First Motor Case

global Perspectives on history Education Volume 5, 2008, 17-25 FIRST MOTORS CORPORATION A CLASSROOM CASE ON IMPAIRMENTS Tim Krumwiede College of stock Bryant University Smithfield, Rhode Island USA Emily Giannini Graduate Student, College of Business Bryant University Smithfield, Rhode Island USA ABSTRACT This event implores a detailed analysis of deadenings of devil undestroyable as baffles and saving grace for foremost Motors potty, a fictitious automobile telephoner. By integrating multiple contributeant roles into this case, students ar entered with some of the complexities and interrelationships that be seen in practice.To justly prep ar solutions to this case, students must successfully read, interpret, and apply some(prenominal) accounting standards and ideal statements. The use of judgment in choosing a discount valuate for amaze encourage computations is an important cistron of this case. In accompaniment, an earnings circumspection issue and resul ting conflict between introductory Motors worry and the participations attendant revolves around the discount array choice. Addition onlyy, the suggested distrusts provided with the case require that students address comp acents of the abstract framework in the context of the evil standards.This case put up be utilise in upper variant financial reporting classes at either the undergraduate or graduate level. Key words Impairment, good forget, undestroyable assets, discount swan BACKGROUND t is soon 2013 and you argon a member of the engagement group assigned to analyse prototypal Motors confederation for the year ending 12/31/2012. first Motors Corporation is a car manufacturing company foc employ on moving from the fruit of gasoline- ground cars to the production of cars I 17 18 Krumwiede and Giannini based on alternative elicit sources.It was one of the depression car companies to successfully produce hybrid-based vehicles in the fall in States. prototyp ic Motors has successfully maintained car sales and retained worthful employees while creating modern, efficient cars. By 2008, First Motors was manufacturing two vehicles, both of which atomic number 18 calm down being reconstructd today. One imitate is a hybrid-powered vehicle that can be customized in style and features for any purchaser around the globe. This model, called the Passaic, is manufactured in Detroit, Michigan, close to the companys corporate headquarters.First Motors in addition manufactures a gasoline-powered model, the Mendoza, at its countersink in Lorain, Ohio. In 2008, to take appreciate of its alternative burn down source expertise, First Motors purchased a broad competitor, Macinaw Motors Corporation, which had do epochal progress with hydrogen-powered cars. As the United States is moving toward alternative pushing sources, hydrogen is increasingly being used as a fuel source to replace gasoline. To achieve such(prenominal) progress, some(pren ominal) processes can be used to make hydrogen. According to the National Hydrogen Association (2006), hydrogen can be made from water, biomass, coal, and natural gas.Much of the hydrogen produced today comes from go reforming natural gas. Alternatively, an electrolyzer can be used to separate water into its components, atomic number 8 and hydrogen. The hydrogen can then be cooled down to form fluidness hydrogen which can be stored at hydrogen fuel stations. Macinaw Motors had experimented with several hydrogen technologies but eventually settled on the use of transparent hydrogen in an internal combustion engine as the intimately effective way to make substantial progress with hydrogen as an alternative fuel.Due to Macinaw Motors valuable research and development program, operating efficiencies, and exceptional reputation, image of the purchase hurt was portiond to goodwill. The amount record as goodwill was $1. 3 million, or the difference between the $5 billion purchase price (fair hold dear) of Macinaw Motors as a whole and the $3. 7 billion fair set of its identifiable boodle assets. When First Motors purchased Macinaw Motors, the combined company retained the name First Motors Corporation.Although First Motors and Macinaw Motors merged, the former First Motors is operated as the First Motors divergence and the former Macinaw Motors is operated as the Macinaw Motors air division. Each division acts as a component of the enterprise that earns revenues and incurs expenses from engaging in its own business activity. Additionally, distributively division is check intoed by the enterprises chief operating decision ecclesiastic to assess its performance and each division has its own discrete set of financial selective information. At the time of the purchase, Macinaw Motors had three manufacturing plants, all of which are still operating today.Each plant is used to produce one car model. vegetation 1 is located in Irvine, California, where the hydrogen-powered Mankato is produced. gear up 2 is located in Mishawaka, Indiana, where the hydrogen-powered Sheboygan is produced. full treatment 3 is located in Braselton, Georgia, where the gasoline-powered Spokane is produced. When Macinaw Motors was purchased in 2008, executives at First Motors believed that consumers were still buying gasoline-powered vehicles because their purchase price was still less than that of similarly equipped hybrid-based or hydrogen-based vehicles. guidance of First Motors plans to convert Plant 3 to manufacture a hydrogen-based vehicle at some point in the succeeding(a). However, for the near several age, First Motors wants to capitalize on the market for gasolinepowered vehicles and Plant 3 will continue to be used in the production of gasoline-powered cars. In late 2008, focal point began retooling Plant 3 of the Macinaw part to create a refreshing, efficient, and highly desirable gasoline-powered model of the Spokane. To retool Plant 3, the First Motors Corporation A Classroom Case on Impairments 19 ivision incurred substantial equipment be including the costs of body assembly jigs, welding equipment, conveyors, robots, and a new platform. Management decided to retool the plant and continue with a new model Spokane under the assumption that there was going to be a significant increase in oil color supply from judge oil reserves in the Arctic National Wildlife Refuge of Alaska (ANWR). It was believed that these oil reserves would function move the price of gasoline down which, in turn, would continue to hie demand for gasoline-powered cars. The retooling process was completed during 2009.THE CASE In 2012, First Motors heed was surprised to learn that oil reserve estimates were inaccurate for the ANWR. After struggle oer this contr everyplacesial drilling location, legislation was finally passed in 2010 that include approval for ANWR oil drilling. Some citizens of Alaska and separate states were angered b y the new law and pro examened the approval of oil drilling. Nevertheless, in 2012, drilling proceeded in one small select and authorized area. Results of the initial drilling revealed that the expect oil reserves in that location were non nearly as large as projected.Due to the ANWR finding and turmoil in the Middle East, there was a spike in gasoline prices during 2012 and the sales of the Spokane model did non seemly expectations. Closure of Plant 3 was considered however, for four reasons, management decided to keep Plant 3 open. First, management believed the spike in gasoline prices was non permanent and that other oil reserves would help to moderate upcoming oil prices. Second, significant expenditures had already been made on the plant, and it would non require large amounts of additional capital in the near future day.Third, consumers were still purchasing gasoline-powered vehicles because of the continued price differential between these vehicles and vehicles using alternative competency sources. Finally, because of union contracts, any assembly line workers laid off would be paid wages by the Macinaw discussion section at 75 pct of straight-time pay. Thus, management immovable that it was non the give up time to convert Plant 3 to a hydrogen-based plant. Impairment Despite these reasons to keep Plant 3 open, its indestructible assets will not generate the shekels capital flows originally anticipated when the plant was retooled.In fact, as the result of really deep discounting of the Spokanes retail price during the year, it is workable that the final numbers for 2012 may sight negative operating immediate payment flows tie in to Plant 3. Accordingly, management determine that an injury test must be performed for the Plant 3 indestructible assets. To determine if the assets are impaired, management compares the future undiscounted immediate payment flows of Plant 3 to the take hold appraise of the plants long-wearing asset s. As of 12/31/2012, the sack up book protect of Plant 3s property, plant, and equipment is $1. 4 billion, before any write-down from impairment is recorded.Additional relevant information is as follows The estimated remaining life of the assembly line equipment is 11 years. per annum anticipated dis steer cash flows for each of the next 11 years is $62,504,377. It is presume that the land, buildings, and equipment for Plant 3 can be interchange for $30 one million million at the end of this 11-year period. The total estimated undiscounted sack up cash flows preserved to Plant 3 over the next 11 years are $717,548,147 (($62,504,377 x 11) + $30,000,000). 20 Krumwiede and Giannini The assembly-line and related equipment are considered the primary assets of Plant 3.In amount the impairment detriment for Plant 3, management considers diverse valuation methods for this equipment. It is determined that most of the equipment has no alternative use and that a sales value is not readily available. Accordingly, side by side(p) the guidance of Statement of Financial story Standards (SFAS) no. 157 (FASB, 2006), management determines that the fair value of the Plant 3 durable assets is best measured by the present value of its future net cash flows. The companys management measures the present value of future cash flows using a hazardfree discount rate of 3 portion.Because expected net cash flows are not adjusted for inflation, management does not be an inflation doer into the discount rate. Using the 3 percentage rate, the present value of the net cash flows is $600 million, resulting in an impairment issue of $800 million (book value of permanent assets of $1. 4 billion less $600 million fair value as determined by discounted future cash flows). Once the impairment discharge is determined, management is not sure how to allocate it and decides to wait for its auditors to assist in the allocation.The property, plant, and equipment of Plant 3 can be divided into four primary categories land buildings robots and related equipment and all other equipment. In anticipation of the audit, the following information is compiled regarding these Plant 3 assets display panel 1 Plant 3 Property, Plant, and Equipment Land Buildings Robots and Related Equipment Other Equipment tot up Net Book Value $500,000 20,000,000 140,000,000 1,239,500,000 $1,400,000,000 Fair Value $1,000,000* 20,000,000* none available Not Available $21,000,000 Without undue costs, the fair value of the land and buildings are obtained from an outside appraisal. The 2012 Audit In early 2013, you go with your audit team to the First Motors headquarters in Detroit, Michigan for the audit, for the year ending declination 31, 2012. Your team gets a ready(a) tour of the factory, and you learn to the highest degree various changes in the car industry, including the lack of oil reserves in the ANWR. You subsist that an impairment loss was recorded for the Plant 3 as sets, and you are affect with managements initiative in measuring, recording, and disclosing the loss.However, you wonder if an impairment loss should have been recorded for the Mendoza, the other gasolinepowered car produced by First Motors. Fortunately, First Motors maintains cash flow and sales information on a plant by plant basis and you quickly learn that during 2012, sales of the Mendoza remained loaded because of its compact size and excellent gas mileage. After reviewing the documentation encouraging the impairment charge, you note that future cash flows are discounted at a risk-free rate of 3 percent and that this rate does not be an First Motors Corporation A Classroom Case on Impairments 1 inflation factor because the cash flow estimates were not adjusted for inflation. You mistily recall from a college class that a discount rate should unified a risk support and although you are relatively new to auditing, you get by that 3 percent is a rather low discount rate. Y ou salute management questioning this low discount rate and they become very defensive in explaining that 3 percent is the rate for all the Plant 3 assets and that no other rate would be appropriate. Upon inquiry about risk being considered in such a rate, management stubbornly states that the 3 percent rate is fine.When asked for justification, management reasons that they reached this conclusion due to the fact that a risk pension could not be adequately measured. Additionally, they fix to Statement of Financial Accounting Concepts No. 7 (FASB 2000), which suggests that in such a situation a risk-free rate can be used. In re-evaluating the net cash flows, and by and by discussions with management, you agree that the cash flows are in fact the single, most-likely amount in a range of possible estimated amounts or the best estimate for the next 11 years (the expected life of the primary assets of Plant 3).However, you believe risk is not factored into these cash flow estimates. You suggest adding a risk indemnity to the discount rate, to incorporate fully the risk inherent in the cash flows. After point of reference with the firms valuation experts, you are told that a risk premium is appropriate. Also, based on their experience in the auto industry and review of First Motors and Plant 3, the valuation experts suggest that an appropriate risk premium is 6 percent. From their advice, you conclude that 9 percent (3 percent risk-free rate + 6 percent risk premium) is a much more fair(a) rate to use in discounting the cash flows.You are very sublime of your findings and hope to make a good impression on your audit manager, Mr. Bother. Although you had briefly discussed with him the magnitude of the impairment loss and the discount rate used, he left the calculations and details up to you. When you approach him, however, he appears extremely disappointed and explains that First Motors never even complied with the yearly test for goodwill impairment, as sp ecified in SFAS No. 142 (FASB 2001). You suggest that the goodwill impairment test may be unnecessary because an impairment loss for the plant assets has already been recorded by management.Mr. Bother shakes his head at you, grumbles, and tells you in a very stern manner that impairment of long-lived assets and goodwill lots go hand in hand. He explains that upon acquisition of Macinaw Motors, $1. 3 billion was recorded as goodwill (the excess of the purchase price over the fair value of the identifiable net assets of Macinaw Motors). Mr. Bother explains to you that the fair value must be re-evaluated and compared to the book value. Furthermore, you heard some members of management kick about losing their bonuses if these auditors keep coming up with more impairment charges. You gather in management has significant bonuses tied to the 2012 target profits, and a large impairment loss will cause them to lose the expected bonuses. A quick review shows that the largest total impairme nt losses that can be recorded before the target profit will be missed and the management bonuses lost is $1. 75 billion. Your calculation is based on two facts (a) 2012 unaudited net income before impairment charges is $2. 25 billion and (b) the management bonus positioning states that bonuses will only be paid if 2012 net income exceeds $. 5 billion.You go home that evening and realize that you do not really date what Mr. Bother said to you about goodwill impairment. For one thing, you do not know if Mr. Bother was referring to the fair value and book value of the ideal company or just the Macinaw Division. You print out the firms training material on impairments and spend the rest of the evening knowledge about SFAS No. 142. 22 Krumwiede and Giannini The next day, you attend a meet with management and Mr. Bother. During the meeting, you are first excited when you hear management level that they made an error in the recorded impairment charge for long-lived assets.You think that management finally realizes the necessity of incorporating a risk factor into the discount rate. However, your jubilation is quickly deflated when management indicates that the impairment test for long-lived assets should have been through with(p) at a different level. In particular, management states that impairment interrogatory of long-lived assets should have been for the company as a whole (Plant 1, Plant 2, and Plant 3 of the Macinaw Division, plus the two plants from the First Motors Division) and that the result is the impairment charge should not have been recorded.Management claims this result would hold because the decline in the value of the Plant 3 long-lived assets could be offset by the increase in the value of the longlived assets at the other plants. It is further explained that the individual who made the error is no daylong with the company. Mr. Bother explains to management that the issue will be examined more closely. in the lead any further explanatio n can be provided, members of management are called away for another meeting.As you leave the meeting you realize that you do not know whether management is conciliate about combining long-lived assets for all plants of First Motors to perform the impairment test. Furthermore, you wonder if impairment scrutiny is done for both plant assets and goodwill, if it can be a combined test, and if it ineluctably to be done in a specific order. After reviewing your notes and the company records, you also begin to wonder if a mistake was made in the original calculation of the impairment loss related to long-lived assets.In particular, for purposes of the present value calculations, you note that the land and buildings are assumed to be sold at the end of 11 years. However, you recall from discussions with management that manufacturing plants are used for many years and are retooled over and over. Accordingly, it does not seem appropriate to assume the sale of the land and buildings after 11 years. After all, fit to the accounting records, the buildings have a remaining useful life of 25 years and the land has an unlimited useful life. A couple of days earlier, the valuation method for any possible goodwill impairment exam was discussed.It was determined that no fair value was readily available for First Motors or its divisions. Additionally, because the stock price of First Motors was so volatile over the past year, the market capitalization was not a good index of the fair value of First Motors. You, Mr. Bother, and management came to an agreement that discounted future cash flows was the appropriate valuation technique to use. However, the calculations provided by management incorporated a riskfree discount rate of 3 percent. You took the initiative to do your own calculations based on an 8 percent discount rate, which includes a 5 percent risk premium.The 5 percent risk premium was recommended by the same valuation experts from the firm who recommended a 6 p ercent risk premium for use in the Plant 3 long-lived asset impairment. Management calculations and your calculations are summarized below in Tables 2 and 3. The information in the first portion of Table 2 represents the total fair value of First Motors and its divisions based on discount rates of 3 percent and 8 percent, respectively. Presented in the second portion of Table 2 is the estimated fair value of identifiable net assets based on discount rates of 3 percent and 8 percent, respectively.Finally, presented in Table 3 is a thickset of the book value of identifiable net assets and the book value of net assets before recording any impairment for long-lived assets (the difference represents the book value of goodwill). First Motors Corporation A Classroom Case on Impairments TABLE 2 Fair Value study 3% reject Rate Total Fair Value First Motors Division Macinaw Division Total (First Motors) Fair Value of Identifiable Net Assets First Motors Division Macinaw Division Total (Fir st Motors) $2,600,000,000 3,200,000,000* $5,800,000,000 8% Discount Rate $2,045,000,000 2,550,000,000* $4,595,000,000 23 2,500,000,000 2,800,000,000 $5,300,000,000 $2,010,000,000 2,200,000,000 $4,210,000,000 * gratify note that the total fair value for the Macinaw Division includes the combined net assets of Plants 1, 2, and 3. TABLE 3 Book Value First Motors Division Macinaw Division Total (First Motors) Identifiable Net Assets $2,000,000,000 3,000,000,000 $5,000,000,000 Goodwill $0 1,300,000,000 $1,300,000,000 Net Assets $2,000,000,000 4,300,000,000 $6,300,000,000 QUESTIONS (Assume that currently enacted GAAP is still applicable in the year 2012) Part 1 divert provide detailed explanations in resultant roleing each of the following questions.For questions 2a, 3a, 4a and 5, provide a citation to the appropriate accounting standard that supports your discussion. 1. draw the organizational structure of First Motors Corporation. 2. a. Under what circumstances is a company required to perform impairment examen for long-lived assets? b. Was impairment testing of long-lived assets required for First Motors? Why or why not? 3. a. At what level is impairment testing done for long-lived assets? b.Are the executives of First Motors good in suggesting that the impairment of longlived assets at Plant 3 is not needed because the decline in the value of the Plant 3 assets can be offset by the increase in the fair value of long-lived assets at other plants? 4. a. At what level is impairment testing done for goodwill? 24 b. 5. Krumwiede and Giannini For First Motors, at what level should this testing be done (i. e. , should it be done for the company as a whole or just for the Macinaw Division)? If impairment testing of both goodwill and long-lived assets is required, in what order is it done?Part 2 Please provide detailed explanations in answering each of the following questions. set aside citations to the standards for each of the following questions 6a, 7a, 8a, and 10a. Additionally, it is suggested that you provide citations to SFAC Number 2 (FASB 1980) when answering questions 10b, 11, and 12. 6. a. piece a schedule showing the computation of the long-lived asset impairment loss at both the 3 percent discount rate and the 9 percent discount rate. In the information provided in the case, it was assumed that the land and buildings for Plant 3 were sold at the end of 11 years.Be sure to consider and discuss if the land and buildings assumed sale after 11 years is appropriate or if the assumed sale should be at the end of the buildings useful life. b. Do you think that management is correct in using the 3 percent rate, or are the auditors correct in suggesting the 9 percent rate, or can either cheer rate be justified? Provide a detailed answer to this question including a discussion about a risk premium. Be sure to consider the type of cash flow information provided by management. 7. a. Once an impairment of long-lived assets is determined, h ow is the write-down allocated among multiple assets?Prepare a schedule showing this allocation for Plant 3 (use the impairment loss determined based on the discount rate you chose in question 6b). b. Refer to your answer for part a. After the allocation is completed, will each longlived asset (or asset category) that First Motors wrote down be stated at fair value? Why or why not? c. How will the impairment loss and the corresponding reduction of book value to the long-lived assets affect future depreciation expense to be recorded, (potential) future impairment charges and/or future gains or losses on the sale of the long-lived assets? 8. . Determine the implied goodwill value and the goodwill impairment loss, if any, using both a 3 percent and an 8 percent discount rate. Which rate should be used and why? b. The valuation experts suggested that the risk premium (6 percent) in discounting the free cash flows from Plant 3, for purposes of the long-lived asset impairment, should exce ed the risk premium (5 percent) in discounting the cash flows for the Macinaw Division. Why is this difference in a risk premium justified? 9. a. Will management still gather bonuses if the 3 percent discount rate is used in the calculations?If the 9 percent and 8 percent discount rates are used? b. What is earnings management? c. Discuss the relationship between earnings management and the choice of discount rate to be used in discounting future cash flows for the long-lived asset impairment of Plant 3 and the goodwill impairment of the Macinaw Division. First Motors Corporation A Classroom Case on Impairments 10. 25 11. 12. Once written down because of impairment, can long-lived asset write-downs or goodwill write-downs be recovered if predictions change (i. e. , the fair value subsequently increases)?Is there such a thing as a write-up for either long-lived assets or goodwill? a. Regarding reliability of financial information, translation on the verifiability and representation al faithfulness characteristics of the conceptual framework as they relate to accounting for impairments. Be sure to incorporate First Motors into your discussion. b. Discuss the tradeoff between the relevance and reliability of reporting long-lived assets and goodwill at fair value. How does the principle of conservatism apply to this trade-off? Consider the case of First Motors in your discussion.Find a real-world company that has taken an impairment charge (either for goodwill or longlived assets) and discuss how the relevant information was disclosed in the notes to the financial statements and the affect the charge had on net income or net loss of the company. TEACHING NOTES Teaching notes are available from the editor. Send a request from the For Contributors page of the journal website, http//gpae. bryant. edu. REFERENCES Financial Accounting Standards Board. 1980. Qualitative Characteristics of Accounting Information. Concepts Statement No. . (Norwalk, CT FASB). _______, 200 0, Using Cash Flow Information and Present Value in Accounting Measurements, Concepts Statement No. 7. (Norwalk, CT FASB). _______, 2001. Goodwill and Other Intangible Assets. Statement of Financial Accounting Standards No. 142. (Norwalk, CT FASB). _______, 2006. Fair Value Measurements. Statement of Financial Accounting Standards No. 157. (Norwalk, CT FASB). The National Hydrogen Association. Frequently Asked Questions. Retrieved July 12, 2006, from http//www. hydrogenassociation. org/general/faqs. asp.