(Estimated reading time: 4 minutes 31 seconds)
The article in brief:
- Market turmoil related to the novel Coronavirus pandemic has companies seeking answers about potential asset impairments.
- As corporations enter the second quarter of 2020, careful consideration to determine if interim impairment tests for goodwill and other intangible assets are warranted is paramount.
- Accurately identifying the potential triggering events for the impairment of goodwill and other assets, in light of COVID-19, is a necessary approach that companies should take now with their trusted partners.
“No surprises” is the typical mantra of many a CFO, corporate controller, and financial reporting professional. But the stark reality in our current COVID-19-impacted economic and business environment is quite the opposite.
Many companies have experienced significant declines in their market capitalization, operational and supply chain disruptions, and market volatility. In such cases, and depending upon a company’s unique set of facts and circumstances, these market events will more than likely trigger the need to conduct interim impairment testing.
Mindfulness in the Model
No one can predict the future, and any projection of future cash flows involves judgment. Setting uncertainties aside, solace can be found in the facts – Did we meet Q1 targets for revenues and earnings? What was our cushion in our most recent impairment test? Has our short-term or long-term outlook for the business changed?
The modeling for goodwill impairment testing involves comparing the fair value of the reporting unit to its carrying amount. Impairment testing for assets such as intellectual property, other intangible assets, long-lived assets, and inventory must be completed first, and any impairment reflected in the reporting unit’s carry amount before moving on to goodwill impairment testing. And with many experts expecting a V or U shaped recovery, the focus of impairments is currently on goodwill.
ASC 350 guidance requires annual goodwill impairment testing. It requires testing more frequently when events occur that indicate a greater than 50 percent probability that the reporting unit could be impaired. Leveraging ASC 350 guidance, companies must focus on the circumstances affecting the inputs of a valuation model to determine if a triggering event is present, requiring an interim test.
With many experts expecting a V or U shaped recovery, the focus of impairments is currently on goodwill.
Coronavirus Calamity = Triggering Event
Even in a “normal” market, questions must be asked and answered to determine if a triggering event has occurred, and must be considered inclusive of ASC 350-20-35-3C. Below, we highlight what we believe to be the most relevant factors that would cause companies to consider whether goodwill may be impaired:
- Decline in company stock price and market cap
- Current period operating or cash flow loss
- Change in the extent or manner of asset use
- Adverse change in legal factors or the business climate
- Capital and financial resource effects, including liquidity risk
Other factors worthy of consideration include:
- Decrease in the market value of an asset
- Manufacturing or other types of production slowdowns or shutdowns
- Store closures, whether permanent or temporary, of your company or competitors
- Workforce shortages or reductions
- Decline in competitor market multiples
- Supply chain disruptions
- Earning expectations well below forecasted levels or downward quarter-by-quarter earnings revisions
- Projected cash flow losses or net losses
These events are not fully inclusive of potential signals that indicate a triggering event. But, when weighing the breathtaking impact the Coronavirus has on the financial markets, specific industry segments, and companies, it is hard to ignore that these examples sound like headline news.
For companies that report on a calendar-year basis, the outbreak and the market downturn will likely establish themselves as current period events.
The Devil is in the Detail
It wasn’t until February 2020 that the virus outbreak began to have recognizable impacts on the market and share prices. As reported on March 25, 2020, the market was down 28 percent from its peak.
When considering this within the context of goodwill and impairment testing, companies with a fiscal year ending December 31, 2019, generally will not recognize COVID-19 as a subsequent triggering event. But companies must think through how COVID-19-related triggers will need to be distinguished from other potential triggers, which will also need to be recognized on the balance sheet.
For companies that report on a calendar-year basis, the outbreak and the market downturn will likely establish themselves as current period events. Whether it is considered a Q1 2020 or (more likely) Q2 2020 (or beyond) event is the immediate conundrum facing business entities. It appears that too many unknowns still exist to determine with certainty if a need for impairment testing is present – but wallowing in the unknowns is not a solution. Ongoing evaluation and re-evaluation are essential for companies to understand the extent of the need for financial reporting recognition and for what period(s).
Even though ambiguity seems to be yet another manifestation of the disease, some of the most significant financial consequences will be seen in both current and coming company disclosures. As pointed out in a recently published blog from Calcbench (who offers database accessible insight into SEC public company filings), for the period ending February 1, 2020, disclosures have begun to address the Coronavirus in the risk factor sections of company filings. As an example, L Brands added “significant health hazards or pandemics,” and Home Depot added “public health issues” to disclosures. While seemingly ambiguous, it is undoubtedly apparent that two well-known public companies have potentially acknowledged COVID-19 as a triggering event, and could be anticipating engaging in interim impairment testing as a result.
Finding a Balance Sheet Remedy
In VRC’s opinion, more than likely during the second quarter of 2020, companies will begin to gather more concrete financial evidence to determine if interim impairment testing is required. We also believe that the effects on complex accounting and valuation issues will take time to be resolved – however, the amount of time and for how many quarters on a go-forward basis is certainly anyone’s guess.
Nearly all companies are managing through a wide swath of challenges as a result of the market downturn. If it can be considered a silver lining, audit professionals, as well as regulatory organizations such as the SEC and the PCAOB, understand the situation. We are all reeling from the known and unknown effects. The SEC has stated within its official guidance that companies should not compromise the health and safety of its colleagues to meet financial reporting requirements.
Events will continue to evolve, and companies will continue to need to seek guidance from their partners. Engaging with third-party valuation experts promptly to ensure how this evolving situation may be impacting company assets, including goodwill impairment, is the best way to address impairment issues in a timely and accurate manner proactively.
VRC professionals are connected to our clients, partners, professional affiliations, and regulatory bodies. We have extensive experience working with public corporations and privately held firms to develop supportable impairment studies. We welcome you to contact article author PJ Patel, any member of VRC’s professional staff, or reach out to us with your questions and concerns through our Contact Us portal.
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VRC's COVID-19 Resource Center
Our professionals are continuously monitoring the rapidly changing environment and proactively discussing impacts and solutions with clients. Visit our COVID-19 Resource Center for continued updates and coverage related to valuation impacts.
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