Triggering Events and Impairment Testing: Financial Reporting Issues in a COVID-19 Environment

March 2020 | Posted in Forensic Litigation & Valuation, Whitley Penn
Forensic Litigation & Valuation, Whitley Penn

The current public health crisis related to the COVID-19 pandemic has created much uncertainty regarding the length and extent of public restrictions, closures, etc.  While the impact to the global economy may not be known for several months, it is reasonable to say the impact will likely be meaningful.

From a financial reporting perspective, the fair value of assets could come under pressure as the economic impact becomes more visible.  Impairment testing is required whether in the case of a “triggering event”, as defined in ASC 350 – Intangibles – Goodwill and Other, and in ASC 360 – Plant, Property and Equipment.  Triggering event-based impairment testing is an issue even for those who have made accounting elections whereby assets are being amortized rather than tested annually for impairment.[1]

With this in mind, we have examined the standards relating to impairment of goodwill, indefinite-lived and long-lived assets, and we have compiled the following in response to questions that will inevitably arise.

Q:  How do ASC 350 and ASC 360 define a “triggering event”?

A:  ASC 350 gives guidelines about indefinite-lived intangible assets and how to account for impairment for goodwill. According to ASC 350, a “triggering event” occurs when there are indicators that the fair value of an entity (or a reporting unit) may be below its carrying amount[2].

ASC 360 gives guidelines on long-lived assets and how to test for impairment and disposition of such assets.   The standard states that long-lived assets should be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable[3].

Q:  Based on those definitions, is it likely that the current market turmoil would qualify as a triggering event?

A:  The standards state that events both inside and outside of a company can cause a triggering event. ASC 350 provides the following list of events and circumstances to consider in determining whether an interim goodwill impairment test is necessary[4]:

  • Macroeconomic conditions (e.g., deterioration in the general economy);
  • Industry and market considerations (e.g., deterioration in the environment in which the company operates);
  • Cost factors (e.g., increases in the cost of raw materials, labor);
  • Overall financial performance (e.g., negative or declining cash flows);
  • Other relevant entity-specific events (e.g., changes in management or key personnel);
  • Events affecting a reporting unit (e.g., change in composition of net assets, expectation of disposing all or a portion of the reporting unit); and
  • A sustained decrease in share price (in either absolute terms or relative to peers).

It is reasonable to conclude that the current market turmoil related to COVID-19 could cause assets’ carrying values on the books to exceed current fair values.  This conclusion would warrant the assessment of impairment or recoverability of assets.

Q:  What steps need to be taken under ASC 350 and 360 if a triggering event is determined to have occurred?

A:  ASC 350 (applicable to goodwill and other indefinite-lived assets)

Step 1- Qualitative Impairment Test[5]

The qualitative assessment allows companies to first consider events and circumstances that may affect the fair value of an indefinite-lived intangible asset to determine whether it is necessary to perform the quantitative impairment test. This determination must be based on all relevant factors like macroeconomic developments, political or regulatory changes, the emergence of new industry competitors, managerial or structural changes within the firm, and others. If the preliminary qualitative assessment shows that the goodwill carried on the company’s balance sheet is unlikely to exceed its fair market value, then no further testing is required. If the carrying value is too high, you must proceed to the quantitative testing.

Step 2- Quantitative Impairment[6]

If the qualitative assessment indicates that it is not more likely than not (a likelihood of 50% or more) that goodwill is impaired, further testing is unnecessary. To perform this step, the company compared the carrying value on the balance sheet to the fair value of the goodwill.  If the fair value is less than the carrying value, the goodwill must be impaired. The impairment loss cannot exceed the entity’s carrying amount of goodwill[7]. Subsequent reversal of a previously recognized impairment loss is prohibited[8]. Disclosure requirements in the event of an impairment loss include description of the facts and circumstances leading to the impairment, the amount of the impairment loss, and the method(s) used for determining fair value[9].

ASC 360 (applicable to long-lived assets)

Step 1- Indicators of Impairment (i.e., the determination of a “triggering event”)

Step 2 – Recoverability Test

The Recoverability Test under ASC 360 differs from the Step 1/Quantitative Test under ASC 350.  The Step 1/Quantitative Test is an impairment test, requiring measurement of the fair value of a reporting unit or an indefinite-lived asset.  ASC 360 calls for a recoverability test to be performed in order to determine if an impairment loss exists, in which case the fair value of an asset or asset group must be determined.  The Recoverability Test is based on the sum of the future undiscounted cash flows expected to be derived from the use and eventual disposition of the asset or asset group[10]. The sum of the future undiscounted cash flows is compared to the carrying value of the asset or asset group at the date of the test. If the future undiscounted cash flows exceed the carrying amount, the carrying value is deemed to be recoverable through the use and eventual disposition of the asset or asset group. If, however, the carrying value exceeds the future undiscounted cash flows, an impairment loss must be measured based on the fair value of the asset or asset group.

Step 2- Measuring the Impairment

If the Recoverability Test indicates an impairment, the loss is measured by determining the fair value of the asset or asset group and comparing such fair value to the carrying value. The amount by which the carrying value exceeds the fair value is recorded as an impairment loss[11].

The following flowchart illustrates the steps and determinations relating to a triggering event[12]:

The economic and business climate has been altered by the COVID-19 pandemic and resulting efforts to control its spread.  The full ramifications of this event will not be fully known for quite some time.  However, financial reporting issues such as impairment measurement and recognition are likely to impact a large number of businesses in coming months.

In coming posts, we will focus on implementation and practical guidance regarding impairment and recoverability testing.

Sources:

  • [1] Accounting Standards Update No. 2017-04 – Simplification of Goodwill Impairment Testing (350-20-05-5).
  • [2] Accounting Standards Update No. 2014-02 – Intangibles—Goodwill and Other (Topic 350): Accounting for Goodwill (350-20-35-66).
  • [3] Accounting Standards Codification Topic 360 – Plant, Property and Equipment (360-10-35-21).
  • [4] ASC 350-20-35-3C
  • [5] ASC 350-20-35-3.
  • [6] ASC 350-20-35-4
  • [7] ASC 350-20-35-73.
  • [8] ASC 350-20-35-13.
  • [9] ASC 350-20-50-2.
  • [10] ASC 360-10-35-17.
  • [11] ASC 360-10-45-4.
  • [12] ASC 350-20-55-26.
  • [8] ASC 350-20-35-13.
  • [9] ASC 350-20-50-2.
  • [10] ASC 360-10-35-17.
  • [11] ASC 360-10-45-4.
  • [12] ASC 350-20-55-26.
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