This article was originally published in FEI Daily on April 30, 2020.
The COVID-19 pandemic has caused unprecedented turmoil in the global economy and financial markets, the breadth and duration of which remains unknown. The pandemic has contributed to market volatility causing substantial declines in market capitalization, one of many factors to consider when determining whether a triggering event for an impairment test has occurred. Company projections may be affected by supply chain disruptions, a shift in demand for its products or services or the loss of customers. While some industries and companies may be more vulnerable than others, both the effects of the pandemic and aggressive COVID-19 containment measures have impacted social and economic behavior while increasing overall uncertainty. In the aggregate, these factors can result in a negative impact on the outlook and valuation of businesses, and the recoverability of any associated goodwill.
As you evaluate the impact of COVID-19 on your business, it is important to consider the below questions around goodwill impairment.
Do I Have a Triggering Event for Goodwill Impairment Testing?
The current environment may prompt the need to perform an interim impairment test. U.S. GAAP and IFRS lay out an illustrative list of impairment indicators, which need to be evaluated when determining if a triggering event has occurred. While all eyes are on the plunge and volatility in equities, the more consequential issue companies grapple with is whether a stock price decline reflects fundamental shifts in their business and industry, and if this affects reporting units (RUs) or cash generating units (CGUs) where goodwill resides.
It is possible that most companies will be required to assess if a triggering event has occurred as of their proximate reporting period end, which may lead to a quantitative goodwill impairment test. Some might have to make this assessment multiple times in future periods as the effects of the pandemic unfold. A conclusion that no triggering event has occurred needs to be supported with thorough documentation. The fact that the accounting standards do not permit a reversal of a goodwill impairment weighs heavily on the judgments made.
Is My Company’s Stock Price Representative of Fair Value?
It might be – or it might not. The key takeaway is that prices from orderly transactions cannot be ignored, and the company’s stock price should be considered (i.e., given some weight) in an analysis, despite the stress experienced by the markets. Market volatility should be considered up to the valuation date, and sensitivities should be used both when applying the market approach (market prices and market multiples) and when using market capitalization as a reasonableness check at the conclusion of the fair value analysis.
Given the volatile state of equity markets, an integral part of the analysis, which can complement and help interpret the market approach indication, is performing a discounted cash flow analysis (DCF) on the RUs/CGUs tested for impairment, and for the company overall, as appropriate.
What Projections Do I Use in Applying an Income Approach (DCF)?
To the extent the company has not yet considered the impact of COVID-19 on its financial planning, it may start from its pre-COVID-19 prospective financial information (PFI) and assess the operational impacts, likely including downside scenarios based on the specific facts and circumstances. While the impact may vary by industry, a significant consideration is the overarching economic fallout and long-term effects of COVID-19, and that even when in recovery, the economy may be growing from a lower base. Real GDP growth estimates for 2020 have been cut by varying amounts for the U.S., the Eurozone and other parts of the world, and beyond 2020, the shape of recovery and its duration are expected to vary by geography.
In the end, the objective is to arrive at a neutral and unbiased set of PFI under the current conditions of uncertainty. Importantly, a fair value measurement does not allow hindsight and considers information that was known or knowable as of the measurement date by a market participant. This includes the results of due diligence that market participants can reasonably be expected to undertake that would arguably resolve certain elements of information asymmetry between the company’s management and the market.
Consider Developing Scenarios Rather Than Using “alpha” in the Discount Rate
Given the high degree of uncertainty and the wide dispersion of potential outcomes, it may be more supportable to consider the impact of various factors and assumptions explicitly using a limited number of scenarios by applying the expected present value technique (EPVT) in the valuation analysis. This approach adjusts the cash flows and can also serve as a more robust basis for supporting any “implied control premium” in the comparison to market capitalization (or to the market value of invested capital (MVIC)). This comparison is performed for corroborative purposes and is meant to explain differences, if any, between market perception and pricing and a fair value measurement performed from a market participant perspective.
Therefore, adjustments made to the discount rate, a.k.a., an “alpha,” used in conjunction with a discount rate adjustment technique (DRAT) should be avoided. However, if a DRAT and alpha are used, risk adjustments should not be double counted in the discount rate and in the cash flows. Additionally, note that using a revised equity risk premium (ERP) for the current environment by itself is an insufficient adjustment for risk regardless of the technique used, whether EPVT or DRAT.
IFRS Value in Use Considerations
As part of the goodwill impairment test, companies reporting under IFRS may also be considering a value in use (VIU) estimate when determining the recoverable amount, which is the higher of VIU and fair value less costs of disposal (FVLCOD). VIU is defined as the present value of the future cash flows expected to be derived from an asset or CGU and is developed by following certain specific stipulations set out in IFRS that are different from the market participant perspective used in fair value measurements. Still, a VIU estimate cannot be disconnected from a post-COVID-19 reality, and the same overarching considerations about PFI development addressed earlier apply.
Is There a Case to Be Made for Asymmetric Information in Comparing to Market Capitalization?
It may be possible to make the case for asymmetric information in comparing to market capitalization, but this assertion should be well supported by the facts and circumstances. A comparison of market capitalization (or MVIC) to fair value based on the company’s PFI and adjusted for market participant assumptions would produce what is known as an “implied control premium,” or a market participant acquisition premium (MPAP). Valuation best practices point to broadly quantifying the elements of MPAP, which could comprise enhanced cash flows or a reduction of risk from a market participant perspective and the elimination of asymmetric information. The assessment of asymmetric information may be best performed at the company’s strategic plan level relative to market capitalization/MVIC, as this focused analysis removes the impact of the other elements of MPAP that are then layered on top to build up to fair value.
In some cases, the market may hold a more pessimistic view than what a company’s fundamentals indicate and may not fully reflect the company’s response to the crisis and its outlook. This is where a robust set of scenario-based PFI may be very useful in supporting an argument for asymmetric information. It should not be surprising if MPAP premiums increase during this time of crisis. However, the analysis may occasionally reveal the opposite—that the market has not yet assimilated potentially negative information about the company.
The comparison to market capitalization or MVIC is not required by U.S. GAAP or IFRS but has been widely applied in practice to corroborate the sum of fair values of RUs/CGUs.
What Other Valuation Issues Should I Think About?
Even if no impairment is taken, SEC filers may need to make goodwill-at-risk disclosures for RUs for which fair value is not substantially in excess of carrying amount. This may require some estimate of fair value to be made.
In addition, the existence of goodwill impairment indicators could raise the question if other assets might be impaired. U.S. GAAP and IFRS provide examples of impairment indicators for assets other than goodwill that a company should evaluate (for example, an adverse change in the business climate can result in the loss of customers and could impact the recoverability of customer relationship intangibles). When impairment indicators exist, certain assets, including long-lived nonfinancial assets and indefinite lived assets, need to be tested for impairment prior to goodwill, as the carrying amount of a RU/CGU (or group of CGUs) with goodwill may be impacted by other asset impairments. Notably, the projections used in the fair value measurement of assets tested for impairment should be consistent with those for the overall company if the premise of value remains continued use in combination with other assets.
Impairments may rise as they did in the aftermath of the financial crisis of 2008-2009 and the Euro sovereign debt crisis of 2011-2012. More importantly, it remains to be seen if a post-COVID-19 world will bring lasting changes in the way we do business and socialize, which also impacts value creation. But perhaps most important is to keep in mind that this crisis, too, will eventually be in the rearview mirror.
Duff & Phelps recently held a webcast around the Impact of COVID-19 on Goodwill Impairment–Perspectives from U.S. GAAP and IFRS. View the replay here.