The COVID-19 pandemic is forcing financial executives to re-examine their methods for goodwill impairment testing. The core difficulty lies in predicting fair value and future cash flows, and the current economic uncertainty makes this task even more complex.

"The pandemic has abruptly changed companies' forecasts and market outlooks," said Greg Franceschi, Managing Director of Valuation Advisory Services at Duff & Phelps, during a webcast.

Stock market volatility and significant declines in market capitalization triggered by the pandemic are seen as key signals for determining whether an impairment test should be triggered.

Not all industries are affected equally, but almost every company is dealing with widespread changes in social and economic behavior. For companies with goodwill on their balance sheets, the question is reassessing fair value and future cash flows.

Two Methods for Calculating Impairment

Goodwill arises when a company acquires another business for more than its book value. Under generally accepted accounting principles, companies must recalculate the value of goodwill assets at least annually to determine whether impairment has occurred.

Impairment occurs when the market value of acquired assets falls below the purchase price, or when the value of goodwill is overstated. To determine whether this is the case, one of two methods can be used: the income approach, which discounts future cash flows to present value; or the market approach, which analyzes the assets and liabilities of companies with similar business models.

Identifying Triggering Events

A triggering event occurs when circumstances indicate that the carrying amount of an asset may not be recoverable and there are signs of impairment. "Triggering events are a hot topic right now, given the pandemic and its economic impact," said Andrew Probert, Managing Director of Transaction Advisory Services at Duff & Phelps.

Many current events can be considered triggering events, covering both overall market and company-specific factors. The latter may include events affecting reporting units, sustained declines in stock prices, changes in raw material costs, and declines in cash flows.

At the macroeconomic level, triggering factors "may include deterioration in overall economic conditions, restricted access to capital, and exchange rate fluctuations," Probert said. "In the current environment, these (events) imply impairment for most companies," raising questions about the recoverability of goodwill.

When multiple triggering events occur simultaneously, consideration of fair value should begin.

Fair Value Calculation Amid Market Turmoil

Fair value is the price that market participants would receive to sell an asset in an orderly transaction. Fair value must consider current market conditions and incorporate information known as of the measurement date.

When calculating fair value, management should also consider information not widely known by the market and therefore not reflected in stock prices. Companies may possess private information unavailable to public shareholders, which typically surfaces during due diligence processes.

However, companies should be aware that some market pricing may be inaccurate due to the current market being overly pessimistic about the ultimate outcome of the pandemic. According to Javier Zoido, Managing Director of Valuation Advisory Services at Duff & Phelps, the current market reaction "may be based on excessive weighting of downside scenarios."

This may indicate information asymmetry, Zoido said, which must be considered in the fair value calculation.

Nevertheless, if market capitalization across the industry continues to decline, Zoido explained, "this may indicate the true value of the company in the current crisis."

Scenario Approach to Cash Flow Forecasting

Cash flow forecasts should consider the short-, medium-, and long-term impacts of COVID-19, but measuring these impacts is challenging. To simplify the process, Zoido recommends two methods. One is to develop different scenarios for multiple possible outcomes, calculated as: scenario value indication × scenario probability = expected value.

The other is to adopt a single scenario based on neutral, unbiased forward-looking financial information (PFI). "PFI itself is not weighted," Zoido said, but rather "derives an expected revenue forecast and links expenses to revenue."

Subsequently, scenarios should be reviewed in light of various internal and external factors, including customer demand, supply chain bottlenecks, labor disruptions, competitor activities, and government initiatives.

For many companies, the net effect of both scenario analyses may be a downward adjustment to asset valuations, including goodwill assets.

Be Prepared to Explain

Preparing explanations for goodwill impairment is crucial because, as one expert noted, companies may be asked to explain to shareholders. According to Sandy Peters, Senior Head of Financial Reporting Policy at CFA Institute, companies typically do not disclose goodwill information in quarterly reports, but in the current environment, investors expect companies to share their judgments.

"Any company with goodwill and declining business should talk about its views this quarter," Peters told The Wall Street Journal.