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 the lines of business. It also plans on severance pay for employees at the two plants.
Required
a. Define the term impairment of assets and the proper accounting treatment for asset impairments.
b. Is management typically motivated to understate or overstate the write-down because of asset impairment? Explain.
c. What information should the auditor gather to develop evidence on the proper valuation of the asset impairment? In answering your question, address the following:
● Should the factory assets be treated as individual assets or as a group in determining the realizable value?
● What are the major liabilities the company should consider when shutting down operations and phasing out a line of business? Should those liabilities be considered as part of the "impairment of asset" cost?
● Because the actual disposal of the plants or the costs of shutting them down are estimates, how should the auditor treat material differences in estimates generated by the auditor vs. those generated by management? Should the differences be disclosed or otherwise accounted for?
d. 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 ethical decision-making framework from Chapter 3 to make a recommendation about the course of action the auditor should take.
Recall that the seven steps in the ethical decision-making framework are as follows:
(1) Identify the ethical issue,
(2) Determine who are the affected parties and identify their rights,
(3) Determine the most important rights,
(4) Develop alternative courses of action,
(5) Determine the likely consequences of each proposed course of action,
(6) Assess the possible consequences, including an estimation of the greatest good for the greatest number, and
(7) Decide on the appropriate course of action.