COVID-19 impact on accounting and valuation for impairments: PwC

Observations from the front lines

Background

In an exceptionally short period of time, COVID-19 has had a major impact across both the “real” economy as well as in the financial and credit markets. With such uncertainty as to when the dislocations will resolve themselves, companies need to begin proactively assessing what this means for the value of their assets, with impairment considerations being a focal point.

While preparers often focus on goodwill when considering impairment, it is equally important for companies to evaluate other assets that may be impaired such as:

property, plant and equipment
definite and indefinite-lived intangibles
inventory, trade receivables
right of use assets
debt and equity investments

Evaluating these assets and ensuring that the appropriate basis is reflected in a company’s financial statements requires a well coordinated effort with cross-functional expertise.

Why it matters

On March 25, 2020, the SEC provided an additional 45 days of extended conditional relief to public companies that are unable to meet filing deadlines due to COVID-19 related circumstances. The relief extends to certain disclosure reports (e.g., Forms 10-K, 10-Q, 20-F) that would otherwise have been due between March 1 and July 1, 2020, but requires companies to issue an 8-K if they opt for the relief.

Based on our discussions with clients, we expect the majority of companies with larger market capitalizations to still file on their original filing timeline. Additionally, the SEC issued CF Disclosure Guidance: Topic No. 9 in which it acknowledged that the ongoing and evolving COVID-19 impact will make it difficult for a limited group of companies and their auditors to complete the work required to maintain timely filings and encouraged companies to proactively address financial reporting matters earlier than usual. Specifically, the Division of Corporate Finance noted that “to the extent a company or its auditors will need to consult with experts to determine how the evolving COVID-19 situation may impact its assets, including impairment of goodwill or other assets, it should consider engaging with those experts promptly so that its reporting remains as timely as possible, as well as complete and accurate.”

In addition to the timeline pressure, companies must assess whether there has been a triggering event for goodwill or other long-lived assets. Companies should note that such triggers are not just due to stock price movements as the majority focus on real economy impacts.

If there is a triggering event and it is ultimately determined, based on a given impairment model, that a valuation is needed, companies should properly sequence their evaluation. Barring any assets meeting the held-for-sale criteria, US GAAP requires companies to sequence their impairment evaluations (see “Impairment evaluation sequencing”).

Such sequencing will help companies avoid inadvertently shielding certain assets. For example, if a company were to assess its goodwill for impairment prior to assessing its asset groups, then the resultant book value ascribed to goodwill, after taking into consideration the impairment, might be understated while the other assets in the asset group may be overstated.

Impairment evaluation sequencing:

1) Other assets, including:

Receivables and inventory under the applicable guidance
Indefinite-lived intangibles under ASC 350-30
Equity method investments under ASC 323-10
Investments in equity securities and available-for-sale securities under ASC 321-10 and ASC 326-10, respectively

2) Long-lived assets, such as property, plant and equipment (PP&E), finite-lived intangible assets and asset groups under ASC 360-10

3) Goodwill of a reporting unit containing any of the above assets under ASC 350-20

A substantial decline in equity value and/or worsening macro economic factors are likely triggering events that companies need to be attuned to. Getting ahead of these assessments will help provide time to react and be deliberate in the messaging of any impacts to investors and creditors. Additionally, triggers only apply to certain assets and there can be multiple triggers in a quarter. Others, such as account receivable, need to be looked at regardless at every balance sheet date.

Additionally, companies should consider initiating conversations with their auditors early in the process as this will help avoid any surprises both in terms of the assumptions used in their impairment evaluations and the application of US GAAP. Companies will want to ensure that they have the appropriate documentation in place supporting their conclusions both in terms of their prospective financial information underlying the valuations as well as the application of the impairment models with respect to the company's specific facts and circumstances.

Valuation considerations in the time of COVID-19

Given the uncertainty with respect to the duration and severity of COVID-19 and its related economic impacts, it is likely that companies will need to employ even more careful considerations and judgment as they work through impairment assessments pertaining to assets such as goodwill, PP&E, and equity method investments. Management should apply informed judgment as it relates to these impacts on financial reporting matters.

Key inputs to valuation models, such as cash flow forecasts and/or inputs into the discount rates, are likely to change, especially in industries where there is likely to be a shift in demand, disruptions in supply chain, etc. Put simply, it is likely to be an iterative process as management works to reflect the risk and uncertainty in its cash flow forecasts and its determination of an appropriate discount rate, given new facts and circumstances in the wake of COVID-19.

To quantify risk, consider applying different forecast scenarios with assigned probabilities to provide a framework for analyzing and adjusting a range of events and outcomes, rather than attempting to compress all the complexity into a single forecast. Many companies are engaging in scenario planning as they develop their strategies to manage the impact of the crisis on their business. Modelling for impairment testing purposes should leverage these plans. And, while it might be challenging for companies to update prior forecasts that have been rendered obsolete due to the impact of COVID-19, it will be critical for companies to develop robust, defensible and up-to-date cash flow projections to confidently communicate the expected impact on its business in the current environment. Scenario forecasting also facilitates a company’s compliance with their risk and control framework with respect to prospective financial information.

In some instances, detailed scenario planning may not be possible or feasible given time constraints. For public companies, consider inferring investor expectations about future cash flows based on current market capitalization. Include a company-specific risk factor in the discount rate, which, when applied to company provided forecasts, reconciles present value to enterprise value as traded (plus a reasonable control premium).

For both private and public companies, quantifiable and measurable support for any discount rate adjustments is recommended. Corroborative analysis — instead of making arbitrary discount rate adjustments — can help avoid overconfidence in the resulting conclusion. For example, reconciling the value calculated from an adjusted discount rate with a value derived from explicit adjustments to the cash flow assumptions without a discount rate adjustment will improve the reliability of, and visibility into, key value drivers.

In summary

There are no shortcuts in estimating risk and the impact on projected cash flows; selecting a company-specific risk factor still requires a robust analysis with respect to what that risk adjustment is trying to measure.

For publicly traded entities, a reconciliation of fair value estimates to the company’s market value is advised, if possible; market capitalization and other market data should be considered when assessing the fair value of a company’s reporting units. The recent declines in market capitalization could represent factors that should be considered in determining fair value.
In reconciling to market capitalization, a reasonable control premium should be considered; these can vary considerably depending on the nature of the business, industry and other market conditions. In the context of fair value measurement, a control premium relates to a market participant’s expectation regarding cash flow enhancement and risk reduction at the measurement date.

Generally speaking, the larger the premium, the more analysis we would expect in support of that premium. We would further expect that relevant concepts, such as the usage of total invested capital in control premium calculations, be considered in the reconciliation.

In conclusion

With a focus on the accounting and valuation details, companies should assess the impact of the current business disruptions on assets and plan the appropriate action. The details often involve complex scenario planning as well as valuation and accounting challenges associated with an impairment, including how to best document the findings. Consider seeking professional guidance when needed.

“Observations from the front lines” provides PwC’s insight on current economic issues, our perspective regarding the financial reporting complexities, and what companies should be thinking about to effectively address those issues. For more information, visit www.pwc.com/us/cmaas.