Given the continued economic slow down, the values of common asset classes have taken a big hit and substantial impairment charges are showing up in the financial statements of many companies. These losses are a further blow to companies that have already seen their earnings gutted by poor trading conditions.
The impairment testing of goodwill and other assets has emerged as a particularly difficult issue. When business conditions deteriorate, goodwill can be subjected to heavy write-downs. Unlike most other asset classes, the carrying value of goodwill must be tested for impairment annually and the impairment charges cannot be reversed when the market improves.
For public companies, impairment losses can depress share prices and alarm investors and lenders. While these losses do not directly affect cash flow, they may precipitate breaches of loan covenants and adversely influence the cost and availability of capital.
Directors, CEOs and finance executives cannot escape responsibility for deciding when impairment testing is required and ensuring that it is carried out in a proper manner.
There are several points to consider:
Has a ‘triggering event’ indicated the requirement for impairment testing?
Current economic conditions do not necessarily constitute a triggering event. However, certain events that result from these conditions are considered impairment triggers.
Such events can include a company’s shares trading at a significant discount to book value or a decline in forecast cash flows. As most businesses will be impacted by the current economic conditions, some form of impairment testing will have to be undertaken.
Has the calculation of ‘value in use’ or ‘fair value less costs to sell’ been updated to reflect current conditions?
Value in use and fair value are estimated using, inter alia, the future cash flows expected to be derived from a particular asset. It can be sensitive to changing economic and business conditions.
Matters to consider include revised revenue assumptions to reflect current expectations, changes in the entity’s cost base and growth projections that go beyond the period for which detailed forecasts are available.
Have discount rates been reassessed compared with those used in previous periods?
Cash flows from the future use of assets need to be discounted to present value. It may need professional advice to get this right.
Cross-checking the reasonableness of the value in use calculation.
Appropriate cross-checks include comparing the total value in use for all assets to market capitalisation and comparing the implied earnings’ multiples resulting from the value in use calculation with market multiples for the company, comparable quoted companies and comparable transactions, if any.
Although equity markets have risen significantly from their crisis lows, it is likely there will be more asset write-downs as 2010 unfolds. Finance managers should be evaluating industry trends, monitoring goodwill on reporting unit balance sheets and be on the lookout for impairment triggers. Companies should also involve their auditors in advance of the reporting dates to help identify impairment issues and enlist the assistance of independent valuers to quantify potential write-offs.