Research Paper

ISSUES IN ACCOUNTING EDUCATION American Accounting Association Vol. 30, No. 1 DOI: 10.2308/iace-50949 2015 pp. 35–46

Using the Codification to Research a Complex Accounting Issue: The Case of Goodwill

Impairment at Jackson Enterprises

Casey J. McNellis, Ronald F. Premuroso, and Robert E. Houmes

ABSTRACT: This case is designed to help students develop research skills using the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (Codification or ASC). The case also helps develop students’ abilities to analyze and recommend alternatives for a complex accounting issue, goodwill impairment, which is very relevant in today’s business world. This case can be used in an undergraduate or graduate accounting class, either in groups of students or as an individual student project.

Keywords: FASB Codification; goodwill impairment.

CASE

Goodwill Impairment—Background Summary

T he requirements for assessing the valuation of goodwill subsequent to acquisition have

significantly changed over the past 15 years, most recently with the option to perform

qualitative assessments prior to the commencement of the two-step impairment test and the

amortization alternative now available for private companies. Furthermore, the valuation of

goodwill requires significant judgment, and thus the authoritative literature is accompanied by

significant implementation guidance. The standards surrounding goodwill and the following case

provide students the opportunity to (1) obtain a further understanding of the related concepts

learned from textbooks, (2) sharpen their professional research skills, and (3) apply judgment in a

relevant scenario.

Casey J. McNellis is an Assistant Professor and Ronald F. Premuroso is an Associate Professor, both at the University of Montana, and Robert E. Houmes is an Associate Professor at Jacksonville University.

We thank the editor, associate editor, and two anonymous reviewers for their comments and suggestions on previous versions of this manuscript. We also thank Shandell VanDonsel, a Master’s of Accountancy candidate at the University of Montana, for her help and assistance in the preparation of this manuscript. The experiment using human subjects described in this manuscript was approved by the Institutional Review Board for the Use of Human Subjects in Research at the respective University.

Published Online: October 2014

35

Company Overview—Jackson Enterprises

Jackson Enterprises (JE), a publicly traded company, produces and sells products in several

sectors of the U.S. economy. One of JE’s major segments, which meets the Financial Accounting

Standards Board (FASB) definition of an operating segment, is its semiconductor business

comprised of two subsidiary companies: Dynamic Technologies (80 percent owned and publicly

traded), and ZD Systems (wholly owned). Dynamic Technologies (hereafter, Dynamic) is

headquartered in the northeastern section of the U.S. and specializes in the manufacture of

electronic sensors and indicators used on automated production systems in North America, Europe,

and Asia. In 2011, JE acquired 80 percent of Dynamic’s common stock, a transaction resulting in

$150 million of recognized goodwill. ZD Systems (hereafter, ZD), a company headquartered in the

mid-western section of the U.S., manufactures sensor-type devices used solely for agricultural

machines and systems in the U.S. At the time of the acquisition of ZD in early 2006, JE recorded

$50 million of goodwill. While the two subsidiaries are classified within the same segment for

segment reporting purposes, they are distinct entities and have no intercompany transactions.

Industry Information—Dynamic

The production of the electronic sensors and indicators sold by Dynamic and its competitors

occurs in a highly structured, semi-automated environment. Accordingly, the industry has

established consistent guidelines and best practices as they relate to manufacturing. Consistent with

this high level of automation, a large labor union actively represents the employees of almost every

company in the industry through a collective bargaining process. Recently, the industry experienced

an influx of technological advancements to its standard manufacturing process. Such innovations

allow the companies to better track raw materials throughout every production run, ultimately

reducing the waste normally present in the manufacturing process. The technology is easily

accessible to existing and potential industry participants; as a result, the number of competitors

increased by 35 percent in the past year.

While those within the industry view the new manufacturing advancements positively, the

related practices used by the companies have faced scrutiny recently due to their extensive

environmental and workplace impacts. The average manufacturing plant in the industry emits

carbon at higher rates than some automobile manufacturers. As a result, many companies have been

subject to the close eye of federal and state environmental agencies. Both regulators and union

representatives have claimed that pollution poses health hazards to Dynamic’s workforce.

Organizational Information—Dynamic

Dynamic’s strategic initiatives begin with the seven executives making up its senior

management team. Overall, the company employs approximately 1,500 employees, 102 of which

staff the accounting department. Recently, the employees of Dynamic successfully secured a

collective bargaining agreement with the backing of the major union within the industry. The

agreement becomes effective in the first quarter of calendar 2015.

Dynamic’s production process for sensors and indicators fits the standards and best practices of

the industry. The company uses a mostly automated assembly line, which is staffed by a number of

machine operators, quality control technicians, and supervisors. These employees receive extensive

training through industry workshops, as well as industry training booklets. The production

department performs two daily production runs six days a week for 50 weeks during each year.

Dynamic has been able to keep material costs low relative to its competitors due to some negotiated

short-term purchase commitments with suppliers in the past three years. During the current year, the

typical cost of producing a sensor was approximately $800, and the company consistently applies a

36 McNellis, Premuroso, and Houmes

Issues in Accounting Education Volume 30, No. 1, 2015

25 percent markup on cost in establishing the sales price. Dynamic sells its finished sensors and

indicators through a number of domestic and international distributors. The domestic distributors

also engage in the distribution of replacement parts for computers and high-end medical equipment.

To address the government agencies’ recent scrutiny regarding industry practices pertaining to

environment and workplace issues, Dynamic’s manufacturing personnel recently developed plans

to institute compliance and reporting systems within the manufacturing department. The system

involves the addition of employees whom will administer self-audits of the company’s emissions,

investigate working conditions, and design practices to better track the company’s carbon emissions

and activities aimed at enhancing workplace safety. No other companies in the industry have

created such a monitoring mechanism. Dynamic’s management feels that such a system is

necessary as part of its long-term objectives in order to respond to recent and future increases in

regulatory activity.

Dynamic has experienced stable growth and profitability since its acquisition by JE. In 2014,

the company’s gross margin held steady at approximately 20 percent, three percentage points above

the industry average for the year. In August 2014, JE executives ordered appraisals of all of its

holdings as part of a strategic management initiative. The independent appraisal company valued

Dynamic’s business at $830 million, based upon earnings multiples derived in conjunction with

analysis of other companies within Dynamic’s industry. As of December 31, 2014, Dynamic had

30,000,000 shares of common stock issued and outstanding. The per share price of Dynamic’s

common stock gradually decreased during 2014 from $27/share on January 1, 2014 to $23/share on

December 31, 2014. A condensed summary of balance sheet information (in millions) for Dynamic

as of December 31, 2014 is presented below.

Dynamic Technologies

Current Assets $2,555

Non-Current Assets (including Goodwill) $3,714

Current Liabilities $2,161

Non-Current Liabilities $3,335

Industry Information—ZD

ZD operates in a loosely organized industry that includes only a few competitors. Each

company’s product contains technology distinctly different from that of the competition and thus a

significant amount of variability exists between the manufacturing processes of competitors in the

industry. As a result, the companies share very little information. Differences within the industry,

including the uniqueness of the technologies employed, have made it virtually impossible for new

potential competitors to carve a niche within this industry sector. In fact, in the past six years, the

number of competitors has remained constant. Because of the role this industry plays in enhancing

agricultural innovation and cultivation, federal and state government leaders have taken an interest

in creating a business-friendly atmosphere for companies in this industry committed to enhancing

the competitive advantage of our nation’s farmers and ranchers.

Organizational Information—ZD

ZD is considered among customers and other industry participants as the driver of agricultural

innovation, being the foremost competitor in the industry. Because of ZD’s established reputation,

the company’s market share is dominant in this industry. JE’s executives consider ZD as one of its

best enterprises. ZD stands apart from its competitors because of the state-of-the-art manufacturing

process management developed over the course of several years. The production system for the

sensor devices involves specialized welding, fusing, assembly, and quality control. ZD managers

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have worked diligently to develop a patent for the company’s unique manufacturing process and

methodology. As of December 31, 2014, the patent application was pending approval, but

management remains optimistic the application will ultimately be approved by the United States

Patent Office.

In addition, during the past two years, company scientists advanced some technology and

created protocols substantially reducing the usage of precious metals and hazardous materials,

allowing production operators to complete the welding and fusing of the materials at less-extreme

machine temperatures. As a result, the company has reduced its utility costs by 15 percent each year

for the past two years, pushing the company’s gross profit margin to 35 percent. Due to these utility

cost improvements, ZD recently became eligible for a state-administered manufacturer energy

savings incentive subsidy. This improvement in energy efficiency also caught the eye of

environmental and sustainable business organizations, and the company recently won an industry

award for its sustainable business practices.

The company produces one batch of sensors each weekday during 46 weeks of the calendar

year. During 2014, the average cost of one sensor was $1,495 marked up by 53.85 percent1 in the

market. ZD runs an in-house distribution system, working directly with agricultural companies, as

well as a few sizable farms/ranches to fill customer orders.

ZD employs 1,200 individuals, including 12 members in executive management positions. The

accounting and finance department is staffed with 86 employees. In general, management maintains

a very good relationship with most of its individual employees, several of whom speak very highly

of the family-like atmosphere surrounding the company’s operations. As a result, employee

turnover is minimal at ZD.

During the round of August 2014 independent appraisals, ZD was valued at $1.1 billion, a

figure derived by using the same valuation methodology applied to JE’s other subsidiaries,

including Dynamic. A condensed summary of balance sheet information (in millions) for ZD as of

December 31, 2014 is presented below.

ZD Systems

Current Assets $3,000

Non-Current Assets (including Goodwill) $1,346

Current Liabilities $1,456

Non-Current Liabilities $1,960

Case Requirements

Financial reporting personnel at JE are in the process of completing year-end activities,

including necessary adjusting entries to the consolidated financial statements. While JE has not

previously believed it necessary to adjust its recognized goodwill from the Dynamic and ZD

acquisitions, the valuation of goodwill is, nonetheless, a prominent concern in the closing process.

Assume you are asked to research the financial statement issues surrounding the goodwill recorded

for the Dynamic and ZD subsidiaries. Please respond to the following questions/statements. Do not

cite your course textbook or any other textbook, as textbooks are not authoritative guidance with

regards to accounting research. You should turn in your answers to all of the requirements below.

1. Identify and cite the relevant topics/subtopics from the FASB Accounting Standards Codification for this case.

1 Average cost is $1,495; times 1.5385 equals a selling price of $2,300. The $2,300 unit selling price less $1,495 unit cost equals a gross margin of $805, which is 35 percent of selling price.

38 McNellis, Premuroso, and Houmes

Issues in Accounting Education Volume 30, No. 1, 2015

2. Identify the specific accounting issue that you believe needs to be initially addressed for

JE’s consideration of goodwill with regards to both Dynamic and ZD.

3. What does the qualitative evidence from the case indicate about whether JE should perform

the two-step impairment test? In your response, identify specific factors discussed in the

Codification and relate them to the information provided to you in the case. 4. Beyond the assessment of qualitative factors, what other evidence should be considered for

the purposes of the analysis? What does this information suggest? With respect to Dynamic,

what do you think is the most appropriate fair value amount to use in assessing the fair value

of this reporting unit? Explain. Why is this important?

5. Based upon the information provided above, should Dynamic and ZD be combined or

separated for the purposes of the goodwill analysis? Explain. Why is this important?

6. Based upon your initial analysis, do you think the $200 million goodwill balance (i.e., the

$150 million for Dynamic and the $50 million for ZD) is the appropriate valuation for

goodwill on the December 31, 2014 balance sheet of JE?

7. Prepare a memo detailing the issues involved, the judgments you made in connection with

the authoritative literature, and your recommendation for the direction of the goodwill

valuation as it relates to Dynamic and ZD (i.e., does the evidence suggest further action is

required in determining the appropriate valuation of goodwill? If so, what steps need to be

taken?).

Using the Codification to Research a Complex Accounting Issue 39

Issues in Accounting Education Volume 30, No. 1, 2015

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