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Galaxy Accounting Memo

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| Deloitte & Touche LLC1 |
Memo
To: | Mary Stanford | From: | Ben Ji | Date: | September 26, 2012 | Re: | Goodwill Impairment Test | | |
Galaxy Sports Inc. is a manufacturer of sports equipment. It is a public company with three reporting units: Fitness Equipment, Golf Equipment, and Hockey Equipment. During our audit, certain accounting treatments by Galaxy regarding goodwill impairment were found to possibly contradict with the Accounting Standard Codification. Based on my research of the ASC, my recommendations are that management should perform an interim goodwill impairment test at the end of third quarter of fiscal year 2009; and that management should not carry forward the 09 goodwill impairment test for Fitness and Hockey in 2010.
Galaxy is in a competitive industry in which growth and profitability are tied to market and consumer demand. During 2010, as discussed in a press release by the management, Galaxy faced strong competition from Chinese imports that are sold at a lower price. Reduced consumer spending resulted from a slowing economy also hurt Galaxy’s sales. These “unanticipated competition” coming from affordable Chinese imports, and “significant adverse changes in the business climate” represented by a weak economy and reduced consumer spending are circumstances under which the ASC 350-20-35-30 mandates a goodwill impairment test between annual tests3. Therefore, an impairment test shall be carried out as of Sep 30, 2010.

Figure 1
I also tracked the changes in control premium to gauge the accuracy of the fair value estimates assuming the 2009 fair values were carried forward. Control premium is the portion of fair value in excess of market capitalization. Control premium represents the added value that comes from controlling the entire business as opposed to a number of investors holding the company’s shares individually. As illustrated in figure 1, if fair value of the units were truly what the previous auditor had estimated- $3,020 million, the estimated implied control premium would be 120%, which is unrealistic given that it was 18% for yearend 2009. It is reasonable to say that fair value of reporting units have fallen significantly in pace with market capitalization, and it has possibly fallen below book value of the reporting units. Therefore, above analysis raises substantial doubt on management’s action to carry forward the 09 fair values of Fitness and Hockey. They should not carry forward the previous fair value estimates and should revalue Fitness and Hockey for 2010.
Another argument refuting the decision to carry forward 2009 values finds its root in the ASC. According to ASC 350-20-35-29, only when all of the three criteria below are met may a company carry forward fair value determinations. The criteria are: a) assets and liabilities of the unit should not have changed significantly. Hockey and Fitness seem to meet this criterion. b) The last fair value determination of the unit should be substantially larger than their carrying amount at the time. Hockey and Fitness meet this criterion. c) The likelihood that the current fair value is less than the carrying amount should be low4. Hockey and Fitness’s current fair value is possibly less than their carrying amount, not meeting this criterion. Because not all of the criteria for a fair value carry forward are met, the fair value of Hockey and Fitness may not be carried forward from 09.
It is important to note the limitations of the analysis. First, fair value estimates are subject to professional judgment and errors exist. Fair value may not decline proportionately to market capitalization. Also, the full impact of Chinese imports and declining economy on the business remain to be evaluated.
In conclusion, we recommend that Galaxy test for goodwill impairment as of Sep 30, 2010 because of affordable Chinese imports and a weak economy that adversely changed the business climate. We also recommend that Galaxy not carry forward 2009 fair values of Fitness and Hockey based on the evidence presented by the control premium analysis and changing industry conditions that increased the likelihood of a below-carrying-amount fair value of Fitness and Hockey.

References and Notes

1. This is not a memo prepared by Deloitte & Touche staff.

2. ASC 350-20-35-30, When To Test Goodwill For Impairment paragraph 30 states the steps to take to determine if an impairment test should be performed.

3. ASC 350-20-35-22, Determining The Fair Value Of A Reporting Unit paragraph 22 states how to determine the fair value of a reporting unit.

4. ASC 350-20-35-29, When To Test Goodwill For Impairment paragraph 29 lists criteria that permit a fair value determination of a reporting unit to be carried forward.

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