We suspect that the value impact of a year or two of challenging top-line forecasts has been partly mitigated by generous levels of government support and rent holidays in the worst-hit sectors. Furthermore, management’s forecast assumptions may have meant negative short-term value impacts being offset by an assumed bounce-back, with potentially higher medium to long-term growth assumptions and other offsetting value levers, such as lower discount rates.
At a time when no one knew what the right answer was, have management teams been given the benefit of the doubt or is it just that the public balance sheet has borne the brunt of the pandemic?
Not all impairments follow sector expectations
If the above is slightly surprising, the findings on a sector basis tend to broadly support the expected impacts of the pandemic, albeit with a significant number of companies bucking general trends in their sectors.
Figure 1 shows that companies in some of the hardest-hit sectors (e.g. high street retail, leisure and travel, automotive) have tended to recognise more impairments, but the size of the impairments is still a relatively modest proportion of value. For sectors that have arguably benefited from behavioural changes driven by the pandemic (such as information technology, online retail, healthcare and pharma)2, the story is not a uniformly positive one, with plenty of IT companies and healthcare companies having recognised impairments in 2020.
Figure 1: FTSE 350 impairments 2020.
What this says is that the medium-to-longer term impact of the pandemic is still not clear. This will depend very much on individual companies’ circumstances, their responses to the pandemic and their positions within complex, evolving national and global value chains. Being a technology business has not provided a get-out-of-jail-free card during the pandemic, in the same way that not all leisure and travel businesses have suffered.
A tough testing process
Our review also highlighted the volume of commentary in accounts around the more challenging aspects of impairment testing, based on disclosures in audit committee and auditors’ reports.
Many noted the difficulty of making forecast assumptions at a time of significant uncertainty. Some also identified weaknesses in the impairment testing process with statements such as:
- “Weakness was identified with respect to… the appropriate discount rates… and assumptions in respect of working capital cash flows included in the impairment calculations”
- “Our testing of models… identified some instances of over and under estimation”
- “We have recommended to management that improvements be made to enhance the precision and granularity of the review controls over the impairment model”
For many companies the impairment testing process has been tough. In large part this is down to the unprecedented and hard-to-predict impact of the pandemic. In our experience, it is also because many companies continue to struggle with certain aspects of performing and supporting their impairment tests in accordance with the accounting standards.
Forecasting – and other challenges
Forecasting has been a particular challenge as companies have had to create different Covid-related scenarios under an expected cash flow approach, where historically they may have relied on the more traditional approach using a single cash flow projection. These scenarios have had to consider not only the extent of the downside impact, but also the timing and magnitude of an uncertain recovery (the 'bounce-back').
In our experience the most common issues with the forecasting processes in impairment testing are:
- Inconsistency – impairment models are often cobbled together from either group or local business unit models, which may be inconsistent with wider firm budgeting and forecasting processes
- Lack of flexibility – few impairment models are set up to run the sort of sensitivities and scenarios which provide real insight into key risk areas
- Out of date – forecasts should represent management’s latest thinking at the date of the impairment test, but may be derived from historical budgeting exercises with out-of-date assumptions
- Incomplete – forecasts often stop at an operating profit or EBITDA level with little thought given to the impacts of capital expenditure or working capital, which can be material
- Short term – forecasts may not extend to a period where the business has reached a 'steady state', when it becomes reasonable to apply a terminal value
- Pre-tax – although the accounting standards refer to pre-tax cash flows/discount rates, the common valuation advice is to perform the analysis on a post-tax basis first and then back-solve to derive pre-tax numbers for disclosure purposes
Potential problem areas for companies
Impairment testing needs to be performed on the smallest group of assets that generate cash inflows that are largely independent of other assets, ie goodwill is tested at a CGU level. Depending on the nature of the business, identifying CGUs can be quite subjective, so this part of the process shouldn’t be overlooked.
Impairment testing models typically originate from other forecasting or budgeting models tweaked, sometimes unsuccessfully, to deal with the requirements of the value-in-use (VIU) concept.
IAS 36 and FRS 102 require impairment analysis to be done on a pre-tax basis, but it’s not as simple as leaving out the tax line and grossing up the discount rate. A number of practitioners recommend a back-solve approach, where the analysis is done post-tax and a pre-tax discount rate back-solved for disclosure purposes.
Tests of goodwill, tangible and intangible assets are enterprise value tests, so what needs to be included on the carrying value side? Many question whether working capital should be included or not. The answer is – it depends. The important point is one of consistency between carrying value and what lines are in the cash flows.
For global businesses/foreign CGU results are often translated at spot rates at the test date, because forward rates are hard to source. However, discount rates are not then adjusted appropriately for inflation differentials. The standard requires using local currencies and discount rates and translating at spot rates at the date of the value-in-use calculation.
Businesses with different service lines in different geographies face the issue of adjusting group risk premiums or betas to reflect the country risk and systematic risk of different CGUs, but these adjustments are often difficult to support.
The standards are prescriptive when it comes to the forecast period, it should not normally exceed five years, except in exceptional circumstances. However, this can mean terminal values being applied at inappropriate points when the business is not in a steady state, causing issues of over or under valuation.
Management and auditors need to be able to understand the sensitivity of valuations to key input assumptions. Models are often not set up to easily run different sensitivities and scenarios efficiently, making the process inefficient and prone to error.
IFRS 16 is often not being reflected properly in discount rates or cash flows.
The results of value-in-use impairment test models need to be cross-checked. If implied multiples are significantly out of line with market valuation metrics, it suggests something is not reasonable with cash flows or discount rates. Similarly if the aggregate values of CGUs less a group’s net debt sum to a number which is significantly more than the market cap of a listed business (taking into account control premia), again something is probably not right.
Whilst compliance with the disclosure requirements within IAS 36 and FRS 102 is the priority, we often see disclosures that don’t provide clarity of the impairment process and key assumptions made.
Allocation of corporate or central costs to CGUs is often overlooked.
Taking the pain out of impairment testing
It's not surprising that auditors and audit committees are challenging these and other aspects of impairment testing. None of these points are difficult to address, but they can be technically challenging and require a combination of accounting, valuation and modelling knowledge to get right.
Auditors who'd like to support their clients through these issues are often restricted by the need to maintain their independence. Grant Thornton’s Valuations and Modelling team can provide independent support, bringing accounting, modelling and valuation expertise together.
For example, we recently worked with a listed business which wanted to improve the forecasting process used in its impairment testing, having been through a difficult review with its auditors. We were able to support them by:
- collating and reconciling forecasts from different areas of the business to ensure consistency
- building simple but easily sensitised models that could run alternative recovery scenarios
- making sure management could support discount rates applied in different businesses and geographies (mapping to cash generating units)
- putting ourselves in the shoes of the company's auditor to ensure all of the requirements of IAS 36 were met and supported
Figure 2 highlights some key focus areas to ensure an efficient and robust exercise. Our support can be focused on a particular element, such as forecasting or setting up VIU models, or may involve full outsourcing of the impairment testing process with an audit-ready deliverable.
Figure 2: Taking the pain out of impairment testing
Looking forward to 2021 and beyond
At the moment, the public balance sheet has taken most of the strain of the pandemic, despite the relatively modest impairments recognised in 2020, we believe the next few years will be testing years for impairment reviews. Assumptions made about the shape of the recovery in 2020 will be tested against reality and refined in 2021 and beyond. Businesses are likely to be challenged on the speed and extent of the assumed bounce-back.
Uncertainty will be a recurring bedfellow for some time and will vary significantly depending on the sector and jurisdictions in which an entity operates. Having a technically robust and well-supported impairment testing process in place, however, will help management considerably in their future discussions with audit committees and auditors, as well as highlighting key risk areas for the business.
For further information on this topic contact Adam Sutton.
1 The same companies that now constitute the FTSE 350
2 FTSE 350 sub-sector classifications based on CapIQ industry codes