Should Gabriela and Rob be concerned about the fair value estimate Morris Mining has computed? Why? What incentive does the company likely have in terms of valuing the patent (over or understatement)? Explain your answer.

Question

What will be an ideal response?

Answer 1

Yes, Gabriela and Rob should be concerned with the fair value estimate of the patent for a number
of reasons. For example, the patent will be shown on the balance sheet at the amount determined by
the discounted cash flow model. The auditors are responsible for ensuring that the company’s financial
statements are materially correct and fairly represent the company’s position. Users of financial
statements trust auditors will follow professional standards with due diligence. Further, valuing the
patent will also impact the income statement in subsequent years through net royalty revenue and
amortization expense.
Gabriela and Rob should recognize that the inputs used in estimating the fair value are largely
based on management’s judgment and assumptions and even slight adjustments to these inputs may
have a material impact on the fair value estimate of the patent, and therefore the representational
faithfulness of the financial statements. To be able to give an opinion on the fairness and accuracy of
these estimates, Gabriela and Rob will need to obtain sufficient appropriate audit evidence to support
the estimates recorded on the financial statements.
In this case, the company has an incentive to underestimate the value of the patent in order to
reduce the amortization expense (positively impacting the company’s earnings). After the patent has
been valued, the company will then compute the amount of goodwill associated with the acquisition
that will be shown on the balance sheet. In subsequent years, the patent will be amortized whereas
goodwill will not. Rather, goodwill will only be subject to an annual impairment test (that is further
subject to management estimates).