First Motor Case

orbiculate Perspectives on Accounting Education flashiness 5, 2008, 17-25 FIRST MOTORS CORPORATION A classroom CASE ON IMPAIRMENTS Tim Krumwiede College of Business Bryant University Smithfield, Rhode Is estate of the realm ground forces Emily Giannini Graduate Student, College of Business Bryant University Smithfield, Rhode Island USA get up This part bears a circumstantial abbreviation of deterrents of some(prenominal)(prenominal) perdurable assets and saving grace for starting livestock Motors potbelly, a fictitious automobile go with. By integrating multiple issuances into this case, students ar presented with some of the complexities and inter kindreds that argon seen in practice.To properly cook solutions to this case, students must successfully read, interpret, and apply both business relationship standards and concept statements. The consumption of head in choosing a expense reduction put for present measure computations is an important particle of this case. In occurrence, an earnings perplexity issue and resulting conflict amid runner Motors solicitude and the ships comp to each one(prenominal)s visitor revolves shoemakers last to the throw out roam quality. Addition ally, the suggested interrogatives supplyd with the case require that students address functions of the conceptual framework in the context of the prejudice standards.This case put up be utilize in swiftness division financial reporting classes at either the to a pocket-sizeder place potash alum or graduate level. Key words detriment, grace of God, long-wearing assets, entailment drift BACKGROUND t is currently 2013 and you atomic number 18 a member of the elaboration team assigned to analyse first-class honours degree Motors sens for the year close blasting 12/31/2012. setoff Motors Corporation is a political machine manufacturing smart set foc ingestiond on moving from the production of gaso tonal pattern- base cars to the production of cars I 17 18 Krumwiede and Giannini based on alternating(a) fire sources.It was one of the first-class honours degree car companies to successfully declare hybrid-based vehicles in the United States. prime Motors has successfully well-kept car gross sales and retained of import employees while creating modern, efficient cars. By 2008, initial Motors was manufacturing 2 vehicles, both of which are ease cosmos manufactured like a shot. One specimen is a hybrid-powered vehicle that open fire be customized in style and features for any emptor around the globe. This personate, called the Passaic, is manufactured in Detroit, Michigan, close to the companys corpo grade headquarters. starting line Motors besides manufactures a gasoline-powered model, the M expiryoza, at its ground in Lorain, Ohio. In 2008, to take advantage of its resource fuel source expertise, start-off Motors bargain ford a adult competitor, Macinaw Motors Corporation, which had m ade significant show up with heat content-powered cars. As the United States is moving toward alternative push button sources, atomic number 1 is increasingly beingness social occasiond as a fuel source to replace gasoline. To achieve such(prenominal) progress, several processes can be applyd to make hydrogen. According to the theme hydrogen Association (2006), hydrogen can be made from water, biomass, coal, and natural gas.Much of the hydrogen produced today comes from steam reforming natural gas. Alternatively, an electrolyzer can be use to sepa prescribe water into its components, group O and hydrogen. The hydrogen can then be cooled d aver to form liquid hydrogen which can be stored at hydrogen fuel stations. Macinaw Motors had experimented with several hydrogen technologies unless eventually settled on the use of liquid hydrogen in an cozy combustion engine as the about effective way to make potent progress with hydrogen as an alternative fuel.Due to Macinaw Motor s valuable research and development program, run efficiencies, and exceptional reputation, part of the purchase legal injury was apportiond to dear volition. The amount preserve as thanksgiving was $1. 3 one million million million, or the difference between the $5 billion purchase wrong ( handsome cherish) of Macinaw Motors as a whole and the $3. 7 billion sensible re cerebrate of of its recognizable force out assets. When first base Motors purchased Macinaw Motors, the combined company retained the name offset Motors Corporation.Although low gear Motors and Macinaw Motors merged, the former root Motors is operated as the First Motors Division and the former Macinaw Motors is operated as the Macinaw Motors Division. to each one division acts as a component of the enterprise that earns revenues and incurs expenses from engaging in its own business activity. Additionally, each division is reviewed by the enterprises chief run decision maker to assess its cogniti ve operation and each division has its own discrete set of financial learning. At the fourth dimension of the purchase, Macinaw Motors had three manufacturing plants, all of which are free operating today.Each plant is use to produce one car model. whole shebang 1 is located in Irvine, California, where the hydrogen-powered Mankato is produced. full treatment 2 is located in Mishawaka, Indiana, where the hydrogen-powered Sheboygan is produced. rig 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 comfort purchasing gasoline-powered vehicles because their purchase price was free less than that of too equipped hybrid-based or hydrogen-based vehicles. perplexity of First Motors plans to vary go under 3 to manufacture a hydrogen-based vehicle at some set in the succeeding(a). However, for the succeeding(prenominal) several years, First Motor s wants to capitalize on the food market for gasolinepowered vehicles and define 3 impart glide by to be utilize in the production of gasoline-powered cars. In late 2008, concern began retooling sic 3 of the Macinaw Division to create a new, efficient, and super desirable gasoline-powered model of the Spokane. To retool ready 3, the First Motors Corporation A classroom causal agency on Impairments 19 ivision incurred self-colored equipment costs including the costs of body aggregation jigs, welding equipment, conveyors, robots, and a new platform. Management fixed to retool the plant and continue with a new model Spokane under the assumption that on that point was going to be a significant increase in embrocate supply from anticipate embrocate militia in the Arctic National Wildlife Refuge of Alaska (ANWR). It was believed that these oil militia would befriend keep the price of gasoline fine-tune which, in turn, would continue to stimulate pauperization for gas oline-powered cars. The retooling process was completed during 2009.THE CASE In 2012, First Motors focus was surprised to reveal that oil reserve estimates were inaccurate for the ANWR. laterwards debate over this controversial drill repair, legislation was at last passed in 2010 that include approval for ANWR oil drill. Some citizens of Alaska and other states were angered by the new law and pro footraceed the approval of oil drilling. Nevertheless, in 2012, drilling proceeded in one small distribute and authorized area. Results of the initial drilling revealed that the judge 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 head in gasoline prices during 2012 and the sales of the Spokane model did non meet expectations. Closure of lay out 3 was dispenseed however, for four reasons, precaution decided to keep establish 3 open. First, prudence believed the spike in gasoline pri ces was non permanent and that other oil reserves would help to moderate forthcoming oil prices. Second, significant expenditures had already been made on the plant, and it would not require large amounts of additive capital in the near time to come.Third, consumers were still purchasing gasoline-powered vehicles because of the continued price differential coefficient between these vehicles and vehicles utilise alternative energy sources. Finally, because of union contracts, any assembly line workers laid off would be pay wages by the Macinaw Division at 75 per centum of straight-time pay. Thus, solicitude hardened that it was not the abstract time to transpose set up 3 to a hydrogen-based plant. Impairment Despite these reasons to keep whole caboodle 3 open, its long assets will not devolve the mesh silver flows originally expect when the plant was retooled.In fact, as the result of really deep discounting of the Spokanes retail price during the year, it is possi ble that the final numbers for 2012 may show negative operating gold flows cerebrate to lay down 3. Accordingly, focussing opinionated that an in exceptice test must be realizeed for the whole kit 3 perdurable assets. To adjust if the assets are impaired, counsel compares the future undiscounted specie flows of Plant 3 to the make survey of the plants long-lasting assets. As of 12/31/2012, the shekels tolerate range of Plant 3s property, plant, and equipment is $1. 4 billion, to begin with any record from constipation is recorded.Additional relevant entropy is as follows The estimated remaining life of the assembly line equipment is 11 years. Yearly anticipated give notice currency flows for each of the next 11 years is $62,504,377. It is sham that the land, buildings, and equipment for Plant 3 can be sold for $30 zillion at the end of this 11-year period. The fare estimated undiscounted straighten out immediate payment flows related to Plant 3 ov er 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 measuring the stultification leaving for Plant 3, management considers various evaluation methods for this equipment. It is fit(p) that most of the equipment has no alternative use and that a sales harbor is not readily available. Accordingly, undermentioned the guidance of program line of financial Accounting Standards (SFAS) no. 157 (FASB, 2006), management determines that the fair value of the Plant 3 indestructible assets is best measured by the present value of its future net notes flows. The companys management measures the present value of future capital flows using a jeopardyfree discount rate of 3 shareage.Because expected net bullion flows are not adjusted for inflation, management does not constitute an inflation reckon into the discount rate. Using the 3 per centuma ge rate, the present value of the net inter variety flows is $600 million, resulting in an impairment harm of $800 million ( countersign value of long-lived assets of $1. 4 billion less $600 million fair value as unyielding by discounted future silver flows). Once the impairment red ink 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 farsightedness of the audit, the spare-time activity selective information is compiled regarding these Plant 3 assets TABLE 1 Plant 3 Property, Plant, and Equipment Land Buildings Robots and Related Equipment Other Equipment inwardness gain Book apprize $500,000 20,000,000 140,000,000 1,239,500,000 $1,400,000,000 equitable order $1,000,000* 20,000,000* not Available none 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 quick rub of the component party, and you learn about various changes in the car assiduity, including the lack of oil reserves in the ANWR. You contend that an impairment leaving was recorded for the Plant 3 assets, and you are impressed with managements inaugural in measuring, recording, and disclosing the tone ending.However, you enjoy if an impairment wrong 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 strong because of its compact size and refined gas mileage. aft(prenominal) reviewin g the documentation accompaniment the impairment vex, you note that future cash flows are discounted at a safe rate of 3 per centumage and that this rate does not incorporate 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 incorporate a bump gift and although you are relatively new to auditing, you know that 3 percent is a rather low discount rate. You approach management questioning this low discount rate and they become real 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 premium could not be adequately measure d. Additionally, they refer to relation of Financial Accounting Concepts nary(prenominal) 7 (FASB 2000), which suggests that in such a function a risk-free rate can be used. In re-evaluating the net cash flows, and by and by proveions 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 premium to the discount rate, to incorporate fully the risk inherent in the cash flows. After consultation with the soakeds 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 a lot more reasonable rate to use in discounting the cash flows.You are in truth proud of your findings and hope to make a good impression on your audit manager, Mr. irritation. Although you had briefly discussed with him the magnitude of the impairment loss and the discount rate used, he left-hand(a) the calculations and details up to you. When you approach him, however, he appears extremely frustrated and explains that First Motors never even complied with the yearly test for grace impairment, as specified in SFAS No. 142 (FASB 2001). You suggest that the blessing 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 rear end manner that impairment of long-lived assets and free grace often go hand in hand. He explains that upon acquisition of Macinaw Motors, $1. 3 billion was recorded as seemliness (t he bare(a) 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 studyd some members of management grumbling about losing their bonuses if these auditors keep feeler up with more impairment postures. You adopt management has significant bonuses tied to the 2012 soft touch gains, and a large impairment loss will cause them to lose the expected bonuses. A quick review shows that the largest center impairment 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 arrangement states that bonuses will completely be paid if 2012 net income exceeds $. 5 billion.You go home that evening and visualise that you do not really s ympathize 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 entire company or just the Macinaw Division. You print out the unbendables training material on impairments and spend the rest of the evening interpreting about SFAS No. 142. 22 Krumwiede and Giannini The next day, you attend a meeting with management and Mr. Bother. During the meeting, you are first excited when you hear management indicate that they made an misapprehension 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 collapse when management indicates that the impairment examen for long-lived assets should have been do at a different level. In particular, management states that impairment exam 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 choose because the filiation in the value of the Plant 3 long-lived assets could be send-off by the increase in the value of the longlived assets at the other plants. It is further explained that the individual(a) who made the error is no eight-day with the company. Mr. Bother explains to management that the issue will be examined more closely. Before any further explanation can be provided, members of management are called away for some other meeting.As you leave the meeting you realize that you do not know whether management is clear about combining long-lived assets for all plants of First Motors to perform the impairment test. Furthermore, you inquire if impairment testing is through for both plant assets and goodwill, if it can be a combined test, and if it needs to be through with(p) 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, according to the score records, the buildings have a remaining usable life of 25 years and the land has an unlimited useful life. A equal of days earlier, the valuation method for any possible goodwill impairment testing was discussed.It was determined that no fair value was readily available for First Motors or its divisions. Additionally, because the stock pric e of First Motors was so volatile over the past year, the market capitalization was not a good indicator 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 corresponding valuation experts from the firm who recommended a 6 percent risk premium for use in the Plant 3 long-lived asset impairment. Management calculations and your calculations are summarized infra 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 rank 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 order of 3 percent and 8 percent, respectively.Finally, presented in Table 3 is a summary 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 reasonably note value Information 3% send away Rate integrality Fair Value First Motors Division Macinaw Division sum up (First Motors) Fair Value of Identifiable Net Assets First Motors Division Macinaw Division fare (First 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 * Please note that the total fair value for the Macinaw Division includes the combined net assets of Plants 1, 2, and 3. TABLE 3 Book Va lue 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) dower 1 Please provide detailed explanations in exercise 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. Diagram the organisational structure of First Motors Corporation. 2. a. Under what mountain is a company required to perform impairment testing for long-lived assets? b. Was impairment testing of long-lived assets required for First Motors? wherefore or why not? 3. a. At what level is impairment testing make for long-lived assets? b.Are the executives of First Motors do in suggesting that the impairment of longlived assets at Plant 3 is not needed because the d ecline 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. issue 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. Prepare a schedule display 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 bet 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, how 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 see 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 exceed 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 receive 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 relations hip 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, chin-wagging on the verifiability and representational 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 trade-off 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? Co nsider 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 tenet 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 educational activity No. . (Norwalk, CT FASB). _______, 2000, Using property Flow Information and Present Value in Accounting Measurements, Concepts assertion No. 7. (Norwalk, CT FASB). _______, 2001. Goodwill and Other impalpable 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/ usual/faqs. asp.