The business and operations of many New Zealand and overseas companies have already been seriously affected by the rapid global spread of COVID-19. Unfortunately, business’s performance is likely to further deteriorate, along with their value and the value of many of their commercial assets.
In this volatile environment, any impairment and subsequent write-down of goodwill and intangible assets’ carrying value has the potential to materially reduce reported financial earnings. While subsequent reporting is likely to provide only a lagging indicator, this does not reduce the importance of ensuring that the reported values for goodwill and other intangibles reflect an appropriate value. This includes any impairment in value reflecting more than the short-term economic impact of COIVD-19 which might be severe but short-lived.
Management teams that perform impairment testing fully in-house can find this requirement disruptive, particularly when there is a significant divergence in opinion from that of the external auditors. In-house impairment testing can distract heavily from the daily management of the business when, more than ever, management’s full attention on operations is crucial.
NZ IAS 36 Impairment of Assets seeks to ensure that the assets of a reporting entity are carried at amounts not in excess of their recoverable amounts.
NZ IAS 36 defines the ‘recoverable amount’ of an asset as the higher of fair value less costs of disposal (FVLCD) to sell or value in use (VIU). FVLCD is defined as an amount obtainable in an arm’s length transaction between knowledgeable and willing parties. VIU is based on an estimate of the future cash flows the entity expects to derive from the use of an asset or associated cash generating unit (CGU) in its current form.
If the carrying amount of an asset exceeds the amount to be recovered through the use or sale of the asset, the asset is impaired. NZ IAS 36 requires the entity to write down the asset to its recoverable amount and recognise an impairment loss.
NZ IAS 36 requires that both intangible assets with an indefinite useful life and goodwill be tested for impairment annually. For other asset classes that fall under the standard, the entity must assess whether there is any indication of impairment and, if so, carry out an impairment test.
Some issues for management to consider in assessing impairment
Does COVID-19 need to be considered as an impairment indicator at the reporting date?
This will depend heavily on the reporting date for the entity. For those with a reporting date at 31 December 2019, the answer is likely no because the facts and circumstances did not exist at the balance date. However, what the accounting standards do encourage is commentary and assessment of the impact of events after the balance date, provided what is disclosed can be reasonably estimated. Those with a 31 March 2019 reporting date and onwards will clearly need to consider COVID-19 as an impairment indicator for financial reporting purposes.
How is COVID-19 likely to impact the discount rate used for the assessment?
It’s likely to be far more challenging. The current volatility in financial markets introduces additional challenges to this process as the parameters used to estimate discount rates become more unpredictable. Values for assumptions which were somewhat settled in the past, such as the use of long-term government bond yields as a proxy for the risk-free rate, may no longer be appropriate. This means that, more than ever, discount rates need to be assessed after a thorough review of:
- current market conditions
- any guidance provided by market evidence of value for comparable companies or assets
- the risks of the asset or CGU to be valued.
How will it impact the cash flow forecasts?
Companies with reporting dates near the outset of the Covid-19 pandemic are likely to have real challenges reflecting the expected impact on forecast cashflows. The judicious use of hindsight during the period of this particular outbreak is key, particularly if your balance date occurs after 11 March 2020 – when the WHO declared this event as a pandemic. While the starting point is that entities are required to determine amounts based on their knowledge of events at the balance date, not after it, information obtained after the reporting date can be considered if such conditions existed as of the reporting period end. Significant professional judgement of all relevant facts and circumstances will be required to make this assessment.
The valuation approach required by NZ IAS 36 also requires careful application to ensure cash flow and discount rate concepts are aligned and so no double counting of COVID-19 risks occur.
What about useful life?
While VIU cash flow forecasts are generally required to be for no more than five years, the impact of COVID-19 may mean that companies will now be forced to use the asset in its current condition for a period extending well beyond that. This means a longer forecast period may instead be appropriate. Conversely, long term growth rate assumptions applied previously may no longer be suitable, particularly if the economic impact of COVID-19 is viewed as being more than short-lived.
Cash flow projections must also relate to the asset in its current condition – this means management may need to demonstrate that any forecast improvements in the financial performance of an asset or CGU as a result of restructuring and/or re-organisation are due to COVID-19 impacts on the asset in its current condition and not to an underlying improvement in the asset.
How Grant Thornton can help
Grant Thornton valuation experts provide time critical independent support and advice to organisations who must review or quantify any impairment risks relating to intangible assets and goodwill caused by the impact of COVID-19.
Our auditors can then help businesses navigate the audit process.