Criteria for Recognizing Intangible Assets

Question: Most major businesses report some amount of intangible assets. These can be developed internally, bought individually, or obtained as part of the purchase of an entire company. Larger amounts usually come from the acquisition of a subsidiary by a parent. The accountant faces the challenge of determining which costs to capitalize and which costs to expense. Because of their very nature, identifying intangible assets is more difficult than identifying tangible assets. A computer is obviously an asset, but is a list of client names inside of that computer also an asset?

For example, when one company buys another, the subsidiary is often holding rights to numerous intangibles. As mentioned previously, company acquisitions often take place to gain those rights. The parent then places the assets that qualify on its balance sheet at fair value to show that a portion of the amount paid for the subsidiary was the equivalent of an acquisition price for these items. That is a major reason why companies such as Microsoft and Procter & Gamble report billions of dollars in intangibles. They have probably gained ownership of many of these assets by acquiring entire companies.

However, according to U.S. GAAP, certain requirements have to be met before intangibles are recognized as assets. What criteria must be satisfied for a company to record an intangible as an asset? A business could very well spend millions of dollars for scores of intangibles: patents, copyrights, databases, smart employees, loyal customers, logos, and the like. Which of these intangibles should actually be recognized on a balance sheet as an asset?

Answer: The rules for reporting intangible assets are best demonstrated through the acquisition of a subsidiary by a parent because large amounts are often spent for numerous items that might qualify as assets. In establishing rules for consolidated financial statements, FASB has stated that a parent company must identify all intangible assets held by a subsidiary on the date of acquisition. The fair value of each of these intangibles is recorded by the parent as an asset but only if contractual or other legal rights have been gained or the intangible can be separated and sold. This authoritative guideline serves as a minimum standard for recognition of intangible assets:

1. Contractual or other legal rights have been gained or
2. The intangible can be separated from the subsidiary and sold

Patents, copyrights, trademarks, and franchises clearly meet the first of these criteria. Legal rights are held for patents, copyrights, and trademarks while contractual rights allow the owner to operate franchises. By acquiring the subsidiary, the parent now controls these same rights and should record them on the consolidated balance sheet at fair value.

Other intangibles that can be separated from the subsidiary and sold should also be consolidated at fair value. For example, an acquired company might have a database containing extensive information about its customers. After purchasing the subsidiary, this information could be separated from that company and sold. Thus, on the date the subsidiary is purchased, the parent recognizes this database as an intangible asset at fair value to reflect the portion of the acquisition price paid to obtain it.

Recognition of Goodwill

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 a subsequently consolidated balance sheet.

However, some intangibles have significant value but fail to meet either of these two criteria. Customer loyalty, for example, is vitally important to the future profitability of a business, 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 regardless of its worth. Much the same can be said for brilliant and creative employees. A value exists but neither rule for recognition is met.

During negotiations, 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 increased profitability in the future. The amount paid to obtain a subsidiary can be 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?

To illustrate, assume Giant Corporation pays $16 million to acquire Tiny Corporation. The subsidiary 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 these four assets is only $15 million. For convenience, assume Tiny has no liabilities. Assume that Giant 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 on consolidated financial statements after the takeover? What recording is appropriate when a parent buys a subsidiary and pays an extra amount because valuable intangibles are present that do not meet the criteria for separate reporting?

Answer: Every subsidiary intangible (such as patents, copyrights, and databases) that meets either of the official criteria is consolidated by the parent as an asset at fair value. Any excess price paid over the total fair value of these recorded assets (the extra $1 million in this example) is also reported as an asset. It has a definite 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 goodwillThe price paid by one company to acquire another that is in excess of the fair value of net identifiable assets and liabilities; this cost is often associated with intangibles that do not meet the criteria for accounting recognition, such as employee expertise and customer loyalty.. Some amount of goodwill is recognized as a result of virtually all 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 entry shown in Figure 11.4 "Giant Company Buys Tiny Company—$1 Million Paid in Excess of Fair Value of Identifiable Assets" is made by Giant to consolidate the two companies. The additional payment of $1 million is labeled as goodwill, which will then be reported along with the other intangible assets.

Figure 11.4 Giant Company Buys Tiny Company—$1 Million Paid in Excess of Fair Value of Identifiable Assets

Excess Payment for a Subsidiary Not Identified with an Intangible

Question: In the previous illustration, Giant (the parent) paid an extra $1 million for specified intangibles. However, the subsidiary’s customer loyalty and talented workforce could not be recognized separately as assets because they met neither of the required criteria. Instead, a goodwill balance was created.

Will the reporting be any different if the parent simply paid this amount as a result of intense negotiations? Assume, for example, that Giant agreed to pay the additional $1 million to obtain Tiny solely because that company’s owners refused to sell for less. That often happens in the business world. Giant believed that the $16 million price was still a good investment even though it required $1 million more than the value of the identified assets (tangible and intangible). If a parent pays an additional amount to purchase a subsidiary without a specific rationale, is this cost still recorded as goodwill?

Answer: The acquisition of one company by another can require months of bargaining between the parties. One company wants to collect as much as possible; the other wants to pay as little as possible. Compromise is frequently necessary to arrive at a figure that both parties are willing to accept. In most cases, the parent has to pay more than the sum of the value of all individual assets to entice the owners of the other company to sell.

Sometimes, as in the initial example, the reason for the added payment is apparent (customer loyalty and talented workforce). More likely, the increased amount is simply necessary in order to make the deal happen. Whenever an extra cost must be expended to gain control of a subsidiary, it is labeled by the parent as an asset known as goodwill. The rationale does not impact the accounting. Any additional acquisition price that was required to obtain a subsidiary appears in the parent’s balance sheet as goodwill and is shown as an intangible asset.

Accounting for Goodwill Over Time

Question: Buildings, equipment, patents, databases, and the like are all assets. They have reported costs that will be assigned to expense over an expected life as they help generate revenues. Goodwill is a different type of asset. It represents either (a) a subsidiary attribute (such as customer loyalty) that is too nebulous to be recognized specifically as an asset or (b) an extra payment made by the parent to acquire the subsidiary as a result of the negotiation process. What happens to a cost identified as the asset goodwill after the date a subsidiary is acquired?

How do Microsoft, Yahoo!, or Procter & Gamble account for their large goodwill balances over time? Is this asset like land that simply continues to be reported at historical cost potentially forever or, possibly, like equipment that is depreciated systematically over some anticipated useful life?

Answer: Because goodwill is the one asset on a balance sheet that is not tied to an identifiable benefit, no attempt is ever made to determine an anticipated life. Consequently, the assigned cost is not amortized to expense. A goodwill balance can remain unchanged on a consolidated balance sheet for decades after a subsidiary is purchased. However, the reported figure is reduced immediately if its value is ever judged to be impaired. Attributes such as customer loyalty or a talented workforce might continue in place for years or disappear completely in a short period of time. If goodwill is merely a premium paid to acquire a subsidiary, the justification for that excess amount could vanish because of poor management decisions or environmental factors. The value of all assets is tentative but probably none is more so than goodwill.

Although a cost recorded as goodwill is not amortized over time, its ongoing worth is not assumed. Instead, a test to check for any loss of that value is performed periodically. This verification process is more complex than can be covered in an introductory course. The result, though, is important to understand. In the event that the goodwill associated with a subsidiary is ever found to be worth less than its reported balance, an impairment loss is recorded. Although not identical, the accounting is similar in some ways to the impairment test for land, buildings, and equipment demonstrated previously.

In 2000, Time Warner and America Online (AOL) merged. Because of the perceived benefit of combining these two companies, a huge premium was paid and reported as goodwill on the consolidated balance sheet. A mere two years later, it was obvious that the anticipated synergies from this transaction had not developed as expected. In simple terms, too much money had been paid by the owners to create the merger. The value of the combined companies had not managed to achieve overly optimistic projections. Consequently, goodwill was reduced in 2002 by nearly $100 billion. A loss of that amount was reported by the consolidated company. The goodwill account was not amortized to expense, but the impairment of its value had to be recognized.