The global pandemic has severely impacted business operations for companies in a wide range of industries across the country, resulting in stagnant or declining profits, or even insolvency.
As a business manager, you must deal with the more immediate operational and financial concerns relating to the coronavirus, while simultaneously considering the accounting consequences of this unprecedented event. For those companies with past merger or acquisition transaction activity, the question becomes whether, and to what extent, goodwill or other intangible assets have been impaired. In some cases, the value of underproductive tangible assets may even have declined.
Asset valuation and impairment issues can be complex, and testing should be conducted systematically with full knowledge of the sometimes arcane procedures. This article is designed to provide you with a roadmap for the most critical aspects of asset impairment testing.
Initial Assessment of Potential Impairment
Most assets other than goodwill are recorded at “fair value” at the time of a business combination, defined by the Financial Accounting Standards Board (FASB) as:
the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
In contrast, goodwill is estimated as the residual amount of excess purchase price over the value of net assets acquired. The original 2001 GAAP accounting rules required an annual impairment test for goodwill and other non-amortized intangible assets. The impairment test rules are codified in Accounting Standards Codification (ASC) 350: Intangibles—Goodwill and Other.
For the past decade or so, accounting regulators have looked for ways to reduce the cost and complexity of asset impairment testing, particularly for smaller, privately-held businesses. In 2004, FASB issued Accounting Standards Update (ASU) 2014-2, which allowed private companies to elect to amortize goodwill, typically over a straight-lined, ten-year period (or a reduced useful life if it can be shown to be appropriate). Since 2014, many private companies have adopted the alternative and no longer perform the annual test.
Public companies and those private businesses not selecting the alternative accounting treatment must still employ the annual impairment test and estimate the fair value of goodwill. Any impairment in these situations is calculated using a simplified one-step process, as opposed to the far more complicated two-step procedure in use prior to 2014.
Has a Triggering Event Occurred?
While removing the requirement for annual goodwill testing, ASU 2014-2 does not eliminate the necessity of determining whether specified events or circumstances, such as the disruptive influence of COVID-19, constitute a “triggering event” for potential impairment. You must assess whether business or economic conditions are such that it is “more likely than not” that a specified reporting unit’s fair value has declined to an amount below carrying, or book value.
ASC 350-20-35 outlines the various factors that should be considered when making this determination. For purposes of providing audit evidence, you and your advisors may be required to analyze these various factors, which range from macroeconomic conditions (such as a decline in the debt or equity markets) to an almost unlimited number of company-specific factors (such as a notable decline in customers, supply chain disruptions or the loss of key personnel).
Companies experiencing a sustained period of reduced revenue and profit will be at higher risk for a triggering event that requires goodwill impairment testing; however, that determination does not in itself constitute potential impairment. The amount of goodwill “cushion” (i.e., the notional difference between the reporting entity’s fair value and carrying value) is particularly important.
For public companies, this analysis may be based on market capitalization (or some apportioned amount in the case of multiple reporting units), greatly simplifying the estimate.
In the case of private companies, management should review the reporting unit’s last fair value estimate in comparison to carrying value. A dated valuation of two or more years may not be very useful in this type of analysis. Transactions occurring within the past 12 months or so may provide useful valuation guidance, but note that at the time of the transaction, the acquisition price would be exactly equal to carrying value, resulting in zero fair value cushion—likely an unhelpful answer for purposes of current impairment testing.
Ultimately, you may be able to present audit evidence that the fair value-carrying value differential is large enough that the potential for impairment due to the negative impact of COVID-19 is low, thereby avoiding the need to test goodwill for impairment. Alternatively, a thin cushion, or no cushion at all, will almost certainly necessitate a test.
Under the ASC 350 guidance, once a determination is made that a triggering event has occurred, you technically still have the option of performing a qualitative test (sometimes called a “step zero test”) for goodwill impairment. Practically speaking, however, the qualitative test involves consideration of the same business, financial and market risk factors used in the triggering event, and it may be difficult for you to provide audit evidence sufficient to support a conclusion of no impairment.
Consequently, most companies experiencing a triggering event will move directly to a quantitative test for impairment.
Another practical question concerning asset impairment will likely be raised as the business moves temporally through the COVID-19 cycle: has a triggering event occurred if, after the initial downturn, business conditions improve? For example, as of the date of this article, market pricing of the major stock exchanges has rebounded significantly from March lows, and unemployment statistics have also improved. Do you still need to test?
In most cases, the answer is yes. Under existing FASB rules, impairment testing is required at the time of the triggering event regardless of subsequent changes to business or market circumstances. However, as a financial executive responsible for testing, you should consult with your audit team regarding the nature of the changes. The question of whether improved conditions were foreseeable or not requires substantive discussion and consideration.
Sequence of Asset Impairment Testing
If you determine that a triggering event for possible asset impairment has occurred, you must follow a prescribed order of impairment testing. Under current guidance, indefinite lived intangible assets (often including trademarks and trade names) are tested first. The fair value of each asset in this class is determined and, if less than current book value, an impairment amount equal to the difference is taken. Note that the write-down of such assets will result in a lower carrying value for the reporting unit tested for goodwill impairment.
Long-lived assets are subsequently tested using guidance from ASC 360: Property, Plant and Equipment. This asset category may include both fixed assets and various types of amortized intangible assets, such as customer relationships, patents or other technology-related intangibles and non-compete agreements. The testing of long-lived assets is notoriously difficult, and you may wish to consult with valuation professionals experienced in this area.
Under ASC 360, “asset groups” are tested for impairment on the basis of their “recoverability.” Future cash flows attributable solely to an asset group are measured on an undiscounted basis (unlike in a typical business valuation where the present value of future cash flows is determined).
Because undiscounted cash flows are used, the test for long-lived assets is often deemed to be a more difficult test to fail relative to that used with goodwill. However, various rules—particularly those involving the estimated useful life of the asset group—complicate the measurement process and require a great deal of study and analysis.
Whether or not you decide to use the services of a valuation professional, you should discuss the approach to long-lived asset testing with the audit team in order to avoid serious missteps that might filter through the entire impairment testing process. As with indefinite lived intangibles, any adjustment to the value of long-lived assets is taken prior to the goodwill test, potentially resulting in a change to the carrying value of a reporting unit.
Quantitative Goodwill Impairment Testing
The quantitative test for potential goodwill impairment involves a fair value analysis of the subject reporting unit. ASC 820: Fair Value Measurement defines fair value and provides a detailed discussion of the hierarchical framework for measuring the fair value of assets and liabilities.
While this guidance can be complex, for impairment purposes, you really only need to be aware that fair value is a market-oriented concept. This means value is determined on the basis of how a market participant (such as a hypothetical competitor, or another company in the industry) would look at the business unit’s value and not what a specific buyer might decide to pay for it. Defining value in this way impacts the valuation in several different respects, most notably in how transactional synergies might be quantified.
As financial manager, you may perform this test in-house if the auditors determine you possess the requisite valuation knowledge and skills. However, in most cases, we recommend the use of a third-party valuation firm since this provides an additional layer of comfort for auditors that the analysis has been conducted professionally and without bias. Most valuation firms certify that their analysis conforms with standard, professional appraisal practice.
Use of an appraisal specialist is particularly important in the current environment since they are more likely to be aware of the impact of tax law changes and government stimulus programs on specific elements of business valuation.
The analysis is typically based on the “enterprise” value of the reporting unit, meaning the fair value estimate reflects the total invested capital of the business. In some cases, particularly if the reporting unit represents a stand-alone business entity, appraisers may adjust the value to reflect equity only. The test may be conducted using either measure, as long as an apples-to-apples comparison is made of the reporting unit’s estimated fair value and carrying value.
Fair value in excess of carrying value results in a determination of no impairment. Under the current one-step procedure, if fair value is less than carrying value, the differential is the amount recorded as the impairment to goodwill. Technically, if goodwill is completely impaired, there are no further adjustments required. However, in our experience, such a result is rare. Complete impairment of goodwill highlights the question of whether other intangible assets, or even tangible assets, are also impaired.
Valuation Methodology – Key Concepts
An extensive discussion of valuation techniques used in the quantitative impairment test is beyond the scope of this article; however, you should be aware of certain key aspects of valuation methodologies and how they are impacted by recent changes—particularly regarding the government’s various stimulus plans.
For going concern businesses, most valuations used in the quantitative test will include either a market approach, an income approach or both. An asset-based methodology is used more often in the case of holding companies, asset-intensive businesses or financial concerns, but is not typically used to value operating companies. An exception to this may be in circumstances where the reporting unit being valued is facing potential insolvency and its ability to continue as a going concern is in question.
Many companies have applied the private company alternative and don’t have historical valuations of their reporting unit. In that case, you should work with advisors to determine which methodologies should be used to estimate fair value. Normally, multiple approaches are relevant and should be used. If prior valuations do exist, you should attempt to remain consistent in their application.
Applying the Income Approach to Estimate Value
The most common method used in estimating fair value today is the income approach—typically some form of discounted cash flow (DCF) analysis. In the DCF analysis, estimated future cash flows of the business entity are discounted at a risk-adjusted rate of return to arrive at an indication of value, which is then adjusted for any non-operating assets or liabilities. The forecast, or projected financial information (PFI) as it is called in the accounting literature, is obviously critically important to the valuation.
Even under the best circumstances of a stable economic environment, estimating future streams of business income is challenging; in the COVID-19 world, uncertainties associated with future contingent paths of financial performance make the process that much more difficult.
You should expect that auditors, including the valuation specialists supporting them, will look skeptically at a “hockey-stick”-style forecast that presents a rosy outlook of strong growth and increasing profitability for a currently underperforming business entity. Such forecasts and their underlying assumptions may be seriously contested, and auditors are likely to request extensive documentation of all critical inputs.
The estimated discount rate—the means by which the projections’ riskiness is quantified in this type of analysis—may also be impacted and should be scrutinized. A reduced discount rate in the current COVID-19 environment, compared to prior years, would seem to be an unusual occurrence and require justification.
Fortunately, there are alternatives to the traditional DCF methodology described above. In recent years, FASB has provided an “expected present value technique” in which multiple PFI scenarios are used—each representing a conditional outlook for the business.
To apply this approach, you would need to prepare two or more forecasts, which are then probability weighted. These projections are directly adjusted for uncertainty, as opposed to quantifying the riskiness of future performance indirectly through an adjustment to the reporting unit’s discount rate. This methodology is well adapted to the highly volatile nature of the current business environment when the amount and timing of future cash flows may depend on uncertain events and trends.
Finally, it may be appropriate in some instances to account for the financial impact of the CARES Act (H.R. 748) and related government programs in management’s PFI. You should discuss with the audit team the timing of this legislation and whether it can be included in forecasted results.
There are many potential adjustments that may arise from the stimulus plans, and a description of them all is beyond the scope of this article. Many of the changes are tax related (e.g., availability of employee retention credits and changes in NOL usage rules), and accounting for them in projections is critical since they may cause significant modifications to future cash flow and, ultimately, value.
We recommend that management receive input from tax specialists when preparing the forecast (or forecasts) model used to estimate value.
Applying the Market Approach to Estimate Value
Most GAAP-related fair value analyses of business entities include consideration of a market approach—normally involving a comparative analysis of the subject reporting unit with a group of guideline publicly-traded companies and/or comparable M&A transactions.
The precipitous decline in market pricing for public companies through the spring of 2020 complicates application of this method. Multiples based on trailing 12-month financial measures at the time of testing will almost certainly be depressed compared to historical averages and may be less relevant in the current environment than the harder-to-determine forward-looking multiples.
The use of market multiples typically requires access to subscription databases that many corporate managers will not have access to—an additional reason we recommend using a valuation specialist.
Another complexity in the use of this method involves the estimation of a “control premium,” or, using appropriate terminology, a “market participant acquisition premium” (MPAP). The amount of the premium is critically important, and you may find that the estimate can make the difference between a finding of impairment or no impairment.
Unfortunately, given the dearth of transaction activity in the first two quarters of 2020, appraisers may find evidence of such premiums lacking. Looking back for a longer period raises questions about how relevant such evidence is in the current environment. Alternative approaches to quantifying a MPAP do exist, but they require sophisticated analyses that involve the consideration of hypothetical acquisition synergies and other factors.
Concluding Value and Determining Impairment
Good valuation practice dictates consideration of multiple valuation techniques. Generally, analysts expect fair value indicators from separate methodologies to converge to a point where differences are relatively small and can be easily reconciled. This final exercise takes on added importance in the current environment of economic uncertainty and volatile market pricing.
For companies with a track record of historical valuations, the valuator should attempt to remain consistent in his or her assignment of weights to different valuation approaches. A change in weighting may be appropriate but should be made only after careful consideration and with explicit, robust documentation of the rationale. Don’t disregard a valuation technique used historically simply because it results in implied impairment, unless a convincing case can be made that it no longer results in a reasonable approximation of fair value.
As company management, you are ultimately responsible for determining asset impairment. Given the potential for reduced valuations during 2020, it is important to maintain open lines of communication with valuation specialists and auditors. Analyses, both quantitative and qualitative, must be thorough and, if appropriate, should include consideration of legislative changes designed to improve economic performance and the financial strength of American businesses.
Finally, we cannot overemphasize the importance of documentation. This is particularly true in situations involving a poorly performing business unit, or for businesses in an industry especially hard-hit by the disruptions caused by COVID-19.
If you have questions about the information mentioned above, contact your Warren Averett advisor or ask a member of our team to reach out to you.