Goodwill - How Good Does it Have to Be?
Keywords:
case study, financial staements, debt to equity ratio, impairment chargeAbstract
Tom Kloos, assistant controller of Thermistics Incorporate, was outlining the requirements for FAS 142, which changed the financial reporting for goodwill. Previously firms had to amortize goodwill over a life not to exceed 40 years. Additionally, each year firms had to determine if the goodwill was permanently impaired and should be written off The impairment test was an easily one to pass, therefore little goodwill was written off in an impairment charge. FAS 142 changed the goodwill reporting in dropping the required yearly charge for goodwill, but requiring a much more stringent test for impairment. In 2002 firms had to decide to adopt FAS 142 with an initial impairment charge, which would be reported as an accounting change. Tom favored the initial adoption of FAS 142 with a large impairment charge. The benefits would be: improved earnings quality in deleting most of the goodwill from the balance sheet, higher stock price from higher earnings quality, higher return on equity ratios, and avoiding a later impairment charge shown as an operating item. Tom's boss, Bill Olet, the controller, could see some pitfalls with a large impairment charge. First, the firm had a loan covenant requiring a debt to equity ratio that could be violated with the impairment charge under FAS 142. Mr. Olet was concerned that the bank would require new performance standards with the violation of the debt covenant. Also Mr. Olet was concerned that certain large investors would question the timing of the goodwill impairment charge under FAS 142. Why did the firm see the impairment in 2002, and not earlier in 2000 or 2001? Does the impairment charge indicate that acquisitions made in the 1990s are not performing to expected levels? And does the impairment charge indicate that future cash flows from acquisitions will be reduced? These are the issues Tom and Bill are debating before they present a unified approach for FAS 142 to the company's board of directors. This case is intended for use in a financial statements analysis class.
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