Question

In 2015 Microsoft Corporation reported a $5.1 billion charge for the impairment of goodwill and a $2.2 billion charge for the impairment of intangible assets in one of its reporting units (segments) in its 10-K annual report. Referring to Microsoft's 2015 financial statements and any other information from the media, address the following:

1. Microsoft's segments serve as its reporting units for assessing goodwill for potential impairments. Which segment suffered a 2015 impairment? Describe the revenue model for this segment.

2. What were the underlying business reasons that required Microsoft to record a goodwill impairment in 2015?

3. How did Microsoft reflect the 2015 goodwill impairment in its income statement and cash flow?

4. Describe in your own words the goodwill impairment testing steps performed by Microsoft in 2015 and the consequent loss measurement.

Answer 1

Please give positive ratings so I can keep answering. If you have any queries please comment. Thanks!

Microsoft Corporation

Hi I have taken the relevant data from Sec.gov website.

1. Microsoft's segments serve as its reporting units for assessing goodwill for potential impairments. Which segment suffered a 2015 impairment? Describe the revenue model for this segment.

Phone Hardware segment suffered a 2015 impairment.

Goodwill Impairment

We test goodwill for impairment annually on May 1 at the reporting unit level, primarily using a discounted cash flow methodology with a peer-based, risk-adjusted weighted average cost of capital. We believe use of a discounted cash flow approach is the most reliable indicator of the fair values of the businesses.

Upon completion of the annual testing as of May 1, 2015, Phone Hardware goodwill was determined to be impaired. In the second half of fiscal year 2015, Phone Hardware did not meet its sales volume and revenue goals, and the mix of units sold had lower margins than planned. These results, along with changes in the competitive marketplace and an evaluation of business priorities, led to a shift in strategic direction and reduced future revenue and profitability expectations for the business. As a result of these changes in strategy and expectations, we have forecasted reductions in unit volume growth rates and lower future cash flows used to estimate the fair value of the Phone Hardware reporting unit, which resulted in the determination that an impairment adjustment was required.

Because our annual test indicated that Phone Hardware’s carrying value exceeded its estimated fair value, a second phase of the goodwill impairment test (“Step 2”) was performed specific to Phone Hardware. Under Step 2, the fair value of all Phone Hardware assets and liabilities were estimated, including tangible assets, existing technology, patent agreements, and contractual arrangements, for the purpose of deriving an estimate of the implied fair value of goodwill. The implied fair value of the goodwill was then compared to the recorded goodwill to determine the amount of the impairment. Assumptions used in measuring the value of these assets and liabilities included the discount rates and royalty rates used in valuing the intangible assets, and consideration of the market environment in valuing the tangible assets

The revenue model for Phone Hardware

Revenue increased $6.7 billion or 8%, reflecting a full year of Phone Hardware sales and growth in revenue from our Commercial Cloud, Surface, server products, search advertising, and Xbox Live transactions. These increases were offset in part by a decline in revenue from Office Commercial, Windows OEM, licensing of Windows Phone operating system, and Office Consumer. Revenue included an unfavorable foreign currency impact of approximately 2%.

Gross margin increased $787 million or 1%, primarily due to higher revenue, offset in part by a $6.0 billion or 22% increase in cost of revenue. Cost of revenue increased, mainly due to Phone Hardware, as well as increasing costs in support of our Commercial Cloud, including $396 million of higher datacenter expenses. Gross margin, as a percentage of revenue, improved year over year in each of our reportable segments.

2. What were the underlying business reasons that required Microsoft to record a goodwill impairment in 2015?

Phone Hardware did not meet its sales volume and revenue goals, and the mix of units sold had lower margins than planned. These results, along with changes in the competitive marketplace and an evaluation of business priorities, led to a shift in strategic direction and reduced future revenue and profitability expectations for the business. As a result of these changes in strategy and expectations, we have forecasted reductions in unit volume growth rates and lower future cash flows used to estimate the fair value of the Phone Hardware reporting unit, which resulted in the determination that an impairment adjustment was required.

3. How did Microsoft reflect the 2015 goodwill impairment in its income statement and cash flow?

An impairment charge is recorded to other income (expense), net and a new cost basis in the investment is established.

Impairment charge is deducted from Gross Margin in the income statement.

Impairment charge is a non cash expense so it is added back to net income for calculating Net cash from operations.

4. Describe in your own words the goodwill impairment testing steps performed by Microsoft in 2015 and the consequent loss measurement.

Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated primarily through the use of a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital.

The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit.