Goodwill Impairment Testing
Galaxy Sports Inc. (Galaxy), a U.S.-based manufacturer of sports equipment, is a calendar year-end SEC registrant with one operating segment and the following three reporting units:
Fitness Equipment.
Golf Equipment.
Hockey Equipment.
Galaxy is in a competitive industry with several publicly traded companies in which growth and profitability are tied to the market and consumer demand
Three reporting units are appropriate because discrete financial information is available for each component, each component is a business, and each component is managed separately.
The Fitness Equipment component is Galaxy’s largest reporting unit. Over the years, various acquisitions have resulted in recorded goodwill of $200 million assigned entirely to this reporting unit.
The Golf Equipment component is a large golf equipment manufacturer that was acquired in 2004. Upon acquisition of the business, Galaxy recorded $130 million of goodwill that was assigned entirely to this reporting unit.
The Hockey Equipment component is a small hockey equipment manufacturer acquired in 2003 to gain entry into the very profitable hockey equipment market.
Galaxy recorded $30 million of goodwill related to this acquisition, which was assigned entirely to this reporting unit.
Galaxy has elected an annual goodwill impairment testing date of December 31 for all three reporting units.
In December 2010, Galaxy management engaged Big Time LLC (Big Time), a reputable external valuation firm, to perform three annual ASC 350, Intangibles — Goodwill and Other, impairment analyses (one for each reporting unit) on the $360 million of goodwill recorded by Galaxy as of December 31, 2010. Previously, management had performed the annual goodwill impairment analysis internally. However, given the increasing complexities involved in the calculation and resource constraints at Galaxy, the company decided to use a third party.
Through early discussions with Galaxy’s management and Big Time, it was expected that the entity was going to pass step 1 of the goodwill analysis for all three reporting units with a significant cushion (i.e., the estimated fair value of each reporting unit significantly exceeded the book value) for each reporting unit. This was also consistent with the goodwill analysis that was performed internally by Galaxy in the previous year. Copyright 2009 Deloitte Development LLC
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Case 11-9: Goodwill Impairment T esting
Galaxy management indicated that the significant cushion was likely because
2010 Q4 sales were very strong, and strong sales were also expected for 2011and beyond. Big Time completed its analysis in late January 2011 and, as expected, Galaxy passed step 1 of the annual goodwill impairment test for each reporting unit. Galaxy’s common share price was $56.75 as of December 31, 2010.
Note: As of December 31, 2010, Galaxy’s share price was $56.75 and 46 million shares were outstanding, indicating a market capitalization of $2.6 billion. The implied control premium of 18 percent is viewed by management as reasonable.
First Quarter of 2011
Management released Q1 earnings, which were slightly below expectations. In a Q1 press release, Galaxy attributed the lower earnings to the slowing economy and reduced consumer spending on recreational activities. Galaxy’s common share price fell to $49.25 after the release of Q1 earnings.
Second Quarter of 2011
Management released Q2 earnings on July 15, 2011. As in Q1, Q2 earnings were also below expectations because the slowing economy resulted in continuing reductions in consumer spending. In Galaxy’s press release, management discussed the impact of the slowing economy on its business. Further, the company experienced additional pressure on its sales during the quarter as a result of an increase in sports equipment manufactured in China that was being sold at large discount retailers. The equipment has a lower price point, which is appealing to consumers during difficult economic times. Historically, Galaxy has not experienced significant competition from imports because the quality of the imports is inferior to the quality of the sports equipment manufactured by Galaxy. Galaxy’s common share price fell to $45.25.
Third Quarter of 2011
During the financial close process, management considered performing an interim goodwill impairment test but, after reviewing ASC 350, determined it was not necessary.
Copyright 2009 Deloitte Development LLC
All Rights Reserved.
Case 11-9: Goodwill Impairment T esting
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Management released earnings on October 15, 2011, and indicated that although Q3 earnings were significantly below expectations because of a continued slowing economy and reduced consumer spending, revenue would rebound in Q4 as retailers stocked up for the holiday shopping season. Historically, Q4 has been the strongest quarter for Galaxy with Q4 sales representing more than 50 percent of the company’s annual sales. Galaxy’s common share price fell to $31.50 after the earnings release. On September 15, 2011, the FASB issued ASU 2011-08, Testing Goodwill for Impairment, which amends the guidance in ASC 350-202 on testing goodwill for impairment. Under the revised guidance, entities testing goodwill for impairment have the option of performing a qualitative assessment before calculating the fair value of the reporting unit (i.e., step 1 of the goodwill impairment test). The carryforward option permitted in ASC 350-20-35-29 was removed. The amendments are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted; however, Galaxy elected NOT to early adopt this guidance when performing their annual goodwill impairment test as of December 31, 2011. Year-End 2011
As Galaxy prepared for its annual goodwill impairment test, management determined that (1) assets and liabilities of the Fitness Equipment and Hockey Equipment reporting units had not significantly changed, (2) the most recent fair value determinations (the 2010 analysis prepared by Big Time) for both reporting units resulted in an amount that exceeded the carrying amounts by substantial margins, and (3) on the basis of its analyses, there have been no significant events or circumstances that would cause the fair value to fall below book value for both reporting units. As a result, management decided to carry forward the prior-year step 1 analyses for the Fitness Equipment and Hockey Equipment reporting units. Management believed that ASC 350 supported its determination to carry forward these analyses. For the Golf Equipment reporting unit, management used the analysis created by Big Time last year and updated it as of December 31, 2011, by using the same growth rate and discount rate as in the prior year. On the basis of this updated analysis, management concluded that the Golf Equipment reporting unit passed step 1. A summary of Galaxy’s 2011 annual goodwill impairment test follows:
* We have elected to carry forward the fair value as of December 31, 2010. Note: On December 31, 2011, Galaxy’s share price was $27.50 and 50 million shares were outstanding, indicating a market capitalization of $1.375 billion. We firmly believe that the reporting unit fair values represent management’s view of the company’s business and expectations. The market has undervalued the company’s stock. Accordingly, the implied control premium of 120 percent is viewed by management as reasonable given the overall market climate.
Galaxy released year-end earnings on January 25, 2012. On the basis of the annual earnings release and the lack of an expected Q4 rebound, Galaxy’s common share price fell even further, from $27.50 on December 31, 2011, to $21.25 after the earnings release. Galaxy filed its December 31, 2011, Form
10-K on February 10, 2012. Required:
Should management have performed an interim goodwill impairment test as of September 30, 2011?
Assume no interim test is required. Was management justified in carrying forward the prior-year goodwill impairment test for the Fitness Equipment and Hockey Equipment reporting units?
