Estimating undiscounted and discounted future cash flows


You are a audit partner with Feeble and Stressed CPAs. One of your audit clients is Greasy Oil, Inc. The company is a public company that has been in existence for over 40 years. It has diversified investments which mostly relate to the petroleum industry. The company has experienced slow but constant growth through internal expansion and acquisitions. You have been the partner in charge of their audit for three years. The company's CEO, Ben O. Lee, is the son of the founder and has held the position for a little over ten years. He was in college for two years before he dropped out and was then (somehow) employed by the company. He has never had an accounting course and he usually cusses those "damn stupid accounting rules." He is an intense businessman and has done an admirable job running the company. He understands the petroleum industry. You ran into Ben at a Birthday party for a mutual friend and while you were waiting for drink refills. He said "We are going through preparation of our year-end financials and my accounting guys discussed with me some of the problems they are having regarding asset impairments. I don't understand why we have to go through this process every year when the company is profitable, but they said it was required. I told them I was expecting to see you here and that if they had specific questions they should write them down and I would pass them on to you. You know me, I like to mix business and pleasure! Here is an envelope with their questions. We discussed these and I, myself, am curious about what the answers might be. Would you please write me a letter providing answers to the questions and please include specific references to those damn GAAP rules so my guys can read up on them? " You said you would be happy to address their concerns and that you would have your response to them in a couple of days. He said "Great, I'll look forward to it! I need to get this glass of wine to my wife. I hope you are enjoying the evening." The next morning you open the envelope and it lists the following items:

We have some questions relating to the specifics on how an impairment test is conducted:

We have a new situation where we have an asset that we will not hold for its useful life but will be selling it after a couple of years of use. In estimating future cash flows from the asset should we include its estimated disposal value in the cash flows?

We have some goodwill from recent acquisitions. When we are testing the goodwill for impairment should it be done before or after impairment tests of other assets acquired?

While we are still profitable, profits have fallen significantly during the last year. We are trying to test our headquarters building for impairment but there are no cash flows that are directly attributable to the headquarters. Do we, therefore, not test it for impairment?

As you know, in the oil patch we are required to restore a property after production is complete and the wells are abandoned. Sometimes these costs are very significant and we recognize them as part of the cost of the production property and record a related liability. Should this restoration obligation be included in our estimates of undiscounted and discounted future cash flows as an outflow?

Required: Write a formal business letter to Ben answering their questions and provide specific references to the GAAP Codification sections used to arrive at your answers.

Your research should use the FASB Codification.

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Financial Accounting: Estimating undiscounted and discounted future cash flows
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