Problem: Gulwest Industries, a public company, used a contrived amount of goodwill to overstate assets and disguise a loss on discontinued operations. The company had decided to discontinue its unprofitable line of business of manufacturing sporting ammunition. They had capitalized the startup cost of the business, and, with its discontinuance, the $7 million deferred cost should have been written off. Instead, Gulwest formed a new corporation named Amron and transferred the sporting ammunition assets (including the $7 million deferred cost) to it in exchange for all the Amron shares. In the Gulwest accounts, the Amron investment was carried at $12.4 million, which was the book value of the assets transferred (including the $7 million deferred cost).
In an agreement with a different public company (Big Industrial), Gulwest and Big created another company (BigShot Ammunition). Gulwest transferred all the Amron assets to BigShot in exchange for (1) common and preferred shares of Big, valued at $2 million, and (2) a note from BigShot in the amount of $3.4 million. Big Industrial thus acquired 100% of the shares of BigShot. Gulwest management reasoned that it had “given” Amron shares valued at $12.4 million to receive shares and notes valued at $5.4 million, so the difference must be goodwill. Thus, the Gulwest accounts carried amounts for Big Industrial shares ($2 million), BigShot note receivable ($3.4 million), and goodwill ($7 million). Audit trail: Gulwest directors included in the minutes an analysis of the sporting ammunition business’s lack of profitability. The minutes showed approval of a plan to dispose of the business, but they did not use the words “discontinue the business.” The minutes also showed approval of the creation of Amron, the deal with Big Industrial along with the formation of BigShot, and the acceptance of Big’s shares and Bigshot’s note in connection with the final exchange and merger.

Amount: As explained above, Gulwest avoided reporting a writeoff of $7 million by overstating the value of the assets given in exchange for the Big Industrial shares and the BigShot Ammunition note.