Global and domestic financial markets are continuing to experience volatility related to the spread of the coronavirus (COVID-19) pandemic worldwide. As businesses assess the impact of COVID-19 on their financial statements, here are five questions around goodwill and long-lived asset impairment testing to consider:
1) Are the adverse market conditions surrounding the COVID-19 pandemic a triggering event for goodwill impairment testing?
Accounting Standards Codification 350, Intangibles: Goodwill and Other (“ASC 350”), provides guidance on accounting for goodwill. ASC 350 requires that goodwill be tested for impairment at least annually, or 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. Such events are known as “triggering events” (accounting guidance also indicates that private companies that have elected to amortize goodwill should test their goodwill for impairment if a triggering event occurs).
ASC 350 guidance provides general examples of what constitutes a triggering event. Some of these events include, but are not limited to, the following:
- Macroeconomic conditions such as a deterioration in general economic conditions, limitations on accessing capital, fluctuations in foreign exchange rates or other developments in equity and credit markets;
- Industry and market considerations such as a deterioration in the environment in which an entity operates, an increased competitive environment, a decline in market-dependent multiples or metrics, a change in the market for an entity’s products or services or a regulatory or political development;
- Overall financial performance such as negative or declining cash flows or a decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periods; and
- If applicable, a sustained decrease in share price, considered in both absolute terms and relative to peers. To clarify, fluctuations in the public equity markets are not meant to serve as triggering events in and of themselves. However, if company management believes that declines in the share price are sustained, or are expected to be sustained over a long period of time, then this may serve as further evidence of a triggering event.
Certainly, for many companies across a broad spectrum of industries, the market disruption brought about by COVID-19 would qualify as a triggering event under one or more of these criteria.
2) What about long-lived assets? Do current market conditions qualify as a triggering event for depreciable tangible assets and amortizable intangible assets?
ASC 360, Property, Plant and Equipment, provides guidance on impairment testing for long-lived tangible and intangible assets. ASC 360 indicates that impairment testing should be performed whenever events or changes in circumstances indicate that an asset group’s carrying value may not be recoverable. In other words, if the sum of the undiscounted cash flows expected to be generated over the life of an asset group (the “recoverable value”) are lower than the asset group’s carrying value, then this would indicate that a triggering event has occurred. If the asset group fails the recoverability test, then the fair value of the asset group is measured, and an impairment loss is taken.
"Due to the significant and broad-based impacts of COVID-19, we’re beginning to see more instances where companies are recording impairments to their long-lived assets."
Guidance under ASC 360 provides general examples of what constitutes a triggering event for long-lived asset testing. Some of these events include, but are not limited to, the following:
- A significant decrease in the market price of a long-lived asset (asset group);
- A significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used or in its physical condition;
- A significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset (asset group), including an adverse action or assessment by a regulator;
- A current period operating/cash flow loss combined with a history of operating/cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset (asset group); and
- A current expectation that, more likely than not, a long-lived asset (asset group) will be sold or otherwise disposed of significantly before the end of its previously estimated useful life.
Once again, we would expect that for many companies across a wide array of industries, the impact of COVID-19 would qualify as a triggering event for ASC 360 under one or more of these criteria.
3) What are some key similarities and differences between ASC 350 and ASC 360 testing, and how are the two tests related?
The table below highlights some of the key similarities and differences between ASC 350 and ASC 360 testing:
|Asset being tested
||Goodwill and indefinite-lived intangible assets
||Long-lived tangible and intangible assets
|Level of testing
||Asset Group - This could be the same as a reporting unit or at some level lower than a reporting unit
|When test is performed
||At least annually or if a triggering event has occurred
||Only if a triggering event has occurred
|Number of steps involved in testing
||One - measure fair value of the reporting unit and compare with carrying value to obtain goodwill impairment amount
- In Step 1, assess recoverable value of asset group and compare with carrying value
- In Step 2 (if Step 1 fails), measure fair value of asset group and compare with the carrying value to obtain total asset impairment amount
|Necessary for individual assets to be valued in testing?
||Generally not, unless testing an indefinite-lived intangible asset
If Step 2 is performed, then individual long-lived assets may need to be fair valued because an asset may not be impaired below its estimated fair value
When both ASC 350 and ASC 360 tests are being performed concurrently, the accounting guidance sets forth the following order of impairment testing:
- Test indefinite-lived intangible assets under ASC 350
- Test long-lived assets under ASC 360
- Finally, test goodwill under ASC 350
Impairment charges are recorded after each test above before moving to the subsequent test.
Often, the threshold for failing the ASC 360 recoverability test is generally higher than that of the ASC 350 goodwill impairment test (i.e., ASC 360 is typically “more difficult to fail”). This is because under the recoverability test of ASC 360, undiscounted cash flows are being compared with the carrying value of the asset group. However, due to the significant and broad-based impacts of COVID-19, we’re beginning to see more instances where companies are recording impairments to their long-lived assets.
4) For publicly traded companies, should estimated fair value be reconciled to market capitalization?
A major point of emphasis when performing a goodwill impairment test for a publicly traded company in the current environment is reconciling estimated fair value conclusions with the company’s market capitalization. While only reporting units that have goodwill are required to be tested for impairment, the fair value of reporting units without goodwill may also need to be estimated in order to perform a reconciliation of the company’s total concluded fair value to the company’s market capitalization.
"We would expect that for many companies across a wide array of industries, the impact of COVID-19 would qualify as a triggering event for ASC 360."
A reconciliation to market capitalization tests the reasonableness of the fair value conclusions. Further, it serves as a litmus test on the company’s projections, which are also being more highly scrutinized by auditors and investors in the current environment.
5) What additional valuation factors should oil and gas exploration and production (E&P) companies be considering in this market environment related to impairment testing?
While most segments of the economy have been hit hard by the impact of COVID-19, the energy industry in particular has been hit even harder thus far in 2020. In addition to a sharp reduction in demand related to stay-at-home restrictions resulting from COVID-19, companies in the energy sector have also suffered the effects of an unprecedented increase in supply resulting from tensions in the oil and gas markets between Russia and Saudi Arabia.
Because of these events, we’re seeing that external auditors are applying more scrutiny in their assessment of impairment triggers for E&P companies, including the following:
- Commodity Price Forecasts: While the NYMEX strip constantly changes to account for new information, price forecasts from analysts are only updated periodically, which can make them stale within a short period of time. During times of lower volatility in commodity prices, analyst forecasts have greater acceptance by external auditors because the change in the market since they were issued isn’t significant enough to warrant a change in the forecast. However, in times of higher volatility (especially volatility that is directional in nature, such as what we have seen recently), it’s difficult to support the use of analyst forecasts on an unadjusted basis. During the current environment, special attention and consideration needs to be paid to the commodity price forecast that’s used in developing fair value conclusions.
- Production Forecasts: Forecasting production in the current market environment is extremely challenging. Currently, there may not be enough production data available given the rise of COVID-19 in the U.S. and the precipitous decline of the financial and energy commodity markets that has occurred during Q1 and Q2 of 2020. Further, another challenge for some oil and gas companies, especially non-operators, is the lag they may experience in receiving recent production data. Compounding the amount and timing of available production data to forecast future production is the looming threat of production curtailments and allocations from regulators. Currently, there’s significant uncertainty as to which states will regulate production and by how much.
Presently, many jurisdictions around the world are beginning to lift their stay-at-home orders related to COVID-19 and attempts are being made to restart the economy. These attempts will hopefully bring some semblance of normalcy back to the economic picture sooner rather than later. However, damage has been done to the values and market capitalizations of many companies across a broad range of industries, including the energy sector.
For some companies, the downturn may last longer than for others, and their recovery may be slower. For this reason, both publicly traded and privately-held companies need to adequately address their goodwill and long-lived asset impairment testing procedures. These procedures can be complex and may require the assistance of a third-party provider. Addressing these procedures in a timely manner will avoid delays issuing interim period financial statements and will also lead to greater shareholder and stakeholder transparency.