3Ware 2005 Annual Report Download - page 26

Goodwill and Intangible Asset Valuation
The purchase method of accounting for acquisitions requires extensive use of accounting estimates and
judgments to allocate the purchase price to the fair value of the net tangible and intangible assets acquired,
including in-process research and development, or IPR&D. Goodwill and intangible assets deemed to have
indefinite lives are not amortized, but are subject to annual impairment tests. The amounts and useful lives
assigned to other intangible assets impact future amortization, and the amount assigned to IPR&D is expensed
immediately. Determining the fair values and useful lives of intangible assets especially requires the use of
estimates and the exercise of judgment. While there are a number of different generally accepted valuation
methods to estimate the value of intangible assets acquired, we primarily use the discounted cash flow method
and the market comparison approach. These methods require significant management judgment to forecast the
future operating results used in the analysis. In addition, other significant estimates are required such as residual
growth rates and discount factors. The estimates we use to value and amortize intangible assets are consistent
with the plans and estimates that we use to manage our business and are based on available historical information
and industry estimates and averages. These judgments can significantly affect our net operating results.
We are required to assess goodwill impairment annually using the methodology prescribed by Statement of
Financial Accounting Standards, or SFAS, No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142
requires that goodwill be tested for impairment at the reporting unit level on an annual basis and between annual
tests in certain circumstances. Application of the goodwill impairment test requires judgment, including the
identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting
units and determining the fair value of each reporting unit. In fiscal 2005, in accordance with SFAS No. 142,
management determined that there were three reporting units to be tested. The goodwill impairment test
compares the implied fair value of the reporting unit with the carrying value of the reporting unit. The implied
fair value of goodwill is determined in the same manner as in a business combination. Determining the fair value
of the implied goodwill is judgmental in nature and often involves the use of significant estimates and
assumptions. These estimates and assumptions could have a significant impact on whether or not an impairment
charge is recognized and also the magnitude of any such charge. Estimates of fair value are primarily determined
using discounted cash flows and market comparisons. These approaches use significant estimates and
assumptions, including projection and timing of future cash flows, discount rates reflecting the risk inherent in
future cash flows, perpetual growth rates, determination of appropriate market comparables, and determination of
whether a premium or discount should be applied to comparables. It is reasonably possible that the plans and
estimates used to value these assets may be incorrect. If our actual results, or the plans and estimates used in
future impairment analyses, are lower than the original estimates used to assess the recoverability of these assets,
we could incur additional impairment charges.
For fiscal 2005, the discounted cash flows for each reporting unit were based on discrete five-year financial
forecasts developed by management for planning purposes. Cash flows beyond the five-year discrete forecasts
were estimated using terminal value calculations. The sales compound annual growth rates ranged from 15% to
33% for the reporting units during the discrete forecast period and the future cash flows were discounted to
present value using a discount rate of 17% and terminal growth rates of 7.5%. We did not recognize any goodwill
impairment as a result of performing this annual test. A variance in the discount rate or the estimated revenue
growth rate could have a significant impact on the estimated fair value of the reporting unit and consequently the
amount of identified goodwill impairment. For example, a 1% - 2% increase in the discount rate would have
resulted in an indication of possible impairment that would have led us to further quantify the impairment and
potentially record a charge to write-down these assets.
Restructuring Charges
Over the last three years we have undertaken significant restructuring initiatives, which have required us to
develop formalized plans for exiting certain business activities and reducing spending levels. We have had to
record estimated expenses for employee severance, long-term asset write downs, lease cancellations, facilities
consolidation costs, and other restructuring costs. Given the significance, and the timing of the execution, of such
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