The Pandemic Effect: Impairment
As of December 31, 2019, there were reported cases of “pneumonia of unknown cause” that were limited primarily to China. The World Health Organization (“WHO”) later characterized the outbreak as a “Public Health Emergency of International Concern” on January 30, 2020. On March 11, 2020, the WHO announced the COVID-19 outbreak as a pandemic.
During the first quarter of 2020, and likely beyond, the pandemic has contributed to economic and financial market volatility, causing market prices to decline, disruptions in supply chains, as well as changes in demand. All these factors need to be carefully considered as to whether a triggering event for impairment has occurred.
Pursuant to ASC 350-20-35-28 through 35-30, an entity is required to test goodwill for impairment at the reporting unit level at least annually or “between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount.” The following table provides examples of events and circumstances that may meet such a “bright line test” or threshold; thereby requiring an entity to test for goodwill impairment between annual testing periods.
COVID-19 has undoubtedly affected major economic and financial markets worldwide with virtually all industries facing challenges. As such, based on the factors outlined above and in ASC 350-20-35-3C, it is more likely than not that COVID-19 is a triggering event for many entities, whether public or private. Specific industries like hospitality, travel, leisure, entertainment, and retail are likely to have been hit hardest with the onset of COVID-19, whereby significant declines in revenue have resulted due to federal and state mandates (e.g., shelter in place, school closures, nonessential work closures) and changes in consumer behavior (e.g., social distancing, online ordering, reduced consumer spending).
For public companies with observable share prices (a Tier I measure of Fair Value Measurement [FVM] under the ASC 820 hierarchy of Fair Value), distinguishing whether or not a drop in stock price is a temporary aberration versus a structural decline is imperative to not only the determination of a potential triggering event but also critical in the FVM process. Unlike the other-than-temporary-impairment (OTTI) for available-for-sale securities, ASC 350 differs in that ASC 350 does not include a determination by Management of whether a decline in fair value is temporary. The severity and anticipated duration of current market conditions, however, are important considerations of Management in the FVM of its reporting unit(s).
In January of 2017, FASB issued an Accounting Standards Update (“ASU”) No. 2017-04 (“ASU 2017-04), which eliminated the traditional two-step process of the goodwill impairment test (Step 2) and the requirements to calculate the implied fair value of goodwill. ASU 2017-04 was effective on January 1, 2020, for all annual and interim impairment tests for all public companies that file with the Securities and Exchange Commission (“SEC”), with an exception for smaller reporting companies (as defined by the SEC). While effective for most public entities, ASU 2017-04 is not yet effective for smaller reporting companies (as defined by the SEC), private and not-for-profit (NFP) entities. Vantage Point Advisors (“VPA”) highly recommends that all such entities early adopt ASU 2017-04 provisions, especially in light of the potential triggering event that is COVID-19.
The illustration below summarizes how to perform the test, including procedures pre- and post-election of ASU 2017-04:
Prospective Financial Information (“PFI”)1
FVM under the income approach (e.g., discounted cash flow [DCF] method) relies significantly on Management’s internally developed PFI as the primary input of the analysis. While prior period PFI’s may have been performed with a most likely scenario of possible cash flow outcomes, in light of COVID-19, it will be important for Management to develop a PFI that considers:
- duration of the impact from COVID-19 to the Company;
- magnitude of the impact from COVID-19 to the Company, whether in terms of revenue, expenses or both; and
- when the Company expects to be able to return to “normal” operating capacity.
Such considerations are facts and circumstances dependent and may be impossible to characterize in a single set of cash flows. As such, VPA recommends that Management prepare the PFI not only using its most likely scenario but also include alternate scenarios in terms of best (better than expected) and worst (worse than expected) cases. There is a particularly high degree of uncertainty regarding the pandemic and the time needed for a return to “normal” (assuming “normal” can ever be reached again). Depending on the facts and circumstances surrounding the PFI and the dispersion of key variables, it may be most appropriate for the Company and the Company’s appraiser to model the PFI in a Monte Carlo Simulation framework, thereby sensitizing key input variables and their resulting outputs.
Audit Committees, Boards of Directors and Management should be thinking of how current market events impact their business, as COVID-19 presents an extraordinary set of circumstances that makes forward-looking information (e.g., PFI) a challenge for many entities.
Companies are encouraged to have open dialog with their auditors and advisors. Should you have any questions, please do not hesitate to contact us at VPA. We regularly provide valuations of goodwill, indefinite-lived intangibles and long-lived assets for impairment testing purposes pursuant to ASC 350, Intangibles – Goodwill and Other, ASC 360 -10, Impairment or Disposal of Long-lived Assets, as well as International Accounting Standard 36, Impairment of Assets.
1 American Institute of Certified Public Accountants (AICPA) Guide, Prospective Financial Information, defines PFI as “any financial information about the future. The information may be presented as complete financial statements or limited to one or more elements, items, or accounts. Prospective financial information can be either a forecast or a projection.”
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Brent Sloan is the Managing Director at Vantage Point Advisors Seattle office. He is an Accredited Senior Appraiser (ASA) in business valuation and holds the Intangible Asset (IA) specialty designation and the Certified in Entity and Intangible Valuations (CEIV) accreditation, all under the auspices of the American Society of Appraisers.