Why COVID-19, Market Volatility Are Catalysts For Goodwill & Asset Impairment Testing

Opportune LLP

The global and domestic financial markets have seen significant downward volatility over the past several weeks coming on the heels of continued uncertainty related to the spread of the coronavirus (COVID-19) worldwide. The effects have been widespread through the equity, debt and energy commodity markets. During the first quarter of 2020, the Dow Jones Industrial Average and the S&P 500 index declined approximately 24% and 21%, respectively.

(Source: Yahoo! Finance)

(Source: Yahoo! Finance)

The impact of COVID-19 on domestic and global economies, along with sharp declines that have occurred in the financial markets, will have an impact on the financial statements of public and private companies through impairments. Accounting Standards Codification Topic 350, Intangibles: Goodwill and Other (ASC 350), requires goodwill and other indefinite-lived intangible assets to be tested for impairment at least annually or when a triggering event occurs. Accounting Standards Codification Topic 360, Property, Plant and Equipment (ASC 360), requires long-lived assets to be tested for impairment when a triggering event occurs.

COVID-19: A Triggering Event

The market forces that have impacted the worldwide economy during the first quarter of 2020 will qualify as a triggering event for both goodwill and/or long-lived asset impairment testing for some companies. As such, the longer COVID-19 disrupts business in the U.S. and abroad, the more companies will experience triggering events. As a result, more impairment charges will be taken on the financial statements of these companies.

Ultimately, companies must consider when the disruption on their business operations from COVID-19 are not short-term, temporary impacts, but instead will have long-term effects on their business. For some, a triggering event may have occurred in the first quarter, while others may be able to justify a “wait-and-see” approach for the first quarter. If current conditions persist, most companies will have difficulty delaying an impairment beyond the second and third quarters of 2020.

"The impact of COVID-19 on domestic and global economies, along with sharp declines that have occurred in the financial markets, will have an impact on the financial statements of public and private companies through impairments."

Because of these larger, external market forces, there’s a renewed focus among external auditors and regulators on impairment testing for goodwill and long-lived assets. Further, performing an impairment test in the current environment has unique considerations. A couple of areas where we’ve seen more scrutiny are:

  • Reconciliation of Fair Value 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. 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 in the current environment.
  • Weighted-Average Cost of Capital: Estimating discount rates in the current economic environment can also pose a challenge. The risk-free rate has decreased, volatility has increased and debt-to-equity ratios are skewed higher. Simply going through the motions of calculating a weighted average cost of capital may erroneously result in a lower discount rate in the current environment than a discount rate calculated a couple of months prior. Given the increased uncertainty with cash flow projections, there’s more risk and the discount rate should be higher than discount rates pre-COVID-19. As such, extra care and consideration must be given to the inputs for a discount rate calculation in the current environment.
Energy-Specific Triggering Event Considerations

These areas of focus by auditors and regulators apply to all industries, and while most segments of the economy have been hit hard by the impact of COVID-19, the energy industry has been hit even harder in recent weeks. The energy supply-demand balance has been upended as a result of a confluence of two events:

  • A sharp reduction in demand related to stay-at-home restrictions put on states and cities across the U.S. and around the world; and
  • An unprecedented increase in supply resulting from tensions in the oil and gas markets between Russia and Saudi Arabia.

During the first quarter of 2020, West Texas Intermediate (“WTI”) crude oil and Henry Hub natural gas spot prices declined by approximately 67% and 23%, respectively.

(Source: Business Insider)

(Source: Business Insider) 

During the first quarter of 2020, NYMEX strip prices for WTI also declined significantly. A comparison of WTI strip prices from the beginning to the end of the first quarter of 2020 are provided below. As shown below, the sharp decline is expected to have a long-term impact.

(Source: Bloomberg)

NYMEX strip prices for natural gas didn’t change significantly during the first quarter of 2020 as shown in the table below. The likely reason natural gas prices didn’t change significantly is that they have been depressed for some time already, and weren’t as impacted as oil from the tensions between Russia and Saudi Arabia.

(Source: Bloomberg)

A couple of additional areas where external auditors are applying more scrutiny in their assessment of impairment triggers for exploration and production (E&P) companies are as follows:

  • 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), 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. As of the end of the first quarter of 2020, 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 happening during the month of March. Further, another challenge for some 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.

Both publicly traded and privately held companies need to adequately address their goodwill and long-lived asset impairment testing procedures. Doing so in a timely manner avoids delays issuing quarterly financial statements, and also leads to greater shareholder and stakeholder transparency. With the restrictions from, and the response to, COVID-19 changing daily, it’s anyone’s guess when life will be back to normal. One thing is for certain: the longer that social distancing requirements are necessary, the longer it will take for financial and commodity markets to recover to where they were before the pandemic. The resulting erosion of value is captured in financial statements through impairments, which like the virus, will be widespread.

Written by:

Opportune LLP

Opportune LLP on:

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