(A6.1) If you were an accountant for Talbots, what specifically would be the relevant accounting research question relating to the case?
(A6.2) What accounting standards must Talbots consider when answering the question?
(A6.3) What must be known, estimated, and assumed to answer the research question?
(A6.4) Do you believe Talbots’ accounting for goodwill in the case was appropriate? Why or why not? Is it possible to arrive at an alternative accounting treatment of goodwill based on your analysis?
The Talbots, Inc., and Subsidiaries: Accounting for Goodwill ________________________________________________________________________________________________________________ Professor William J. Bruns prepared this case solely as a basis for class discussion and not as an endorsement, a source of primary data, or an illustration of effective or ineffective management. This case was developed from published sources. Copyright © 2008 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School. W I L L I A M J . B R U N S The Talbots, Inc., and Subsidiaries: Accounting for Goodwill “This is what passes for good news at Talbots, Inc. these days: The bad news wasn’t as bad as most people had feared. Talbots, the women’s clothing retailer from Hingham [Massachusetts], told investors yesterday that it lost $171 million in the final quarter of its fiscal year, when sales fell nearly 8 percent. The company’s stock climbed more than 11 percent, its best day in over a month. — Steven Syre, “Losing, but in a good way,” The Boston Globe, March 13, 2008, p. E1. Talbots, Inc., was an international specialty retailer and direct marketer of women’s apparel, shoes, and accessories. On May 3, 2006, the company acquired J. Jill, another multi-channel specialty retailer of women’s apparel. Both companies operated stores under their brand names, and both made extensive use of sales catalogs and websites. Both focused their selection and merchandising on women 35 and older, but each had a different style. Talbots brand merchandising promoted the “current classic look” emphasizing timeless current styles and quality, a variety of key basic and fashion items, and a complementary assortment of accessories and shoes to enable customers to assemble complete wardrobes. Consistency in color, fabric, and fit of Talbots-brand merchandise allowed customers to create wardrobes across seasons and years. The company believed that a majority of Talbots-brand customers were high-income, college-educated, and employed primarily in professional and managerial occupations. J. Jill merchandising strategy focused on offering easy sophistication for every day. The company believed that J. Jill brand merchandise reflected its core customers’ desires and needs—style, comfort, individuality, artistic simplicity, a woman’s version of femininity and community. Customers were thought to be mid- to high-income, well-educated, employed in a managerial or leadership role, and attracted to the J. Jill brand by its unique aesthetic style, exceptional customer service, and quality of well-priced merchandise. J. Jill was purchased for $518 million in cash. Since the amount paid exceeded the fair market value of the net physical assets acquired, Talbots was required to recognize goodwill, trademarks, and other intangible assets included in the purchase price. The acquisition was detailed in the Talbots annual report on the Form 10-K filed with the U.S. Securities and Exchange Commission for fiscal year 2007. An excerpt from that report is shown in Exhibit 1, which gives details of the 3254 O C T O B E R 1 0 , 2 0 0 8 This document is authorized for use only by Jennifer Robinson in ACCT-6140-1,Current Trends Acct Standards.2020 Summer Sem 05/04-08/23-PT2 at Laureate Education - Walden University, 2020. 3254 | The Talbots, Inc., and Subsidiaries: Accounting for Goodwill 2 BRIEFCASES | HARVARD BUSINESS SCHOOL purchase and the allocation of the excess of the purchase price over the fair value of tangible and identifiable intangible net assets and liabilities assumed by Talbots. Accounting for Goodwill Although goodwill generated internally is never recognized as an asset, when one business purchases another, the amount paid would be equal to the fair market value of tangible assets only by rare coincidence. Instead, any excess paid over the value of tangible and identifiable intangible assets is recorded as goodwill. Companies often pay more to acquire another company than the fair value of tangible assets purchased because of trademarks acquired, existing leases, assumed customer loyalty, or other intangible assets such as reputation. Once goodwill is recognized and recorded, accountants have used various methods to account for goodwill in order to match its cost with revenues in subsequent accounting periods. At least four possible treatments have been proposed and used in recent years. Estimated life amortization. Until January 2001, when the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 142, goodwill was amortized over its estimated life, but not to exceed 40 years. Companies charged goodwill amortization as an expense that reduced net income similar to the accounting treatment of depreciation. Intangible assets could be separately identified, and they would be accounted for appropriately for their type. The required amortization of goodwill, and the fact that internally created goodwill could not be capitalized to offset the expense of goodwill amortization, promoted the use of a method of accounting for mergers known as “pooling of interests” which recognized no goodwill. Pooling-of-interests accounting was declared to be no longer part of generally accepted accounting principles (GAAP) in 2001 by the Financial Accounting Standards Board. Goodwill as a permanent asset. Another approach to accounting for goodwill would recognize goodwill at the time of a purchase of one company by another, but not require any subsequent amortization or adjustment. That approach seems unrealistic and flawed. The conditions and factors that might lead to an acquiring company to pay more than the fair value for assets at one time would change, and the changing value of goodwill would not be accurately reported in financial statements. In considering this possibility the Financial Accounting Standards Board considered changing the maximum amortization to 20 years or using some other test for goodwill reporting, but these alternatives were rejected in 2001. Eliminating goodwill at the time of acquisition. In some countries and situations, goodwill was immediately written down to zero when it was acquired, using a direct write-off to retained earnings or stockholders’ equity. Using an impairment test to recognize changes in goodwill. The goodwill impairment test is a two-step impairment test. First, the fair value of each reporting unit is determined using a combination of a discounted cash flow and a market value approach. The evaluation of goodwill requires the use of significant judgments and estimates. If the fair value of the reporting unit exceeds the carrying value of the net assets of that reporting unit, goodwill is not impaired and no further testing is required. If the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the reporting unit, then a second step is required to determine the implied fair value of the reporting unit’s goodwill to be compared to the carrying value of the reporting unit’s goodwill. The activities in the second step include valuing the tangible and intangible assets and liabilities of the impaired reporting unit’s goodwill based on the residual of the summed identified tangible and intangible assets and liabilities. If the fair value is less than the carrying value, goodwill is considered impaired and its carrying amount must be reduced by reducing income for that period. When the This document is authorized for use only by Jennifer Robinson in ACCT-6140-1,Current Trends Acct Standards.2020 Summer Sem 05/04-08/23-PT2 at Laureate Education - Walden University, 2020. The Talbots, Inc., and Subsidiaries: Accounting for Goodwill | 3254 HARVARD BUSINESS SCHOOL | BRIEFCASES 3 carrying amount of any long-lived asset is no longer recoverable, a company is required to write off the cost that no longer has value. In 2001, Statement of Financial Accounting Standards No. 142 mandated that accounting for goodwill be based on the impairment model using the two-step process. Once goodwill is impaired and written off, it can never be restored to its original carrying amount. International Financial Reporting Standards also use impairment tests for assets and goodwill. If an impairment of goodwill is recognized, that loss cannot be reversed. However, for other assets, impairment losses can be reversed (and recognized in the income statement) so long as the carrying amounts do not exceed the depreciated historical cost if the impairment had not been recognized. Goodwill and Intangible Assets at Talbots A summary of accounting for goodwill and intangible assets for Talbots in 2006 is shown in Exhibit 2. In its 2006 Form 10-K filed with the Securities and Exchange Commission, the Company explained its accounting policies for impairments of long-term assets, goodwill, and other intangible assets as follows: Impairment of Long-lived Assets. The Company periodically reviews the period of depreciation or amortization for long-lived assets in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-lived Assets, to determine whether current circumstances warrant revised estimates of useful lives. The Company monitors the carrying value of its assets for potential impairment based primarily on projected future cash flows. If an impairment is identified, the carrying value of the asset is compared to its estimated fair value, and provisions for impairment is recorded as appropriate. Impairment losses are significantly impacted by estimates of future operating cash flows and estimates of fair value. While the Company believes that its estimates are reasonable, different assumptions regarding items such as future cash flows could affect the Company’s evaluations and result in impairment charges against the carrying value of those assets. Impairment of Goodwill and Other Intangible Assets. The Company applies the provisions of SFAS No. 142, Goodwill and Other Intangible Assets, to goodwill and trademarks and reviews annually for impairment or more frequently if impairment indicators arise. The Company has elected the first day of each fiscal year as its annual measurement date. No impairment charges were recorded during the fiscal years ending February 3, 2007, January 28, 2006, and January 29, 2005. In assessing impairment for goodwill and trademarks