Staples 2014 Annual Report Download - page 127

APPENDIX B
STAPLES B-9
STAPLES, INC. AND SUBSIDIARIES
Management’s Discussion and Analysis of Financial Condition and
Results of Operations (continued)
goods sold as the merchandise is sold. Amounts that represent
reimbursement for specific, incremental costs we incur related
to selling a vendor’s products, such as advertising, are
recorded as an offset to those costs when they are recognized
in our consolidated statement of income. Several controls are
in place, including direct confirmation with vendors, which we
believe allows us to ensure that these amounts are recorded in
accordance with the terms of the contracts.
Past experience has shown little variability in purchase and
advertising rebate estimates, no collectibility issues and no
significant write-off history. Given the historical accuracy of
our estimates, we believe that a significant change in our
estimates is not likely.
Impairment of Goodwill: See our accounting policy related to
testing goodwill for impairment in Note A in the notes to the
consolidated financial statements.
For the annual test in 2014, we performed an optional qualitative
assessment for our North American Commercial and Canada
Retail reporting units (combined goodwill of $1.28 billion at the
time of the impairment test) to determine whether it was more
likely than not that their fair values were less than their carrying
amounts. The assessment requires management to identify the
key drivers of fair value for the reporting units, to consider all
significant events and circumstances that are relevant to their fair
values, and then to weigh the positive and negative evidence.
Examples of factors considered include trends and conditions
in the macro economy, industry, and financial markets, as well
as Staples-specific factors that would likely be considered by
market participants, such as recent financial results and our
latest forecasts, our current strategic plans, and our stock price.
This process requires management to exercise a great deal
of judgment. Based on our assessment, we concluded that
it was more likely than not that the reporting units’ fair values
continued to exceed their carrying values by significant margins,
and accordingly that it was not necessary to perform the two-
step impairment test for these reporting units.
For our U.S. Stores & Online (USS&O) (goodwill of
$633 million at the time of the impairment test) and
International reporting units (combined goodwill of $1.25 billion
at the time of the impairment test), we proceeded directly to
the two-step impairment test. In step one, we determined
fair value using discounted cash flow (“DCF”) analysis, which
requires management to make assumptions and develop
estimates regarding industry and economic factors and the
future profitability of our businesses. The key assumptions and
estimates used in the discounted cash flow approach include:
• The reporting unit’s projections of financial results over
periods that range from five to eleven years, depending
on the maturity of the underlying business. For more
established businesses, such as USS&O and our
European and Australian operations, we used projection
periods of five to seven years, while in our emerging
market businesses we used an eleven year projection
period which reflects management’s expectations of the
development time for these growth-oriented businesses.
In general, our reporting units’ fair values are most
sensitive to our sales growth and operating profit rate
assumptions, which represent estimates based on our
current and projected sales mix, profit improvement
opportunities and market conditions.
• The discount rate, which is used to measure the present
value of the reporting unit’s projected future cash flows,
including those relating to the reporting unit’s terminal
value. The discount rate is based on a weighted-average
cost of capital (“WACC”) that reflects market and industry
data as well as our specific risk factors that are likely to
be considered by a market participant. The WACC is our
estimate of the overall after-tax rate of return required by
equity and debt holders of a business enterprise.
• The reporting unit’s perpetual growth rate, which is based
on projections for long-term GDP growth in the reporting
unit’s local economy and a consideration of trends that
indicate its long-term market opportunity. While we believe
our growth assumptions are reasonable, actual growth
rates may be lower due to a variety of potential causes,
such as a secular decline in demand for our products
and services, unforeseen competition, long-term GDP
growth rates in established economies being lower than
projected growth rates, or a long-term deceleration in the
growth rates of emerging markets.
The fair values of our reporting units are based on underlying
assumptions that represent our best estimates. Many of the
factors used in assessing fair value are outside of the control
of management and if actual results are not consistent with
our assumptions and judgments, we could experience
future impairment charges. To validate the reasonableness
of our reporting units’ estimated fair values, we reconcile the
aggregate fair values of our reporting units to our total market
capitalization. This exercise required judgment for our 2014
impairment test, given that it incorporated high-level estimates
of the fair values of the two reporting units for which we relied
on the optional qualitative screen.
Based on the results of our testing in 2014, three of our
reporting units failed step one of the impairment test -
Australia, China, and South America. In step two of the test,
we measured impairment charges of $280.2 million related to
Australia, $116.3 million related to China, and $13.0 million
related to South America. See Note C in the notes to the
consolidated financial statements for a description of the facts
and circumstances leading to these impairment charges and a
summary of the process by which the charges were calculated.
The fair value estimates incorporated in step two were
primarily based on the income approach, specifically the multi-
period excess earnings method. The valuations incorporated
significant estimates and assumptions made by management
including those relating to projected long-term rates of growth,
customer attrition, and profitability; appropriate market-based
royalty rates; and discount rates discussed above.
As of January 31, 2015, taking into account the charges
recorded during the fourth quarter of 2014 as well as the
impact of currency translation adjustments, the remaining
amount of goodwill associated with our Australia, China, and
South America reporting units was $51.3 million, $80.2 million,
and $0.0 million, respectively. The current year valuation of our
China reporting unit was predicated on the business achieving
significant growth in the future, and therefore this reporting
unit could experience additional impairment charges if sales
growth doesn’t accelerate in the near-to-mid term future.
The current year valuation of our Australia business assumes
improvements in sales trends and profitability compared with