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Triggering Event Impacts and Impairment Testing in a Pandemic

by PJ Patel

These are the most relevant factors that would cause companies to ask whether goodwill may be impaired.

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As companies experience market capitalization declines, disrupted operations and supply chains, and market volatility, in many cases these market events will more than likely trigger the need to conduct interim impairment testing.

Finding solace in the fact pattern

Nobody can predict the future and projections of future cash flows have always involved judgment. With that in mind, comfort can be found in the facts – Did we meet Q1 revenue and earnings targets? How big was the cushion in our most recent impairment test? Has the short- or long-term outlook for the business changed? 

Modeling for goodwill impairment testing entails comparing the fair value of the reporting unit to its carrying amount. Impairment testing for assets such as IP, other intangible assets, long-lived assets, and inventory must be completed first, and any impairment reflected in a reporting unit’s carry amount before moving on to goodwill impairment testing. With many experts expecting a V or U shaped recovery, the focus of impairments is currently on goodwill.

ASC 350 requires annual goodwill impairment testing. It also calls for testing more frequently when events occur that suggest a greater than 50 percent chance that the reporting unit may be impaired. Following ASC 350 guidance, companies need to consider the circumstances affecting the inputs of a valuation model to determine if a triggering event is present, requiring an interim test.

Coronavirus Pandemic as a Triggering Event

Even in a “normal” economy, questions must be asked and answered to determine if a triggering event has occurred, and must be considered inclusive of ASC 350-20-35-3C. Below are what we consider to be the most relevant factors that would cause companies to ask whether goodwill may be impaired:

  • Decline in company share price and market cap
  • Operating or cash flow loss in the current period
  • Change in the extent or manner of asset use
  • Adverse change in the legal or business climate
  • Capital and financial resource changes, including liquidity risk

Other factors worthy of consideration include:

  • Decrease in an asset’s market value
  • Production slowdowns or shutdowns
  • Permanent or temporary store closures (yours or your competitors)
  • Workforce shortages/reductions
  • Drop in competitor market multiples
  • Disruptions in the supply chain
  • Well below forecast earning expectations or downward quarter-by-quarter revisions
  • Projected cash flow losses or net losses

This is not an exhaustive list of potential triggering events, but it paints a sufficient picture considering the breathtaking impact the novel Coronavirus is already having on financial markets, specific industry segments, and companies.

The Practical Effects

It wasn’t until halfway through the first quarter that the Coronavirus outbreak began to have discernable impacts on the market and share prices, but by March 25, 2020, the market was down 28 percent from its peak.

Considering all of this within the context of goodwill and impairment testing, companies with a fiscal year ending Dec. 31, 2019, generally will not recognize COVID-19 as a subsequent triggering event. But they must think through how COVID-19-related triggers will be distinguished from other potential triggers that will also need to be recognized on the balance sheet.

For companies reporting on a calendar-year basis, the outbreak and market downturn will likely be treated as current period events. Whether it is considered a Q1 2020 or, more likely, Q2 (or beyond) event is the immediate conundrum facing businesses. For now, it appears that there are still too many unknowns to determine with certainty if there is a need for impairment testing is present. But deferring to unknowns is not an enduringly viable solution. Ongoing evaluation and re-evaluation are essential for companies to determine the extent of the need for financial reporting recognition and for what period(s).

Though ambiguity seems to be a prominent feature of the disease, some of the most significant financial consequences will be seen in both current and coming company disclosures. Indeed, disclosures have begun to address the Coronavirus in the risk factor sections of company filings. As an example, L Brands added “significant health hazards or pandemics,” and Home Depot added “public health issues” to disclosures. While seemingly ambiguous, it is undoubtedly apparent that two well-known public companies have potentially acknowledged COVID-19 as a triggering event, and could be anticipating engaging in interim impairment testing as a result.

Silver Linings

In our view, companies in the second quarter will begin to gather more concrete financial evidence to determine if interim impairment testing is required. The effects on complex accounting and valuation issues will take time to be resolved, but how much time and for how many quarters on a go-forward basis is certainly anyone’s guess.

Nearly all companies are in the same boat as they manage through a wide swath of challenges resulting from the market downturn. If it can be considered a silver lining, auditors and regulatory organizations understand the situation. For example, the SEC has made it clear in official guidance that companies should not compromise the health and safety of its colleagues to meet financial reporting requirements.

As events evolve, companies will continue to need to seek guidance from their partners. Engaging with them to determine how this evolving situation may be impacting company assets, including goodwill impairment, is the best way to address impairment issues in a timely and accurate manner.

PJ Patel is Co-CEO and Senior Managing Director and leads VRC’s financial reporting practice.