In the current climate of economic uncertainty created by the pandemic, many entities have experienced a triggering event requiring the accounting team to test goodwill, intangibles and long-lived assets such as property, plant and equipment for impairment. An entity’s annual business plan, or re-forecast for interim periods, is typically the cornerstone of the impairment analysis for these assets. To be used in impairment testing, such forecasts, referred to as prospective financial information (or PFI) in
GAAP parlance, must be reasonable, supportable and made in good-faith. The following are key considerations specific to 2020.
Developing Future Cash Flow
Developing reasonable and supportable PFI is a challenging task in any given year due to the need to consider recent trends and developments including the accuracy of management’s historical projections. Past failures to achieve forecasted results increase the scrutiny placed on the controls surrounding the overall planning process. Layering on the uncertainty caused by the COVID-19 pandemic simply adds to the challenge, as the duration and severity of the disruption is still unknown and there could be a number of possible paths to the ultimate resolution.
While the impact will vary by entity and change over time, management teams should start by considering the expected shape and timing of recovery, how the entity intends to mitigate the effects of COVID-19, and the resulting direct and indirect influence on its expected cash inflows and outflows. The indirect impact focuses on what is being felt by its suppliers and customers. As a result, an entity may need to consider multiple probability-weighted cash-flow scenarios that reflect the effects of the pandemic when developing PFI for determining fair value instead of attempting to create a single most-likely scenario.
An advantage to using multiple probability-weighted cash-flow scenarios when determining fair value is that it simplifies the determination of a discount rate when calculating a fair value. The multiple scenario approach may reduce the amount of uncertainty that must be incorporated into the discount rate because the uncertainty can be accounted for in the probability weighting. In contrast, with a single cash flow scenario, all of the risks and uncertainty within the cash flows is incorporated into the discount rate.
It often falls to the accounting team to comprehensively document the assumptions and estimates underlying the PFI. Assumptions should be objectively verifiable and supported by available evidence. The accounting team can also get a jumpstart on the required disclosures around key assumptions as the cash flows are developed by including a sensitivity to change analysis.
Consistency of Information
The amount of information gathered for the impairment analysis can lead to complex modeling and PFI that includes many different inputs. It’s tempting to develop a single set of PFI for all purposes when performing the accounting and preparing the financial statements, however, accounting guidance may require that different considerations and assumptions be used. For example, a going concern analysis considers facts and circumstances that exist when the financial statements are made available to be issued or issued, while impairment analysis considers facts and circumstances when a triggering event occurs or when the annual impairment test is performed (if required). In other cases, the PFI may need to be developed at an entity-wide basis, or at the level of a reporting unit, asset group, or single asset. As a result, the PFI may have significant differences, however, avoid the temptation to develop them in isolation. Although they may be designed differently, or need to incorporate different assumptions, much of the underlying data and assumptions will either use the same information or should be developed in a consistent manner.
To further complicate the issue of PFI when it comes to closing the books, the long-lived assets guidance in ASC Topic 360-10 requires the use of entity specific cash flow assumptions for the Step 1 test, which is also referred to as the recoverability test. However, if the recoverability test fails and the fair value test is required (the Step 2 test), market participant cash flow assumptions would be required to determine the fair value. For purposes of recoverability, the entity-specific cash flows incorporate the plans of the organization and the existing service potential of the asset or asset group (i.e. the estimated useful life, the cash flow generating capacity, and the assets ability to generate outputs). When using a discounted cash flow model to determine fair value, it is necessary to use assumptions to determine the price that would be received to sell the asset(s) in an orderly transaction between market participants. In other words, the assumptions about the cash flows should be from a market participant standpoint and not consider entity-specific factors.
In some cases, entities are able to use the same cash flow projections in their recoverability test (i.e. entity-specific assumptions) for the discounted cash flow model by adjusting the discount rate to reflect the fact that the entity’s cash flow assumptions are not consistent with that of a market participant. Other tests such as goodwill or indefinite lived intangibles will also require market participant assumptions to determine fair value, although the level of cash flows required will vary based upon the testing for an individual asset, group of assets, or reporting unit.
Considering Internal Controls
Management should consider the design of its internal controls whenever PFI is used to support accounting conclusions. PFI assumptions must be reasonable and consistently applied to assumptions used for similar purposes in the financial statements. For instance, the PFI used in evaluating the fair value for testing goodwill impairment in an organization with one reporting unit should be consistent with the PFI used in testing the fair value of the organizations equity for use in determining shard based payment costs.
Above and beyond the standard controls to ensure clerical accuracy of the PFI and that the data underlying assumptions used in developing the PFI is complete and accurate, consider controls specifically around the reasonableness of significant assumptions particularly given the uncertainty due to the pandemic recovery. This should be a holistic assessment, as any slowdown in economic activity will impact many, if not all, key assumptions impacting cash flows. Ultimately, the assumption story must be consistent and the discount rate must reflect the level of uncertainty in the amount and timing of projected cash flows. Said differently, if management’s cash flow projections are deemed to be aggressive, the discount rate should be increased to reflect the additional level of risk which is commonly referred to as the company-specific risk premium, or CSRP.
Additionally, PFI used in determining impairment of goodwill, intangibles and property, plant and equipment will also be the same as, or be generally consistent, with projection information provided to the board of directors, equity analysts, creditors, as well as those used in the determination of whether a valuation is needed for deferred tax assets, and whether the entity is a going concern (adjusted for the appropriate dates). Naturally, entities implement a specific control to verify that the PFI is developed using the appropriate methodology. This includes whether the assumptions are entity-specific or market participant specific, as well as, whether the assumptions are developed at the appropriate level such as on an entity-wide basis, reporting unit or segment basis, or at the level of an asset group or individual asset. In addition, in order to avoid misleading various stakeholders with inconsistent PFI, many entities develop internal controls that apply to all PFI developed for all users whether they be accounting, finance, investor relations, or the board. The goal of these internal controls is to ensure that adjustments made for a specific use are appropriate and that otherwise assumptions are consistently applied. Ultimately, the best internal control systems account for the different requirements of PFI for each different purpose and monitor how adjustments are made to the assumptions used in developing PFI to ensure that the overall assumptions and methodologies are applied in a consistent manner to avoid inappropriate bias.
Management teams may want to build in additional time to their financial reporting calendars for performing an impairment analysis during 2020 as the level of detail required to support a conclusion of no impairment may be greater than in prior years. This is particularly true for scenarios where there is not significant headroom between the value determined using the forecasted cash flows and the asset’s carrying amount. While at it, management should also consider the need for including early warning disclosures if ultimately there is no current impairment.
Our team is here to support the accounting teams of both private and public companies in navigating and interpreting the various impairment accounting models, as well as to aid in the preparation of accounting memorandum and other documentation that may be required. For more information on forecasting cash flows and assessing for impairment, please contact us.
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Melissa Henry is a Director in our Tampa, FL office. She can be reached at firstname.lastname@example.org or 727.572.1400.
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