AUDIT MEMORANDUM To:First Motors Corporation From:Nam Do CC:Dr. Jeff Archambault Date:11/10/2011 Re:The Accounting Policies and Procedures Purpose: The purpose of the audit memo is to clarify the accounting policies and procedures used by clients and the accounting policies and procedures that should be followed. The audit memorandum also provides a clear explanation of a difference between the risk premium in discounting the free cash flow from Plant 3 and the risk premium in discounting the cash flows for the Macinaw Division and which of the appropriate discount rate for computation of goodwill impairment.
The case mentioned about impairments which will be written down after the assets are tested for impairments and how the impairment loss will be allocated among group of assets. The audit memo gives the answer about whether long-lived asset or goodwill write-downs due to impartment or write-ups if the fair value subsequently increases. Fact: To take advantage of the alternative fuel source expertise, First Motors purchased Macinaw Motors Corporation which has significantly specialized in hydrogen-powered cars.
Although First Motors and Macinaw merged together, they want to operate separately to utilize its own efficiency and engage in its own business activities. Macinaw Motors has three manufacturing plants which are still in operation. Each plant is located in different locations such as Plant 1 (California) specializing in the hydro-powered Mankato, Plant 2 (Indiana) focusing in the hydrogen-powered Sheboygan and Plant 3 (Georgia) working on the gasoline-powered Spokane.
The long-lived assets in Plant 3 do not generate the net cash flow as expected since the plant was retooled that caused the argument whether or not to keep Plant 3 open. Management required an impairment test to determine if the long-lived assets impaired. * The estimated remaining life: 11 years * Net cash flow for next 11 years: $62,504,377 * Selling estimates after 11 years: $30 million * Total estimated undiscounted net cash flow over next 11 years: $717,548,147 Issues: The audit team figured out that risk-free rate 3 percent does not incorporate an inflation factor because the cash flow estimates were not adjusted for inflation.
As you know that the discount rate should incorporate a risk premium. There was an argument on a discount rate of 3 percent that management thought that it is appropriate and you thought that that rate is low. Based on the analysis in the auto industry and review of First Motors and Plant 3, a 6 percent risk premium with a 3 percent risk-rate is more reasonable. The valuation method for any possible goodwill impairment testing was discussed but they had not come up the decision of which valuation method should be used.
When the impairment test to the long-lived assets should be performed to test the assets whether or not impaired and what valuation methods for the Plant 3 should be applied. After the impairment test has been done and management came up with the impairment loss, how the impairment loss is allocated to the land, buildings, robots and related equipment and other equipment There is a difference in using discount rate for determining the implied goodwill value and the goodwill impairment loss.
To the long lived asset impairment, the risk free premium 6% in discounting the cash flow from Plant 3 is different from the risk free premium 5% in discounting the cash flow for the Macinaw Division. The different brings arguments around the selection of an appropriate risk-free rate and risk premium rate. What are the reasons for the difference in risk premium? In case of impairment loss, the long-lived asset or goodwill should be written down and whether or not be written up when its fair value increases. Reasoning: 8A. . 2 checkpoint stated that “a long-lived asset is considered impaired when its carrying amount is not recoverable and exceeds the asset’s fair value. The carrying amount is deemed unrecoverable if it is greater than the sum of undiscounted cash flows expected to result form use and eventual disposition of the asset. An impairment loss is equal to the excess of the carrying amount over the fair value of the asset. Thus, once it is determined that carrying value will not be recovered, an impairment loss must be recognized”.
For purposes of testing for recoverability and measuring an impairment loss, individual long-lived assets should be grouped with other assets forming the lowest level for which identifiable cash flows are largely independent of those of the entity’s other assets. Note, though, that, if an impairment loss is recognized, it should be applied only to the long-lived assets in the group that are covered by FASB ASC 360-10 ; thus, other assets in the group are not affected but should, if necessary, be adjusted for impairment in accordance with other applicable GAAP.
As defined in FASB ASC 350-10: “Goodwill should be part of an asset group to be tested for impairment only if the group is itself a “reporting unit” or includes such a unit”. Note that when we want to evaluate or compute the implied goodwill or test goodwill impairment, we should include the combined net assets of Plant 3 which includes property, plant and equipment. 8A-Impairment or Disposal of Long-Lived Assets (WG&L) provided relevant parts that: “impairment occurs when the carrying amount of asset is not recoverable and a write-off is needed”.
The section also mentioned about various events and changes in circumstances might lead to an impairment such as a significant decrease in the market value of an asset which usually applies to land, equipment, a significant adverse change in legal factors or in the business climate that affects the value of an asset, an accumulation of costs significantly exceeding the amount originally anticipated for the acquisition or construction of the asset, and a projection or forecast that demonstrates continuing losses associated with an asset.
If the events or changes indicate that the carrying amount of the asset may not be recoverable, a recoverability test is used to determine whether impairment has occurred and then we come up the impairment measurement. The table below showed the computation of the long-lived asset impairment loss at both 3 percent discount rate and the 9 percent discount rate | 3% discount rate| 9% discount rate| Net book value – Plant 3| 1,400,000,000| 1,400,000,000| Fair value over 11 years with discount rate| (600,002,144. 12)| (436,980,181. 30)| Impairment loss| 799,997,855. 88| 963,019,818. 70| Present value=( 3%,11, $62,504,377, $30,000,000)| Present value =( 9%,11, $62,504,377, $30,000,000)| | | | | | | Information provided: * Yearly anticipated net cash flows: $62,504,377 * The total estimated undiscounted net cash flows: $717,548,147 * Plant 3 at end of 11 years: $30,000,000 Once an impairment loss is recorded, the reducing carrying amount of assets of Plant 3 held for use becomes its new cost basis. An impairment loss should be applied only to the covered long-lived assets in the group. Allocation of the loss should be pro rata and based on relative carrying amounts.
However, an individual long-lived asset in the group may be reduced to a carrying amount below the asset’s fair value (if that fair value is determinable without undue cost and effort). As a result, the new cost basis is not changed except for depreciation in future periods or for additional impairments. If the equipment which is impaired and is written down to its fair value and at the end of the end year, the fair value subsequently increases, the carrying amount of the asset should not change except for the depreciation taken on that year.
The impairment loss may not be restored or write-up for assets in plant 3 held for use. Once written down because of impairment, long-lived asset write-downs or goodwill write-downs should not be written up if there is the prediction of increase in fair value. The rationale for not writing the long-lived assets up in value is that the new cost basis puts the impaired asset on an equal basis with other assets that are not impaired. The accounting for Business Combinations (WG;L) 9. 1 provided that “the acquiring entity recognizes goodwill in a business combination as the difference between: 1) the fair value of the consideration transferred, plus the fair value of any noncontrolling interests in the acquiree 2) the fair value of the identifiable net assets acquired. 2 Goodwill is measured as a residual amount, and it is only recognized if the sum of the fair value of the consideration transferred and noncontrolling interests exceeds the fair value of the acquired net assets”. The First Motor tests for goodwill impairment at the reporting unit level, which are the First Motor’s operating segments.
Separate financial information about these segments is regularly evaluated by the first Motor’s chief operating decision maker in deciding how to allocate resources. The general rules that apply to impairments of long-lived assets also apply to goodwill. The impairment happens whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Goodwill is a “going concern” valuation and cannot be separated from other assets and liabilities which give it value. As a result, goodwill impairments involve a grouping of net assets.
In the case goodwill is involved an impairment loss, how should the impairment loss be allocated to the net assets? The FASB required that where goodwill is associated with assets that are subject to the impairment loss, the carrying amount of the associated goodwill should be eliminated before the carrying amounts of impaired long-lived assets are reduced to their fair values. If the impairment loss were greater than the carrying amount of goodwill, the additional loss would be used to reduce the remaining long-lived assets to fair value. Financial Statement Disclosures for Intangible Assets (WG;L) 10. 1: “In determining the appropriate discount rate, the company considered the weighted average cost of capital for comparable companies. Management uses all available information to make these fair value determinations, including the present values of expected future cash flows using discount rates commensurate with the risks involved in the assets”. The tables below show us the computation in determining the implied goodwill value and the goodwill impairment loss using a 3 percent discount. (In millions) Table 2 ( from case)| Fair value information| 3% Discount Rate| 8% Discount Rate| First Motors Division| 2,600| 2,045| Macinaw Division| 3,200| 2,550| Total (First Motors)| 5,800| 4,595| | | | Fair value of Identifiable Net Assets| First Motors Division| 2,500| 2,010| Macinaw Division| 2,800| 2,200| Total (First Motors)| 5,300| 4,210| Table 3 ( from case)| Book Value| | Indentifiable Net Assets| Goodwill| | First Motors Division| 2,000| 0| | Macinaw Division| 3,000| 1,300| | Total (First Motors)| 5,000| 1,300| | Computation for implied goodwill and goodwill impairment loss | 3% Discount Rate| 8% Discount Rate|
Macinaw Division| 3200| 2550| Identifiable net assets| 2800| 2200| Goodwill| 400| 350| | 3% Discount Rate| 8% Discount Rate| Book value ( table 3)| 1,300| 1,300| Goodwill ( current FV)| 400| 350| Impairment loss| 900| 950| | | | Fair value| 1,300| 1,300| Goodwill ( current FV)| 400| 350| Implied goodwill| 900| 950| In selecting an appropriate discount rate for determining the implied goodwill and the goodwill impairment loss, I think we should consider relevant factors which can influence our choice of a discount rate * Inflation expected in the future Risk perceived in the combination of First Motor and Macinaw Motor or the efficiency of separate operation after merging * Other opportunities available in the gasoline-powered vehicles, equipped hybrid-based or hydrogen-based vehicles. The strategic planning for keeping assets is vague. There were so many unclear things on determination of whether the assets should be sold after 11 years of operation or retooled over and over. Based on accounting records, the buildings have a remaining useful life of 25 years and the land has an unlimited useful life and the asset should be put in operation for the whole useful life.
One important factor is that the stock price of First Motors was so volatile over the past year and the market capitalization was not good indicator of the fair value of First Motors. The effects of future inflation are a significant factor in our selection of a discount rate. A discount rate should incorporate an inflation factor and the cash flow estimates should be adjusted for inflation. As a general rule of thumb, we always want to have our “Cap Rate” higher than our borrowing rate. Otherwise, negative leverage may occur. Risks to old equipment and buildings significantly influence in determining an appropriate discount rate.
As we can see, there is a higher risk in older buildings and equipment with greater functional obsolescence. It could be in the wrong part of town or in an area where vandalism is a problem. After considering the relevant factors, I think that an 8 percent discount rate, which includes a 5 percent risk premium, is reasonable compared with a 3 percent discount rate which is considered too low. The discount rate would be risk-adjusted, reflecting the market assessment of the First Motors Division and Macinaw Division risks, including those related to the liquidity of the assets, capital controls.
The difference in a risk premium in discounting cash flow between Plant 3 and Macinaw Division may be explained as the following: * First Motor Executive believed that consumers were still purchasing gasoline-powered vehicles because the purchase price was still less than that of similarly equipped hybrid-based or hydrogen-based vehicles. However, management would like to convert Plant 3 to manufacture a hydrogen-based vehicle at some point in the future. The potential risks exist if the consumers switch from gasoline-powered vehicles to hydrogen-based vehicles and First Motor management cannot response quickly to the demand.
It will require a higher risk to compensate for the expected loss in the future * To retool Plant 3, it requires substantial equipment costs such as welding equipment, conveyors, robots and a new platform. One more thing, there is just an assumption, not for sure, about a significant increase in oil supply from expected oil reserves in Alaska. But in 2012, management was surprised that oil reserve estimates were inaccurate for the ANWR, Alaska. There was a spike in gasoline prices during 2012 and the sales of the Spokane model did not meet expectations.
Clearly, this reason brought higher risk in sales of Spokane that Plant 3 was being responsible for. * There are some severe arguments about whether or not Macinaw Division should keep Plant 3 operated and wait to convert Plant 3 to manufacture a hydrogen-based vehicle. Conclusion: In real world, to come up with an appropriate discount rate including risk premium is not an easy problem. Each of different companies is affected by different factors in the industry. The rate depends on many factors such as financial strength, products, company size, competitors, etc.
The company has to analyze internal and external factors to give an appropriate rate. To determine the fair value of identifiable net asset information of each asset is just relative based on the appraisals, from then we will come up with the implied goodwill. The general rules used to test an asset or goodwill impairment are similar but it will depend on the characteristics or features of assets used for business activities. In general, the methods or techniques, used in accounting policies and procedures, should be in uniform no matter what forms of entrepreneur or industries are you in.