Goodwill and Intangible Asset Impairment Considerations During the COVID-19 Pandemic
As we noted in our prior blog post regarding the potential negative impact on business valuations, there are implications for financial reporting as a consequence of the COVID-19 pandemic. With the financial markets unpredictable and certain economic indicators deteriorating, CFOs need to consider the impact on the impairment of their balance sheets. Specifically in this blog, we are focusing on intangible assets, goodwill, and long-lived assets.
Goodwill and Other Indefinite-Lived Intangible Assets
According to Accounting Standards Codification (ASC) 350 – Intangibles – Goodwill and Other, businesses with goodwill or other indefinite-lived intangible assets on the balance sheet must perform an impairment test at least annually, but may start with a qualitative assessment as to whether these assets may be impaired. The ASC 350 standard is to determine whether it’s “more likely than not that the fair value of a reporting unit is less than its carrying amount.” Although qualitative assessment is subjective, ASC 350 provides examples of circumstances that suggest a possible impairment of goodwill. These include:
- Macroeconomic conditions – It is fairly clear that macroeconomic conditions have deteriorated. Equity markets have declined, credit markets and liquidity have tightened, and unemployment has skyrocketed due to large parts of the economy being at a standstill.
- Industry and market considerations – Industries such as hotels, travel related industries, retail, restaurants, among others have been severely negatively impacted. On the other hand, some industries such as medical devices, pharmaceuticals, or e-commerce may be less negatively impacted. It should also be noted that special considerations should be made to determine if a company’s customer base is negatively impacted.
- Cost factors – Supply chain disruptions, both domestic and international, may have a material negative impact on cost structures. Operational disruption from COVID-19 may force employees to work from home, or require paid sick leave to employees infected by the virus, which may pressure profit margins and increase the likelihood that goodwill may be impaired.
- Overall financial performance – A sudden decline in revenue or profit margins may result in financial performance that falls short of forecasts. It may be necessary to perform quantitative analyses to determine whether or not there may be a sustained decline in the value of the business.
- Other entity specific factors – As a result of the COVID-19 pandemic, if there is an abrupt change in key personnel, or a sudden need for outside financing to sustain operations, or change in strategy, or other material change in the business, this may be an indicator that goodwill may be impaired.
- A sustained decrease in share price – For publicly traded companies, a sustained decrease in the price of shares of its publicly traded stock or bonds, in either absolute terms or relative to industry peers, may be an indicator of goodwill impairment.
If an assessment of the totality of all available information (including the above factors) indicates that an impairment is more likely than not, the next step is to perform a quantitative impairment test. Thus, management’s determination that goodwill may be impaired after considering qualitative factors does not automatically imply that goodwill is impaired, only that further analysis is necessary. Note that management does have the option to directly perform the quantitative impairment test, as the above factors should be considered in any quantitative analysis.
The quantitative impairment test is performed to determine the amount of impairment if the fair value of the asset (or reporting unit) is below its carrying amount. To determine the fair value of the asset or reporting unit, it is best practice to apply the traditional valuation methods, such as the Income Approach, the Market Approach, or the Cost Approach. If the fair value is below the carrying amount, and if the subject entity early adopts the provisions of Accounting Standards Update (ASU) 2017-4,then the impairment equals the carrying amount less the fair value. If the fair value is above the carrying value, then no impairment is necessary for financial reporting purposes. If the subject entity does not early adopt ASU 2017-4, then there is a Step 2 of the goodwill impairment analysis that requires the valuation of goodwill itself (the mechanics are complex and may require the valuation of individual intangible assets, so we will not go into detail about Step 2). However, under no circumstances should the carrying value be increased if the fair value exceeds the carrying value for goodwill or indefinite-lived intangible assets. The carrying value acts like a ceiling in that once carrying value is reduced by impairment the ceiling is lowered, and no upward adjustments are allowed in the future, even if the fair value rises back to previous levels.
For companies that have elected alternative accounting standards created by FASB’s Private Company Council (PCC) the eligible entity amortizes goodwill, which reduces its carrying amount over time and thus reduces the risk of goodwill impairment over time. Under the PCC alternative framework, companies do not have to perform an annual impairment test. However, there is a requirement to perform the an impairment test if there is a triggering event, which is a circumstance that may indicate impairment based on the qualitative factors listed above. For many companies, the COVID-19 pandemic may be a triggering event.
Definite-Lived Intangible Assets and Other Long-Lived Assets
The process for determining whether or not long-lived (definite lived) intangible assets and other long-lived assets are impaired is slightly different under ASC 360. Definite-lived intangible assets are not required to be tested annually, but similar to the PCC standards pertaining to goodwill and indefinite-lived intangible assets, there is a requirement to test if there is a triggering event. The qualitative assessment is similar as for goodwill and indefinite-lived intangible assets as described above. However, for the quantitative analysis, the first step is to perform the “Recoverability Test”. In the Recoverability Test, the estimated sum of the undiscounted cash flows for a long-lived asset being evaluated are compared to the carrying amount. If the sum of the undiscounted cash flows exceeds the carrying amount, the long-lived asset is not impaired.
Thus, as applicable to the current COVID-19 pandemic or otherwise, management, valuation analysts, and auditors may have to place additional scrutiny on the reasonableness of the forecast. Forecasting over long time periods is imprecise, particularly given the uncertainties of the COVID-19 pandemic, but inherent biases within the forecast may be mitigated when applying a discounted cash flow method. In the Recoverability Test, there is no discounting cash flows and thus this may be a limiting factor in a Recoverability Test analysis.
If the sum of the undiscounted cash flows falls short of the carrying amount, the next step is to determine the fair value of the asset in the similar manner as indefinite-lived intangible assets using traditional valuation methods. If the fair value is below the carrying amount, then the impairment equals the carrying amount less the fair value. If the fair value is above the carrying value, then no impairment is necessary for financial reporting purposes.
When goodwill, indefinite-lived, and definite-lived intangible assets all may be impaired, there is a required sequence of how the carrying value of assets are written down. This is because the carrying value of indefinite-lived and definite lived assets impact the carrying value of the goodwill. The appropriate sequence of impairment is as follows:
- Adjust carrying values of non-fixed assets and liabilities (such as accounts receivables, inventory, mark-to-market securities, etc. which is outside the scope of this blogpost);
- Test indefinite-lived intangible assets for impairment and adjust carrying value, if necessary;
- Test definite-lived intangible assets and long-lived assets for impairment and adjust carrying value, if necessary; and
- Test goodwill for impairment after all adjustments have been made to the carrying values of #1-#3 above.
In summary, as the COVID-19 pandemic continues to unfold, it may be time for CFOs to take a fresh look at their prospective financial information to better understand the possible near-term and longer-term impacts to cash flows. Impairment analyses with respect to goodwill or intangible assets or other long-lived assets may become quite complex given the uncertainty that many businesses are facing currently.
 Examples of indefinite-lived intangible assets other than goodwill include but are not limited to trade names, trademarks, licenses, distribution rights, or certain types of franchise agreements. It should be noted that whether or not an asset is indefinite-lived is not solely dependent on a perpetual legal or contractual terms, but also depends on its useful economic life.
 Companies that elect the Private Company Council alternative are not required to explicitly perform an annual test, but must perform impairment test if there is a triggering event.
 A U.S. Securities and Exchange Commission (SEC) filer should adopt ASU 2017-4 for annual or interim goodwill impairment tests in fiscal years beginning on or after December 15, 2019. All other entities should adopt ASU 2017-4 beginning December 15, 2021. Early adoption is permitted for interim and annual goodwill impairment tests after January 1, 2017.
 It should be noted that under the PCC alternative framework, goodwill may include intangible assets such as non-competition agreements, customer relationships, and assets that are not contractual separable in nature. These subsumed assets are separately recognized in the non-PCC alternative or vanilla GAAP framework.
 Long-lived assets are considered any asset that has a useful life by the business of more than 1 year. These may include be tangible assets such as property, plant, and equipment, or intangible assets such as patents, licenses, or software.