: 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.

Step by step solution

01

Meaning of Goodwill

Goodwill is the fraction of the purchase price that is greater than the net fair valueof 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).

02

(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.

03

(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

04

(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

05

(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.

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