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Intermediate Accounting (Kieso)
Found in: Page 649

Short Answer

: As a new intern for the local branch office of a national brokerage firm, you are excited to get an assignment that allows you to use your accounting expertise. Your supervisor provides you with the spreadsheet below, which contains data for the most recent quarter for three companies that the firm has been recommending to its clients as “buys.” Each of the companies’ returns on assets has outperformed their industry cohorts in the past. But, given recent challenges in their markets, there is concern that the companies may experience operating challenges and lower earnings. (All numbers in millions, except return on assets.)

A

B

C

D

E

Company

Fair Value of Company

Book Value (Net Assets)

Carrying Value of Goodwill

Return on Assets

Sprint Nextel

$36,361

$51,271

$30,718

3.5%

Washington Mutual

11,742

23,941

9,062

2.4

E* Trade Financial

1,639

4,104

2,035

5.6

Instructions

  1. The fair value for each of these companies is lower than the corresponding book value. What implications does this have for each company’s future prospects?
  2. To date, none of these companies has recorded goodwill impairments. Your supervisor suspects that they will need to record impairments in the near future, but he is unsure about the goodwill impairment rules. Is it likely that these companies will recognize impairments? Explain.
  3. Estimate the amount of goodwill impairment for each company and prepare the journal entry to record the impairment. For each company, you may assume that the book value less the carrying value of the goodwill approximates the fair value of the company’s net assets.
  4. Discuss the effects of your entries in part (c) on your evaluation of these companies based on the return on assets ratio.

The depressed market values suggest that market participants are not very optimistic about the future prospects for these companies. The total goodwill impairment is $26,007. Impairment losses are reported in operating income.

See the step by step solution

Step by Step Solution

Step 1: Meaning of Goodwill

Goodwill is the fraction of the purchase price that is greater than the net fair value of all the assets and liabilities sold. When a firm buys a new business, it obtains goodwill, which is an intangible asset (one that isn't tangible but has a long-term worth).

Step 2: (a) Explaining the implications does this have for each company’s future prospects

The low market valuations (less than book value) indicate that market players are pessimistic about these firms' future prospects. In many circumstances, accounting figures are based on previous costs, but market pricing will reflect fresh knowledge about the company's future. This does not appear to be a promising scenario.

Step 3: (b) Explaining if the company should recognize impairment

Since each company's market (fair) value is less than its net asset book value, it fails the first stage of the goodwill impairment test, and impairment should be recorded.

A

B

C

D

E

F

G

H

(Columns C–D)

(Columns B–F)

(Columns D–G)

Company

Market Value

Book Value (Net Assets)

Carrying Value of Goodwill

ROA

Estimated Fair Value of Net Assets

Implied GW (NA-Market Value)

Goodwill Impairment

Sprint Nextel

$36,361

$51,271

$30,718

3.5%

$20,553

$15,808

$14,910

Washington Mutual

11,742

23,941

9,062

2.4%

14,879

0

9,062

E-Trade Financial

1,639

4,104

2,035

5.6%

2,069

0

2,035

Total

$26,007

Step 4: (c) Estimating the amount of goodwill and preparing a journal entry

Each of these firms is expected to record a goodwill impairment, as shown in the extended spreadsheet above unless their market valuations significantly improve. The goodwill asset will be completely written down for Washington Mutual and E-Trade as a result of the impairment. These corporations' previous purchases, from which the goodwill was reported, apparently did not play out.

Date

Particular

Debit ($)

Credit ($)

Loss on Impairment

26,007

Goodwill

26,007

Step 5: (d) Explaining the effect of journal entries

Operating income includes impairment losses. As a result, the numerator in the return on asset ratio will be reduced by the impairments. These firms' operating performance is inflated in comparison to other companies in their cohort if the impairments are not recognized.

Most popular questions for Business-studies Textbooks

The following is selected information for Alatorre Company.

1. Alatorre purchased a patent from Vania Co. for $1,000,000 on January 1, 2015. The patent is being amortized over its remaining legal life of 10 years, expiring on January 1, 2025. During 2017, Alatorre determined that the economic benefits of the patent would not last longer than 6 years from the date of acquisition. What amount should be reported in the balance sheet for the patent, net of accumulated amortization, at December 31, 2017?

2. Alatorre bought a franchise from Alexander Co. on January 1, 2016, for $400,000. The carrying amount of the franchise on Alexander’s books on January 1, 2016, was $500,000. The franchise agreement had an estimated useful life of 30 years. Because Alatorre must enter a competitive bidding at the end of 2018, it is unlikely that the franchise will be retained beyond 2025. What amount should be amortized for the year ended December 31, 2017?

3. On January 1, 2017, Alatorre incurred organization costs of $275,000. What amount of organization expense should be reported in 2017?

4. Alatorre purchased the license for distribution of a popular consumer product on January 1, 2017, for $150,000. It is expected that this product will generate cash flows for an indefinite period of time. The license has an initial term of 5 years but by paying a nominal fee, Alatorre can renew the license indefinitely for successive 5-year terms. What amount should be amortized for the year ended December 31, 2017?

Instructions:

Answer the questions asked about each of the factual situations.

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