LeapFrog 2008 Annual Report Download - page 70

LEAPFROG ENTERPRISES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except per share data)
Goodwill
The Company tests its goodwill for impairment at least annually, and between annual tests if indicators of
potential impairment exist in accordance with the provisions of SFAS No. 142, Goodwill and Other Intangible
Assets (“SFAS 142”). When evaluating goodwill for impairment, SFAS 142 requires a company to compare the
fair value of the reporting unit(s) to which the goodwill is allocated, to the carrying value of the unit(s) to
determine if there is an impairment loss. If the fair value of the reporting unit exceeds its carrying value,
goodwill allocated to that unit is considered not impaired. Application of the goodwill impairment tests require
significant judgment by management, including identification of reporting units, assignment of assets and
liabilities to reporting units, assignment of goodwill to reporting units, determination of the fair value of each
reporting unit and projections of future net cash flows, which projections are inherently uncertain.
The Company considers the results generated from using both of the approaches set forth in SFAS 142 to
estimate the fair value of each relevant reporting unit as follows:
1. The market approach is used to develop indications of fair value. This approach uses market values and
revenue multiples of other publicly traded companies engaged in the same or similar lines of business
as ours.
2. The discounted cash flow (“DCF”) methodology is used to develop an additional estimate of fair
value. The DCF methodology recognizes that current value is premised on the expected receipt of
future economic benefits. Indications of value are developed by discounting projected future net cash
flows to their present value at a rate that reflects both the current return requirements of the market and
the risks inherent in the specific investment.
The determination of whether goodwill is impaired involves numerous assumptions, estimates and the
application of significant judgment. For the market approach, considerable judgment is required to select
comparable companies and estimate the multiples of revenues implied by their market values. For the DCF
approach, management must exercise judgment in selecting an appropriate discount rate and must also make
numerous assumptions in order to develop future business and financial forecasts and the related estimates of
future net cash flows. Future net cash flows depend primarily on future sales of the Company’s products, which
are inherently difficult to predict. This is especially true at times such as the present, when a significant portion
of the Company’s future net sales is expected to be generated not by the Company’s mature products but by
products introduced in 2008 and planned to be introduced in 2009.
The Company tested its goodwill as of December 31, 2008 and 2007. No goodwill impairment was
identified for either period. However, future impairment tests may result in a charge to earnings if the Company
experiences sales shortfalls, fails to reduce expenses or other events occur that would require the Company to
reassess the assumptions used in determining fair value. Therefore, the potential exists for future write-downs of
goodwill in connection with the annual impairment test.
Research and Development Costs
The Company accounts for its research and development costs in accordance with SFAS No.2, “Accounting
for Research and Development Costs” (“SFAS 2”), SFAS 86 and related guidance. Internal and external costs
incurred before a project reaches technological feasibility are expensed as incurred. External costs incurred after
a project reaches technological feasibility are capitalized. Capitalized costs are amortized into cost of sales when
the product is released to the market, generally using a three-year life and the “sum of the years’ digits”
method. Capitalized research and development costs are reviewed for future recoverability on a quarterly basis.
Impairment losses are charged to cost of sales in the period in which they occur.
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