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Case 6: Gator Electronics Handout 1 Page 1 Exhibit 1 Valuation Schedules: Gator Electronics Inc. December 31, 20X3, ASC 350 Goodwill Impairment Analysis Summary Step 1 Test (U.S. Reporting Unit) $US in thousands Fair Value of Equity Reporting Unit Book Value of Equity U.S. $ 990,000 $ 730,000 Total $ 990,000 $ Step 1 Passed? YES 730,000 Copyright 2011 Deloitte Development LLC All Rights Reserved. Case 6: Gator Electronics Handout 1 Page 2 Exhibit 2 Valuation Schedules: Gator Electronics Inc. December 31, 20X3, Income Approach: Discounted Cash Flow Method (U.S. Reporting Unit) $US in thousands Audited FYE Audited FYE 12/31/20X1 12/31/20X2 Revenue Revenue growth $ 1,325,000 Operating expenses $ 1,100,000 $ 1,140,000 -17.0% 1,145,000 1,155,000 Pro Forma LTM** 9/30/20X3 $ 1,140,000 3.6% 1,100,000 (55,000) -130.6% -5.0% 40,000 3.5% 50,000 190.9% 4.4% 33,125 27,500 28,500 146,875 (82,500) 11,500 21,500 44,063 Earnings before interest and taxes (EBIT) Provision for income taxes - 420 Debt-free income Debt-free net income growth Debt-free net margin (82,500) -180.2% -7.5% 11,080 27,500 (25,000) (4,000) 102,813 Cash flow adjustments: add/(deduct) Plus: depreciation Less: capital expenditures Less: incremental working capital 33,125 (30,000) (4,000) $ -7.2% FYE 12/31/20X4 101,938 $ (84,000) $ 1,156,896 1,191,603 1,227,351 360,606 775,452 $ 1,136,058 Less: interest-bearing debt Equity value $ 150,000 986,058 Equity value (rounded) $ 990,000 Terminal 1,227,351 80,000 60.0% 6.9% 166,800 108.5% 12.9% 183,104 9.8% 13.7% 188,397 2.9% 13.7% 222,649 18.2% 15.4% 222,649 18.2% 15.4% 29,000 32,250 33,500 34,500 36,250 36,250 51,000 134,550 149,604 153,897 186,399 186,399 6,450 15,300 40,365 44,881 46,169 55,920 55,920 35,700 137.2% 3.1% 94,185 163.8% 7.3% 104,723 11.2% 7.8% 107,728 2.9% 7.8% 130,479 21.1% 9.0% 130,479 1.0% 15,050 118.2% 1.3% 28,500 (30,000) (5,000) 28,500 (30,000) (5,000) 29,000 (25,000) - 32,250 (25,000) - 33,500 (20,000) - 34,500 (25,000) - 36,250 (36,250) - 36,250 (36,250) - 4,580 $ 8,550 -47.3% -61.7% -71.0% $ $ $ Normalized 1,123,200 39,700 $ 0.9407 Present value of discrete cash flows FYE 12/31/20X8 1,080,000 Present value factor (mid-year convention) Total present value of discrete cash flows Present value of terminal value Business enterprise value Entity Projections FYE FYE FYE 12/31/20X5 12/31/20X6 12/31/20X7 $ 1,160,000 $ 1,290,000 $ 1,340,000 $ 1,380,000 $ 1,450,000 $ 1,450,000 1.8% 11.2% 3.9% 3.0% 5.1% 28,500 180,000 Less: depreciation Two-Year CAGR* 1,090,000 13.6% Operating income (EBITDA) Operating income growth Operating margin Free cash flow to the firm Unaudited LTM** 9/30/20X3 37,346 101,435 $ 0.8325 $ 84,445 118,223 $ 0.7367 $ 87,095 117,228 $ 0.6520 $ 76,433 130,479 9.0% $ 130,479 $ 134,394 0.5770 $ 75,287 Capitalization multiple Terminal value Assumptions: Discount rate Depreciation rate Incremental working capital ra Long-term growth rate Corporate income tax rate 10.0000x $ 1,343,937 13.0% 2.5% 0.0% 3.0% 30.0% * Two-year CAGR: Compound annual growth rate of key financial metrics. ** Figures based on income statement of the latest twelve months (LTM). Copyright 2011 Deloitte Development LLC All Rights Reserved. Case 6: Gator Electronics Hanout 1 Page 3 Exhibit 3 Valuation Schedules: Gator Electronics Inc. December 31, 20X3, WACC Analysis (U.S. Reporting Unit) $US in thousands Description Risk-free rate Equity risk premium Beta Unsystematic risk factors: Size premium Company-specific risk U.S. Notes 4.5% 7.5% 1.10 12.8% 2.0% 1.0% Long-term governmental bond as of the measurement date. Long horizon equity risk premium. Beta is based on guideline public companies. Risk free rate + [beta x equity risk premium]. Applicable size premium. Risk premium is based on qualitative factors that reflect specific risks not factored in the beta or size premium. Cost of equity 15.8% Risk-free rate + [beta x equity risk premium] + size premium + company-specific risk. Estimated pretax cost of debt Tax rate After-tax cost of debt 8.0% 30.0% 5.6% Applicable borrowing rate for market participant/subject company as of the measurement date. Corporate income tax rate. After-tax cost of debt = 8% * (1 - 30%). Equity-to-capital Debt-to-capital 70.0% 30.0% Industry/market capital structure. Industry/market capital structure. Estimated WACC (rounded) 13.0% WACC = [equity-to-capital * cost of equity] + [debt-to-capital x after-tax cost of debt]. Copyright 2011 Deloitte Development LLC All Rights Reserved. Case 6: Gator Electronics Handout 1 Page 4 Exhibit 4 Valuation Schedules: Gator Electronics Inc. September 30, 20X3, Reporting Unit Balance Sheet (U.S. Reporting Unit) $US in thousands 9/30/20X3 Balances Common Size ASSETS Cash and short-term investments Net accounts receivable Inventories Other current assets Total current assets $ 140,000 150,000 100,000 40,000 430,000 11.7% 12.5% 8.3% 3.3% 35.8% 400,000 70,000 280,000 20,000 770,000 33.3% 5.8% 23.3% 1.7% 64.2% $ 1,200,000 100.0% $ 140,000 80,000 100,000 320,000 11.7% 6.7% 8.3% 26.7% Long-term debt Other long-term liabilities Total long-term liabilities 150,000 150,000 12.5% 0.0% 12.5% Total liabilities 470,000 39.2% Preferred stock Common equity Total shareholders' equity 730,000 730,000 0.0% 60.8% 60.8% 1,200,000 100.0% Net PP&E Intangible assets Goodwill Other assets Total long-term assets Total assets LIABILITIES & SHAREHOLDERS' EQUITY Accounts payable Income taxes payable Other current liabilities Total current liabilities Total liabilities and shareholders' equity $ Copyright 2011 Deloitte Development LLC All Rights Reserved. Case 6: Gator Electronics Handout 2 Page 1 December 31, 20X3 U.S. Reporting Unit Strategic Plan Support Our business has been affected significantly by the global economic downturn. Our goods are primarily luxury goods and consumer demand decreased. In response to the decrease in our revenues and operating profits, the Company implemented a number of cost cutting initiatives in an effort to bring our costs back in line with historical levels. We recognized some of the benefits of management's cost cutting initiatives in 20X3. In addition, we have begun to downsize our production team of Product A. We will discontinue Product A in 20X5. Our projections include annual cost savings related to the reduction in employee headcount in 20X4 that amount to approximately $10 million. The sales growth rates we are anticipating are just getting us back to prerecession levels and we have not lost market share. Our revised growth rates have helped us begin recovery and by 20X6 we fully expect to be back at prerecession levels of sales. Sales Strategy We are in the process of revising our marketing strategy and rebranding our products for the U.S. reporting unit. This rebranding includes design changes to Product B and discontinuing our less profitable Product A. Thus far, we have had favorable test results for our rebranding campaign and expect it will add significantly to our revenue growth in 20X4 and beyond. In addition, we expect further growth because of the new Product C. We are just coming out of the development phase for Product C, which we acquired as a business three years ago, and expect to go to market with our new cutting-edge technology in 20X4. We already have market share and scale and we intend to use our existing distribution channels. We believe we will really begin seeing the benefits of Product C in 20X5. Lastly, we expect growth as a result of the synergies between Product B and Product C. Because of the economic downturn, we have not been able to capitalize on those synergies as we intended to as of the acquisition date because we have been waiting for the economy to recover to introduce Product C. Cost Strategy We have gone through several cost cutting initiatives in the past year, which included consolidation of facilities and reduction in forces primarily for our office and administrative staff. We will also discontinue product line A. We expect the cost of these restructuring activities will be approximately $10 million in the next year, which we have built into the projections. We expect total cost savings as a result of these initiatives to be upwards of 1 percent of current costs. Copyright 2011 Deloitte Development LLC All Rights Reserved. Case 6: Gator Electronics Handout 2 Page 2 EBITDA The Company is committed to improving our earnings before income taxes, depreciation, and amortization (EBITDA) margin to 15 percent, which management believes is an attainable margin and is consistent with competitors' margins. It has been the Company's intention to bring the margins of the U.S. reporting unit in line with the rest of the Company's products; the ending margin of 15 percent is in line with the Company's consolidated EBITDA margins, which reached nearly 14 percent in 20X1. The Company's EBITDA projections are supported by the Company's business strategy, as described herein. Copyright 2011 Deloitte Development LLC All Rights Reserved. Case 13-4 Gator Electronics Gator Electronics Inc. (\"Gator\") is an electronics manufacturer that sells electronic products to third-party retail centers in approximately 100 countries. Gator is an SEC registrant. Gator has identified its reporting units as geographical regions in which it operates, and the chief decision makers manage and review operating results and performance. The reporting units are: United States South America Canada Asia Europe, Africa, and the Middle East. You are planning to audit the current-year goodwill impairment analysis of Gator. Gator's total assets as of December 31, 20X3, are approximately $1.6 billion. Revenue and net income for the year ended December 31, 20X3, are approximately $1.7 billion and $0.1 billion, respectively. Gator has performed its annual goodwill impairment analysis as of December 31, 20X3, with the assistance of an external valuation specialist, Management's Expert. Gator elected not to perform the qualitative assessment for determining whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount and proceeded with Step 1 of the quantitative two-step goodwill impairment test for all reporting units. On the basis of the valuation prepared by Management's Expert, Gator estimated that the fair value of all of the reporting units exceeded their respective carrying values and no Step 2 analysis was required or prepared. The focus of this case study will be on the U.S. reporting unit. The engagement partner has determined that goodwill for the U.S. reporting unit is a material account balance as of December 31, 20X3, because it is quantitatively significant ($280 million) and qualitatively significant because of its susceptibility to misstatement arising primarily from recent market declines. The engagement partner has asked you to review Gator's discounted cash flow analysis (part of Step 1 test in determining fair value of the reporting unit) to determine what audit procedures should be performed. Gator management has also provided you the valuation schedules (Handout 1) and a memo documenting its strategy (Handout 2). Required: 1. What are some of the key assumptions within Gator's discounted cash flow analysis? 2. What questions or concerns do you have for management on some of these key assumptions? Copyright 2011 Deloitte Development LLC All Rights Reserved. Case 13-4: Gator Electronics Page 2 3. What audit procedures could you perform on some of the significant business assumptions within Gator's discounted cash flow analysis? (Focus on the substantive testing procedures and assume the control testing is addressed elsewhere). Copyright 2011 Deloitte Development LLC All Rights Reserved. Case 13-4 Gator Electronics Copyright 2011 Deloitte Development LLC All Rights Reserved. BACKGROUND FOR CASE Objectives of the Case This case provides students with the opportunity to review a company's discounted cash flow analysis prepared in conjunction with its annual goodwill impairment analysis. Through this review, students can (1) identify the key assumptions in the analysis and (2) determine what audit procedures could be performed on these assumptions. Applicable Professional Pronouncements ASC 350 Intangibles Goodwill and Other (ASC 350) ASC 820, Fair Value Measurements and Disclosures (ASC 820) PCAOB Interim Auditing Standards, AU Section 328 Auditing Fair Value Measurements and Disclosures (PCAOB AU 328) Note that if the audit was being performed under the AICPA standards the guidance would be as follows: AICPA Professional Standards (Clarified) AU C Section 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures \" AICPA Practice Aid , Assets Acquired in a Business Combination to Be Used in Research and Development Activities: A Focus on Software, Electronic Devices, and Pharmaceutical Industries Chapter 5, \"Valuation of Assets Acquired\" ( AICPA Practice Aid ) Background on goodwill impairment tests under ASC 350 20 (as outlined here). . ASC 350 20 requires that goodwill not be amortized but rather tested for impairment. This test should be performed at least annually and may be required between annual test in certain circumstances. In September 2011, the FASB issued ASU 2011 the FASB issued ASU 2011-08, Testing Good will for Impairment, which amended guidance in ASC 350-20. 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). If entities determine, on the basis of qualitative factors, that the fair value of the reporting unit is more likely than not less than the carrying amount, the two-step impairment test would be required. The amendments were effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. ASC 350-20-35- 4 through 35-17 outline the two steps for testing go goodwill for impairment if a qualitative assessment is not used, or a qualitative assessment is performed and the \"more likely than not\" threshold is not supported. Step 1 Determine whether the fair value of the reporting unit is less than its carrying amount, including goodwill. If so, proceed to Step 2. If the fair value of the reporting unit is not less than its carrying amount , further testing of goodwill for impairment is not performed. Step 2 Determine the implied fair value of the goodwill of the reporting unit by assigning the fair value of the reporting unit used in Step 1 to all the assets and liabilities of that reporting unit (including any recognized and unrecognized intangible assets) as if the reporting unit had been acquired in a business combination. Compare the implied fair value of goodwill with the carrying amount of goodwill to determine whether goodwill is impaired. In relation to determining the fair value of the reporting unit ASC 350 relies on ASC 820's definition of fair value, which is the \"price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.\" Any valuation technique used to measure fair value should incorporate the principles of ASC 820. One of that Topics overall principles is that the fair value of assets and liabilities should be determined on the basis of assumptions that market participants would use in pricing assets and liabilities. ASC 350 -20- 35-22 states, in part: Quoted market prices in active markets are the best evidence of fair value and shall be used as the basis for the measurement, if available. However, the market price of an individual equity security (and thus the market capitalization of a reporting unit with publicly traded equity securities) may not be representative of the fair value of the reporting unit as a whole. ASC 350-20-35-24 states: In estimating the fair value of a reporting unit, a valuation technique based on multiples of earnings or revenue or a similar performance measure may be used if that technique is consistent with the objective of measuring fair value. Use of multiples of earnings or revenue in determining the fair value of a reporting unit may be appropriate, for example, when the fair value of an entity that has comparable operations and economic characteristics is observable and the relevant multiples of the comparable entity are known. Conversely, use of multiples would not be appropriate in situations in which the operations or activities of an entity for which the multiples are known are not of a comparable nature, scope, or size as the reporting unit for which fair value is being estimated. Although ASC 350 provides guidance on determining the fair value of a reporting unit, it does not prescribe a method that must be used by an entity to perform the goodwill impairment test. The income approach is a generally accepted valuation technique used in determining a value indication of a business (e.g., a reporting unit for goodwill impairment testing under ASC 350, business ownership interest, security, or intangible asset using one or more methods that convert anticipated economic benefits into a present single amount) The discounted cash flow (DCF) method is a generally accepted valuation method within the income approach whereby the present value of future expected cash flows is calculated using an appropriate discount rate. ASC 350 does not indicate whether the same method must be used every time an entity performs the goodwill impairment test. While entities should generally be consistent in the impairment test method they use to calculate the fair value of a reporting unit, there may be instances when a different method would yield more reliable results. For example, a reporting unit that completes a public offering of its common stock may wish to use a market approach to measure the fair value, under which the quoted market price of the common stock is used as an input, instead of or in addition to using a present -value technique. Under no circumstances should entities change their methods to avoid recognizing a goodwill impairment charge. Similarly, entities should not change methods to accelerate the recording of an impairment charge