsidiary (Tiny) owns property

and equipment worth $4 million. It also holds patents worth $6 million, a database worth $2 million, and

copyrights worth $3 million. The total value of those assets is only $15 million. For convenience, assume Tiny

has no liabilities. Assume that the parent agrees to pay the extra $1 million because the subsidiary has customer

loyalty valued at $600,000 and a talented workforce worth $400,000. How is this additional $1 million reported

after the takeover?

What recording is made when a parent buys a subsidiary and pays an extra amount because intangibles are

present that have value but do not meet the criteria for separate reporting?

Answer: Every subsidiary intangible (such as patents and databases) that meets either of the official criteria is

consolidated by the parent at fair value. Any excess price paid over the total fair value of these recorded assets

(the extra $1 million in this question) is also reported as an asset. It has a cost and an expected future value. The

term that has long been used to report an amount paid to acquire a company that exceeded all the identified and

recorded assets is “goodwill.” Some amount of goodwill is recognized as a result of most corporate acquisitions.

In this example, it specifically reflects the value of the customer loyalty and the quality of the subsidiary’s

workforce.

If Giant pays $16 million for the stock of Tiny when its reportable assets have a value of only $15 million, the

following entry is made by Giant to consolidate the two companies. As shown, the additional $1 million is labeled

as goodwill, which will then be included within the intangible assets.