Please read the following case in its entirety and answer the special requirements at the end in a memo format.

ABSTRACT: Accounting for goodwill has long been a theoretical problem for accountants. Although most businesses possess some goodwill, accountants record it only when a premium is paid in the acquisition of another company. Subsequent to acquisition, valuing goodwill becomes a problem. Statement of Financial Accounting No. 142, Goodwill and Other Intangible Assets (FASB 2001), is the current standard for testing goodwill for impairment. This case is designed to introduce you to the realworld problems that many practitioners are likely to encounter while implementing this new standard.The case involves two antagonists: an auditor eager to record an impairment of goodwill and a client even more eager to avoid recording any impairment. You must tactfully address both individuals' arguments and determine the correct method for accounting for goodwill and the standard for testing for impairment per SFAS No. 142.

INTRODUCTION: Mary Aah and John Baa were best friends and rivals in college. After graduating with computer science degrees in 1988, they decided to start rival Internet Service Provider (ISP) firms. Being innovative and artistic, they named their companies A Company and B Company, respectively. Both firms were extremely successful. By 1995, A Company and B Company accounted for 30 percent and 15 percent, respectively, of the market for ISP users. In addition, both companies stocks were actively traded on national exchanges. After turning 30 in 1995, John suffered a midlife crisis and decided to sell his company to Marys A Company and pursue other interests. John and Mary settled on a purchase price of $3,250 million cash and the deal was consummated effective January 1, 1996. The price reflected the high premium associated with technology stocks. The respective balance sheets immediately before and immediately after the merger are disclosed in Table 1. (Note: The fair market value of tangible assets is the same as the book value throughout the case.) The net assets of A Company are exactly twice that of B Company on the date of the merger. Because the fair market value of B Companys net assets equaled only $2,250 million and the purchase price was $3,250 million. Goodwill of $1,000 million was recorded on A Companys Balance Sheet.

TABLE 1

Individual Company Balance Sheets Immediately before and

A Company Balance Sheet Immediately after the Merger

(in millions of dollars)

	A Company before combination Jan. 1, 1996	B company before combination Jan. 1 1996	Immediately after combination Jan. 1, 1996
Current assets	$4,000	$500	$1,250
Fixed assets (net)	4,000	2,500	6,500
Other assets	500	250	750
Goodwill	0	0	1,000
Total	$8,500	$3,250	$9,500
Liabilities	$4,000	$1,000	$5,000
Common stock	1,000	500	1,000
Retained earnings	3,500	1,750	3,500
Total	$8,500	$3,250	$9,500

The merger went very well. Because the two companies were so similar, their hardware was compatible and was quickly integrated. Similarly, due to a shortage of technologically savvy workers in the 1990s, the two work forces were seamlessly integrated without any layoffs. Because the two companies were integrated into one entity, no individual segments have ever been reported on A Companys financial statements. This is in accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information (FASB 1997.) Following the requirements of APB Opinion No. 17 (AICPA 1970), the annual amortization expense of $25 million was recorded on the surviving A Company financial statements for the six years from 1996 through 2001, resulting in total amortization of $150 million of goodwill and a remaining balance of $850 million. (Note: 2002 goodwill amortization has not been recorded.) Now, seven years later, no office or region is dominated by a group of workers from either of the before-merger firms. Little of the equipment and other tangible assets from before the merger remains in use. In fact, it is difficult to identify any area of the company that can be easily traced to one of the two formerly independent companies. A Company continued to grow and has been very profitable. The company also moved into providing additional services to its subscribers. For example, the company has contracted with organizations to provide special websites for reviewing news and other data, companies that allow subscribers to legally download music, and special chat rooms. A Company now considers itself to be a full-service Internet content provider. The company paid very high dividends, especially for a technology-based company. Nevertheless, A Companys share price was hurt significantly by the market fluctuations for technology companies that occurred in 2000, 2001, and 2002. During 2002, A Companys stock lost half of its market value.

THE CASE: You just graduated from college in May 2002 and your first assignment is to audit A Company for the year ended December 31, 2002. Your audit senior is very strict Mr. Dogmatic. You have never met the audit partner, but have heard that he is very easygoing. His name is Mr. Easy. The audit is almost finished and both you and your audit senior are pleased with your performance on your first engagement. There are no major problems with the clients information and you are confident of all your findings. You are especially honored when Mr. Dogmatic, your audit senior, invited you to the exit conference. In attendance with you are Mary Aah. president and CEO of A Company, Mr. Dogmatic, and Mr. Easy. At first, the meeting goes very well. Mary Aah is very impressed with your findings and the recommendations included in the management letter, She promises to implement all of your recommendations immediately. However, toward the end of the conference, Mr. Dogmatic states, There is only one more matter to discuss, SFAS No. 142 and goodwill. Mary replies, I love the new standard because we [A Company] will no longer be required to amortize goodwill. This will increase our net income by $25 million. Now that the market is hitting our stocks so badly, not having to amortize goodwill will make our income statements and earnings per share (EPS) look better. At this point, Mr Dogmatic states, Mary, you are going to have to take an expense for impairment of goodwill. Referring to his notes, Mr. Dogmatic quickly explains, The fair market values of tangible assets and liabilities are the same as their book values. A Companys market capitalization based on stock price on December 31, 2002 is $12,000 million. Since the companys net book value excluding goodwill is $10,200 million ($21,850 million assets less $850 million goodwill and $10,800 million liabilities (Table 2)), you can take one-third of that value and attribute it to the old B Company (Table 1). One third of the $10,200 million net worth is $3,400 million and one-third of the market value of $12,000 million market capitalization is $4,000 million. Both numbers should be assigned to B Company, you have a total of $4,250 million, which exceeds the $4,000 million market value for the old B company. Therefore, $250 million of the goodwill should be written off as impaired. Mr. Dogmatic proudly looks around the room, confident that everyone is impressed with his mastery of numbers.

TABLE 2

Balance Sheet of Aah Company as of 12/31/2002

(in millions of dollars)

Current assets	$3,450
Fixed assets (net)	15,850
Other assets	1,700
Goodwill	850
Total	$21,850
Liabilities	$10,800
Common stock	1,000
Retained earnings	10,050
Total	$21,850

Mary Aah does not like this. Thinking quickly, she makes the following five arguments against recording an impairment of goodwill:

No test of goodwill is required since this is the first full year that the standard is in effect.

The net assets of the combined company are significantly above the value on the date of acquisition. This means that the combined company is worth significantly more than it was on the date of the merger when goodwill was first recorded at $1,000 million.

The company has consistently paid dividends since the merger. If the dividends paid to the stockholders since the merger were added back to the current stock price, the current value of the stock and the dividends paid since the merger would exceed the market value of the stock at the time of the merger. The company would, therefore, be worth more if no dividends had been paid.

A Company has expanded into new areas, such as content provider, and the current stockholders do not appreciate the market potential of the expansion. Therefore, the stock price does not properly reflect the expansion into new fields.

The market downturn, although it may be long term, is not permanent, (Note: the stock price of A Company has declined by one-half during 2002.)

Obviously, a major conflict with the clients CEO has arisen. Mr. Easy is very upset over this problem. He has never heard of SFAS No. 142 and does not understand the issues. He is also unsure of what acronym SFAS stands for. He turns to you and says. Your inexperience in auditing suggests that you would have an open mind about this matter. I want you to provided me with a memo explaining the issues and providing a solution to the problem. Remember, Mr. Dogmatic is your boss and Mary Aah is one of our most valuable clients. You take the last sentence to mean that your future with the accounting firm is dependent on your tactfully addressing these issues.

SUGGESTED REQUIREMENTS:

What is the reporting unit?

How do you measure the fair value of the reporting unit?

Separately review and assess each arguments raised by Mary Aah.

Should the auditors require the company to record an impairment of goodwill? Base your answer first on Mr. Dogmatics interpretation of SFAS No. 142. Is his interpretation correct? Explain why or why not. Refer to SFAS No. 142 to answer this question.