March 2, 2021
Published: Journal of Accountancy
By Gautam Goswami, CPA, and Jennifer Kimmel, CPA
In addition to the serious public health threat it poses, the COVID-19 pandemic has affected the current and future financial performance of many entities, with its impact showing on both projections of future cash flows and estimated earnings.
As a result, goodwill impairment has been an area of increased focus when it comes to financial reporting since the onset of the pandemic. FASB also has ongoing projects that look not only to broadly change the accounting for goodwill but also to provide optional relief to private companies and certain not-for-profit entities from monitoring goodwill triggering events throughout their fiscal year.
Under current U.S. GAAP, a public company or an eligible entity that has not elected the accounting alternative for goodwill is required to assess goodwill for impairment annually or when a triggering event occurs that would more likely than not reduce the fair value of a reporting unit below its carrying amount, including goodwill. Private companies and not-for-profit entities that have elected the accounting alternative to amortize goodwill are still required to test it for impairment (at either the entity level or the reporting-unit level) if a triggering event occurs. Companies are required to monitor for and evaluate goodwill triggering events as they occur throughout the year.
Ongoing COVID-19 impacts
As previously noted, the pandemic has affected almost all entities in some way. Although hope is on the horizon with the development and approval of several vaccines, as well as third-party intervention from governments and central banks to stabilize economic conditions, impacts of the COVID-19 outbreak continue to evolve. As a result, many companies have had to take a hard, fresh look at their processes around goodwill impairment. This process has been complicated by uncertainty around how much longer the pandemic will last and what the long-term effects will be, making assessing the amount of an impairment more challenging and subjective. The ongoing deterioration in general economic conditions and the resulting negative effect on earnings and cash flows also triggered the need for an interim goodwill impairment test for many companies.
Financial statement preparers typically begin considering if a triggering event occurred by evaluating macroeconomic changes. In some cases, geography plays a role. In the beginning of the pandemic, management teams based in the United States understandably didn’t know the severity of the issue as it was developing in Asia. Therefore, if an organization has operations in Asia or Europe, the risk of impairment occurring there may not have been obvious in the early days, which could have slowed down the “triggering event” analysis required under the guidance.
A company’s industry was also relevant, as some have been affected more than others. For example, the large technology and e-commerce companies saw heightened demand for their offerings as people shifted to shopping online and working remotely. On the flip side, retail, restaurant, fitness, travel, and commercial real estate businesses experienced huge drops in demand. Across the spectrum, evaluating potential impairment indicators may not have been as obvious in some industries as it was in others.
Communicating and disclosing impairment
Companies also recognized the importance of timely and frequent communication between management, the board, and the audit committee. For companies that had to complete an interim impairment exercise, making sure the board and audit committee had current information with the benefit of management’s analysis in real time was key. It wasn’t an option to wait for the next regularly scheduled meeting, which could have been several weeks later.
Management also focused closely on the timing and content of external communications regarding goodwill impairment, which are generally made in quarterly and annual reports. Management should not only consider disclosures related to goodwill impairment in the current period but also disclosures for a potential material impairment loss in the future. These disclosures are often referred to as “early-warning” disclosures and are generally included within the critical accounting estimates section of management discussion and analysis (MD&A). The SEC staff has previously communicated that such disclosures are expected when the fair value of a reporting unit does not substantially exceed its carrying value. Given the judgment involved in determining the potential for a material future impairment, especially as the ongoing impact of COVID-19 remains uncertain, management should consider any process changes that may be necessary to provide such disclosures.
A pivotal element of the goodwill impairment analysis is valuation, the quality of which depends upon the quality of the projections. Due to the prevailing uncertainty, many companies had to rethink their approach to valuation as it relates to goodwill impairment. For companies whose “cushion” (that is, the excess of the reporting unit’s fair value over its carrying amount) decreased from historically high levels, the monitoring needs and level of rigor went up. For instance, a company with a lot of cushion in the past may have been required to go back to the drawing board and build a fresh set of projections. In many cases, this led the finance teams that typically own the goodwill impairment process to interact holistically with other parts of the business, like the sales and operations teams or procurement department, to capture the relevant data needed to refine and calibrate their impairment models in real time.
Many financial statement preparers faced forecasting challenges, primarily because now past performance was unexpectedly not necessarily indicative of future results. Previous economic downturns, such as the real estate crisis of 2008, do not provide a precedent for the current pandemic situation. The long-term impact of prolonged strain on industries such as financial lending, commercial real estate, aerospace, entertainment, and hospitality is still unclear. There is no relevant historical data that could be used when making projections, as the last severe pandemic, the influenza pandemic of 1918, occurred more than a century ago and in a different economy that bears little resemblance to the current environment. In addition, many companies are facing resource constraints due to layoffs or furloughs that affect their overall workforce, including the finance department.
As a result, companies and their valuation experts have recently focused on scenario-based forecasting, in which multiple projection scenarios are developed with appropriate weighting placed on each of the scenarios, because one static forecast may no longer be enough. For example, many companies have applied a Monte Carlo simulation model, which projects the probability of different outcomes in a process that cannot easily be predicted due to high risk or random variables.
Additionally, it is critical that financial statement preparers and their valuation experts understand the key drivers in any estimate and how reliable those inputs are. Finance teams should identify which inputs are more subjective and should apply rigorous sensitivity analysis to support the final judgment. Some factors to consider include the expected timeline for recovery, short- and long-term effects on margins, and shifting cost assumptions.
For example, many companies quickly invested in technology to enable effective remote-work arrangements, which may become the new norm moving forward. Those companies would need to consider efficiency levels and various other ways that costs are affected by the change. Other companies may be considering moving operations to a different state or jurisdiction to take advantage of tax incentives because employees can now telecommute. Even companies that continued to see heavy demand during the pandemic should review assumptions to ensure they still make sense, also keeping in mind the requirement to use market participation assumptions in determining the fair value of a reporting unit. For example, despite improved revenues, online retailers may have experienced some margin erosion due to increased shipping costs.
Finally, the importance of strong internal controls around the estimation process cannot be overstated. Due to the inherent uncertainty associated with key assumptions used in impairment testing, controls should be designed and updated to ensure the highest-quality data available is identified, likely possibilities are considered, and appropriate individuals are reviewing the inputs, assumptions, and estimates.
On the horizon
FASB has two projects underway to improve the subsequent accounting for goodwill.
In one project, FASB decided to allow private companies and not-for-profit entities the option to perform the goodwill impairment triggering event assessment at the reporting date any time that they report financial information, including interim reports. FASB’s staff has been directed to prepare a final standard for a written vote by the board.
This decision responds to stakeholder concerns, accentuated by the COVID-19 pandemic, that there is undue cost and complexity in evaluating triggering events and projecting cash flows for potentially measuring a goodwill impairment at a date that is not a reporting date. Because the facts and circumstances that led to the potential triggering event may have changed by the end of the reporting period, those stakeholders also assert that performing a goodwill impairment evaluation at another date may not provide useful information to financial statement users. For more information on this project, visit FASB’s website.
The other FASB project is broader in scope and is still in its early stages. Stakeholders expressed concerns in a post-implementation review of FASB’s business combinations guidance about the cost to perform the goodwill impairment test. Since then, FASB has issued various Accounting Standards Updates to respond to those stakeholders’ concerns. Some of these updates, including the option to perform a qualitative assessment and the removal of Step 2 from the impairment analysis, apply to all entities. Others are alternatives for private companies and not-for-profit entities — for example, the options to amortize goodwill and assess it for impairment at either the entity or reporting-unit level and to subsume certain intangible assets into goodwill. The option to amortize goodwill is not currently available to public companies. For more information on this project, refer to the FASB website.
The objective of the current project is to revisit the subsequent accounting for goodwill and certain identifiable intangible assets broadly for all entities. Based on stakeholder feedback, FASB has tentatively determined to require all entities to amortize goodwill on a straight-line basis, generally over a 10-year period. The staff is conducting additional research and outreach on the proposed model.
Potentially affected organizations should keep up with the most recent FASB guidance and closely follow the impacts of the COVID-19 pandemic to ensure they comply with the latest requirements and avail themselves of any relief provided.