Considerations for Acquisition Accounting During COVID-19 [What You Should Know About Asset Impairment Testing]

Written by Lyle Simons, Jeff Plank on May 4, 2021

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If your company has past merger or acquisition activity, during events such as the COVID-19 pandemic, it’s important to know 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, so companies need to test impairment systematically with full knowledge of the sometimes-arcane procedures.

Here, we’ve provided a roadmap for asset impairment testing during the COVID-19 pandemic.

Understanding Fair Value, Goodwill and How to Initially Assess Potential Impairment

Organizations record most assets other than goodwill at “fair value” at the time of a business combination.

The Financial Accounting Standards Board (FASB) defines fair value 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 the difference between the purchase price of the business and the value of the assets acquired.

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GAAP rules traditionally required companies to test impairment for goodwill and other non-amortized intangible assets annually.

In 2014, 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. Since 2014, many private companies have adopted the alternative and no longer perform the annual test.

Public companies and private businesses that do not select the alternative accounting treatment must still test impairment annually and estimate the fair value of goodwill. Any impairment in these situations is calculated using a simplified one-step process instead of the far more complicated two-step procedure used prior to 2014.

Although companies may not have to test goodwill annually, they still need to determine whether events or circumstances, such as the disruptive influence of COVID-19, constitute a “triggering event” for potential asset impairment. Learn more about triggering events here.

Qualitative Goodwill Impairment Testing

Once you’ve determined 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 considering the same business, financial and market risk factors used in the triggering event. It may be difficult to support a conclusion of no impairment. As a result, most companies move directly to a quantitative test for impairment.

Sequence of Asset Impairment Testing

If you determine that a triggering event has occurred, you must follow a prescribed order of impairment testing.

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Step #1: Test indefinite-lived intangibles

Under current guidance, you must test indefinite-lived intangible assets such as trademarks and trade names first. Determine the fair value of each asset in this class, and, if less than the current book value, take an impairment amount equal to the difference. Note that the write-down of such assets results in lower carrying value.

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Step 2: Test long-lived assets

Next, test long-lived assets.

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.

Testing long-lived assets is notoriously difficult, so you may wish to consult with experienced valuation professionals.

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According to FASB rules, “asset groups” are tested for impairment based on their “recoverability.” The company needs to measure future cash flows attributable solely to an asset group on an undiscounted basis (unlike in a typical business valuation where the present value of future cash flows is determined).

Because you’re using undiscounted cash flows, the test for long-lived assets is a more difficult test to fail than the one used for goodwill.

Whether or not you decide to use the services of a valuation professional, you should discuss the approach to long-lived asset testing with your audit team 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 test for potential goodwill impairment involves analyzing the fair value of the subject reporting unit.

While the FASB guidance for this testing can be complex, for impairment purposes, you really only need to be aware that fair value is a market-oriented concept. This means you determine value based on how a market participant (such as a hypothetical competitor or another company in the industry) would look at the asset’s value – not what a specific buyer might decide to pay for it.

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, appraisers may adjust the value to reflect equity only. They may conduct the test using either measure, as long as they make an apples-to-apples comparison of the asset’s estimated fair value and carrying value.

A fair value above carrying value results in a determination of no impairment. Under the current one-step procedure, if fair value is less than the carrying value, the difference is recorded as the impairment to goodwill.

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Technically, if goodwill is completely impaired, no further adjustments are 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.

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.

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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. Then you adjust that amount for any non-operating assets or liabilities. The forecast, or projected financial information (PFI), 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 financial performance make the process even more difficult.

You should expect that auditors and valuation specialists will look skeptically at any forecast that presents a rosy outlook of strong growth and increasing profitability for a currently underperforming business entity.

Fortunately, there are alternatives to the traditional DCF methodology described above. In recent years, FASB has provided an “expected present value technique,” which uses multiple PFI scenarios—each representing a conditional outlook for the business.

To apply this approach, you need to prepare two or more forecasts, which are then probability-weighted. You then adjust these projections for uncertainty, as opposed to quantifying the riskiness of future performance indirectly through an adjustment to the reporting unit’s discount rate. This method works well with 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 and other government programs. You should discuss the timing of this legislation with your audit team and whether you can include it in forecasted results.

Many potential adjustments may arise from the stimulus plans, and describing all of them is beyond the scope of this article. Many of the changes are tax-related (e.g., availability of employee retention credits and NOL usage rules). Accounting for them in projections is critical since they may significantly modify future cash flow and, ultimately, value.

We recommend that management receive input from tax specialists when preparing any forecasts used to estimate value.


Applying the Market Approach to Estimate Value

Most GAAP-related fair value analyses include a market approach—normally involving comparisons with a group of publicly-traded companies or comparable M&A transactions.

The decline in market pricing for public companies through the spring of 2020 complicates the use 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 do 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 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.

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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 an MPAP do exist, but they require more sophisticated analyses.

Concluding Value and Determining Impairment

Good valuation requires considering multiple valuation techniques. Generally, analysts expect fair value indicators from different methods to converge to a point where differences are relatively small and 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 assign weights to different valuation approaches consistently. Don’t disregard a historical valuation technique simply because it results in implied impairment unless you can make a convincing case 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 in an especially hard-hit industry.

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.


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