Low Expectations

Goodwill Impairment: Low Expectations

Pursuant to IAS 36, companies must examine their tangible and intangible assets in terms of their recoverable value at least once per year, which means conducting an impairment test.

One provision of international financial reporting, which was introduced in 2004, is designed to prevent the overvaluation of balance sheet assets.  In times of economic crisis, companies are faced with having to conduct extraordinary write-offs, particularly with regard to goodwill. This mainly affects companies that made expensive acquisitions during years in which takeovers boomed.  The considerable value adjustments required now can result in serious damages to the results of the consolidated financial statements.

In some cases, goodwill impairments are likely to be unavoidable, with profit expectations lowered considerably due to the crisis. In principle though, this decision also depends on long-term corporate planning and must be verified accordingly.

Currently, the market capitalisation of some listed corporations is below book equity.
A goodwill impairment test is based on two value concepts: the fair value, which is the market price less sales costs, is compared to the value in use, which represents the internal profit expectation.  The concept that results in the higher value is then applied.  Generally, the test looks at a group of values instead of just one asset value - the cash generation unit (CGU). Such CGUs to which goodwill is assigned usually include entire business segments.

Market prices in the form of stock prices or purchase prices are considered fair value indicators. However, it is precisely these indicators that have seen steep declines as a result of the crisis. As a result, some listed corporations now even exhibit a market capitalisation that falls below the book equity value. This development also affects the M&A market, which has practically come to a halt.

There is no automatic formula that says that a crisis must result in write-offs. Credible corporate planning is a decisive factor.
The value in use is derived from the value of the group of asset values, based on the current use concept of the reporting company.  What is needed are payment surpluses that are achieved by the CGU specifically for the company.  This concept is based on expectations, therefore, and not on prices. The value is determined by the CGU's future expected payment surpluses. But this also means that a probable deterioration, for which indications exist, may lead to impairments today. For this reason, companies may be forced to adjust their plans downwards.

As a result, both of these value concepts - fair value and value in use - are currently leading to lower valuations. The risk of having to make value adjustments increases. But this need not lead to an automatic formula that stipulates that a crisis must necessarily result in write-offs, because the total sum of future payment surpluses need not necessarily deteriorate, as seen from today's point of view.

Valuation periods cover a period of several years.  The useful life of main assets such as goodwill can often even be set for an indefinite time. It is possible, therefore, that deteriorations expected in the next few years can be compensated, at least partly, by better subsequent years.

Companies need credible scenarios that allow them to estimate the effect of the recession on their own industry and company. Such scenarios must be able to provide important answers - what are the fundamental structural problems, for example, in the automotive industry? Which players, technologies, products or services will dominate the market in the future? The uncertainties of the future, which are implicit in such questions, affect the current valuation of company assets.

Hence, the issue in this context is the ability to prepare corporate planning in a comprehensible and plausible way. 

 

Contact

If you would like to discuss any of the issues raised then please do contact Simon Collins.