Your audit firm has been the auditor of Cowan Industries for a number of years. The company manufactures a wide range of lawn care products and typically sells to major retailers. In recent years, the company has expanded into ancillary products, such as recreation equipment, that use some of the same technology. The newer lines of business, while successful, have not been particularly profitable. The company's stock price has languished, and management has recently been replaced.
The new management team announces that it will close two factories and will phase out one of the newer lines of business. It plans to expand existing products and increase marketing efforts. Even though there is no technological obsolescence of existing products, the new management does not believe the company has a competitive advantage.
It wants to take a one-time hit to the balance sheet and income statement of $15.3 million (about one-third of total assets) as a reserve for the shutdown of the plants and the disposal of a line of business. It also plans on severance pay for employees at the two plants.
a. Define the term impairment of assets.
b. Is management typically motivated to understate or overstate the write-down because of asset impairment? Explain.
c. Assume in this situation that the auditor believes management is overestimating the impairment charge and thus the improvement in future earnings because of reduced depreciation charges in subsequent periods. Further assume that the auditor has gathered and evaluated evidence that convincingly reveals the impairment charge should more reasonably fall in a range from $8 to $10 million, rather than management's estimate of about $15 million.
Finally, assume the auditor has discussed the issue with management and it refuses to vary from its original estimate.
Management has stated that its assumptions and evidence are just as convincing as the auditor's. Use the seven-step framework for ethical decision making from Chapter 4 to make a recommendation about the course of action the auditor should take. Recall that the steps are as follows: (1) identify the ethical issue; in this case the ethical issue is how to properly ensure that the review comments are taken seriously and addressed; (2) determine the affected parties and identify their rights; (3) determine the most important rights for each affected party; (4) develop alternative courses of action; (5) determine the likely consequences of each proposed course of action on each affected party; (6) assess the possible consequences; and (7) decide on an appropriate course of action.