COVID-19: Anxious Times for Financial Statement Preparers Worried About Goodwill Impairment

(Estimated reading time: 3 minutes 14 seconds)

The article in brief:

  • The impact of the proliferation of coronavirus cases on financial markets is creating challenges for companies attempting to wrap up quarterly reporting.
  • On top of concerns about the outlook for the economy  and implementation of the CARES Act, companies with goodwill on the books are questioning whether they need to test for impairment and, if so, what parameters to adjust  in a rapidly changing environment  
  • VRC Co-CEO PJ Patel briefed financial reporting and SEC professionals on how companies are dealing with impairment questions in Q1 and planning for Q2.

Public company financial executives are coming to realize that the coronavirus is unlikely to be a short-lived phenomenon and that realization is hitting just as they go into the quarterly reporting season. Even as business in China slowly returns to a sense of normalcy, businesses, and equity markets in Europe and the U.S. are still reeling from the impact of the pandemic.

According to Patel, that has many business leaders questioning whether a triggering event has occurred that might compel them to take an impairment charge on goodwill. He said the two triggers that are most on financial executive’s minds today are actual declines in their share price and potential declines in future earnings. “When you look at those two things,” Patel said. “Many companies are asking ‘Do I need to do something around testing for impairment?’”

The Merits of a “High-level Refresh”, For Now

At this late stage in the reporting cycle, Patel suggested that many companies—especially those that conducted thorough impairment tests on their goodwill in the latter part of last year and found they had a comfortable cushion of fair value over book value—might consider a “high-level refresh” for the first quarter with the understanding that a more robust exercise may well be in Q2.

In this scenario, rather than completely updating the full set of projections supporting goodwill value, companies should consider running the numbers from the most recent impairment test again, updating any input figures they already have, such as the share price and current market multiples.

Patel suggested there are a couple of compelling reasons for companies not to attempt to update the projections behind their goodwill valuation for Q1 financial statements at this juncture. The first is mechanical—there’s not a lot of time to put together a new model with new forecasts. But the second is a matter of accuracy; there are so many unknowns about the scope and duration of the pandemic at this stage that any forecasts will be suspect.

"Many companies are asking, 'Do I need to do something around testing for impairment?'"

Valuation Reconciliation Challenges

Going forward, as companies do undertake more robust impairment tests with coronavirus concerns potentially still hanging over the economy, they likely will find it more challenging than before to reconcile different indications of value. Commonly used income approaches entail a discounted cash flow analysis based on projections that may be somewhat lower, but not necessarily dramatically so, especially long-term. Similarly, when companies use transactions (M&A deals) as part of their valuation analysis, those transactions are typically undertaken with a longer time horizon, so they are unlikely to produce a large delta with prior valuations. However, a third popular approach—looking at multiples of publicly traded comparable companies could lead to some significant swings in value.

In order to reconcile valuations from the income approach and market transactions with the more volatile and potentially much lower comparable company approach, Patel said it is considered best practice to use an average of comparable company multiples observed over a reasonable period of time.

Two Other Factors to Bear in Mind

Patel stressed two additional points to the group as they look ahead to impairment testing in the time of coronavirus and a potentially prolonged downturn in the markets:

  1. Control premiums should be reviewed. Data from Mergerstat and CapIQ suggest that average and median control premiums typically range between 20 to 30 percent, moving lower in a bull market and moving higher in a bear market. However, in a market that declines quickly, such as in 2009, the average and median control premiums can move more dramatically. Data from 2009 suggests a median control premium of 50 percent with the average going higher.
  2. Discount rates should be relatively higher to reflect higher equity risk premiums; the amount of the increase depends on many factors—including the extent to which coronavirus factors are included in forward projections and the quality of that analysis—but in general, estimate of the equity risk premiums appear to be moving upwards in the range 100 to 150 basis points on coronavirus concerns. The increase in ERP is slightly more than offset by the decline in the risk-free rate – based on current yields of the 20-year U.S. Treasury.

Summary

Even amid a pandemic, companies have been encouraged to report financials on their regular schedule. With a foggy crystal ball, they can be forgiven for keeping things simple at this time of nearly unprecedented uncertainty in the market.

To help find certainty in this current uncertain business climate, VRC is staying well-connected to our clients and partners, as well as 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 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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Questions About Goodwill Impairment Testing?

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