We are living through one of the most challenging times in recent history with the COVID-19 pandemic impacting businesses globally by disrupting supply chains, travel, production and consumption patterns etc. and causing turbulence of an unimaginable scale. The resultant effect on business and the dramatic volatility exhibited on securities markets worldwide has led to many companies experiencing significant shifts in demand and supply curves and decline in their market capitalization. These effects could either be temporary, semi-permanent or roughly permanent depending on the sector in which they operate.
Given the forceful impact of the pandemic, companies need to address whether a triggering event necessitating testing for impairment of its assets has arisen for financial reporting. Given the uncertainty as to the duration, impact and severity of the economic impact, it seems certain that the companies need to apply a more careful and informed judgment while carrying out impairment assessment of its assets such as Goodwill, Property, Plant and Equipment (PPE)and other intangibles.
In an Indian scenario, as per applicable accounting standards, it requires an enterprise to assess at each reporting date as to whether there is any indication for impairment of its asset. If there exists an indication for impairment, the enterprise is required to estimate the recoverable amount of its assets. Impairment exists when the carrying value of assets exceeds its recoverable amount.
This article attempts to analyze the various challenges and questions that may arise in the impairment assessment in light of COVID-19 crisis.
The current economic environment may prompt the need for companies to conduct an impairment assessment of its assets. An external indicator signifying the need for impairment under the Accounting Standard (AS 28 or Ind As 36) is “significant changes with potential adverse effect on the entity have taken place in the technological, market, economic or legal environment in which the entity operates“. At the same time, while conducting impairment assessments, a note may be made that these standards focus on the recoverability amounts of the assets, thereby underscoring the need to take a long-term view. Thus the companies may be required to make a careful evaluation of macroeconomic factors and their impact on its business and industry in the long run.
The Government has already exempted banks and non-banking financial institutions from booking certain impairment losses and provided forbearance for two quarters for non-performing loans. Aligning with the same strategy, whether other Industries can also generate public opinion and seek exemption or clarity from the Government on the applicability of the impairment rules is something for the regulators to contemplate.
A valuation based by applying the Discounted Cash Flow (DCF) method is critically dependent on the future cash flow projections. Entities would need to review and adjust their cash flow projections in the light of likely effects of the pandemic, in short, medium, and longer terms. While there is a negative impact in the near term and medium-term cash flows, cash flows, in the long run, might have a limited or even negligible impact.
Given the extreme uncertainty and volatility prevailing in the markets, it may be appropriate to develop a scenario-based approach for cash flow projections with probabilities assigned to each scenario.
Further, there would be a need to perform rigorous stress testing of all the variables and related assumptions such as growth rates, profit margins, working capital requirements and discount rates. A robust ‘what-if analysis’ of these changing assumptions would provide a better understanding of the results in worst- and best-case scenarios.
Companies would also need to make a thorough and informed re-evaluation of the viability and need for the otherwise planned future CAPEX in the light of changing economic conditions, which have undergone a radical shift the effects of which are far-reaching and of unimaginable magnitude.
In India, we have a faced a time where businesses have had to enforce shutdowns at the year-end, which is, generally, the most critical part of the year for almost every business from the point of revenue generation—losing one and half months of year-end amounts to losing almost a whole of a quarter of the year. Hence, re-evaluating the accuracy and appropriately normalizing the base data for projections assumes utmost importance. The importance and delicacy of this task also emanate from the fact that the true clarity on the various economic impacts of the pandemic on various businesses, industries, and real economy as a whole is still uncertain and we are under a learning curve, which is rising ever so slowly. The challenges are that using FY20 numbers as the base date would result in an overstatement of valuation as the impact of the pandemic was still to set in. And using FY21 numbers as base data would result in an understatement of the valuations as the Profit and Loss statements are likely to be skewed and would require to be adjusted from approximately ten months to twelve months.
In the current economic conditions, discount rates estimated using historical data may not reflect the true picture for the business in future. In this scenario, the issue of a robust re-testing of the discount rates built using historical data in the light of present and expected future economic business environment acquires paramount importance to ensure that it appropriately captures all the present and future risks, be it systematic or unsystematic.
Given the fact that the COVID crisis has different impacts on different industries (e.g. restaurants have been severely negatively impacted while e-commerce, online & telecommunication sectors boomed), adding a company or industry-specific risk premium to capture the unsystematic risk also becomes paramount.
It is observed that regulators all over the world have been reducing interest rates for injecting liquidity into the system. In such circumstances, risk-free rates used in asset valuations may be meagre, which may provide a very anomalous number of asset valuations if the cash flows are not appropriately adjusted considering reduction in long term growth rates. In some economies (such as the US or Japan), interest rates have even become zero or negative. In such scenarios, adding an appropriate company-specific risk factor to the discount rate and appropriately adjusting the cash flow projections considering the impacts on long term growth rates gathers more importance. Values for assumptions that were somewhat settled in the past, such as the use of long-term government bond yields as a proxy for the risk-free rate, may no longer be appropriate. This means that, more than ever, discount rates need to be assessed after a thorough review of:
- current market conditions
- any guidance provided by market evidence of value for comparable reporting entities or assets
- the risks of the asset or CGU to be valued.
It is also likely, given the recent volatility of capital markets, that:
- beta for the entity may increase (as a result of increased risk related to forecasts given increased uncertainty); and
- the indicated cost of equity may increase.
Detailed and explicit value in use cash flow forecasts are generally required to be for no more than five years. Beyond the detailed forecasting period, it requires an extrapolation using a steady or declining long-term growth rate. The impact of COVID-19 may mean that enterprises will now be forced to use the asset in its current condition for a period extending well beyond five years, However, using a detailed forecast period of more than five years may be done only if management cannot demonstrate an ability to forecast accurately over such a period. Conversely, long-term growth rate assumptions applied previously may no longer be suitable, particularly if the economic impact of COVID-19 is viewed as being more than short-lived.
Cash flow projections must also relate to the asset in its current condition. Also, many enterprises may restructure their operations as part of their response to COVID-19. This means management may need to demonstrate that any forecast improvements in the financial performance of an asset relate to the asset in its current condition and not to an enhancement or uncommitted future restructuring.
Given the highly volatile public markets and uncertainty as to the duration & ultimate impact of the crisis, in the long run, the challenge arises as to whether the stock price truly reflects the fair value of a particular business or asset or not. Exercising professional judgement becomes daunting where stock prices are not indicative of the asset or business values or in circumstances where stock prices cannot be a barometer for estimating the fair value of an asset. Companies cannot altogether ignore the prices prevailing orderly transactions in active markets. However, due considerations should be given to volatility comparisons of different periods and adjusting them in the light of present and expected future market and economic conditions. Estimations using various moving averages also merit consideration.
In India, the scale and impact of the pandemic crisis are still unfolding. It is still uncertain as to how and when the things may settle. The impact of global macroeconomic factors and how the economy as a whole and various industries individually get impacted from the after-effects of the pandemic on other developed economies of the world like US, Japan or China is unknown. The impairment assessment would need to be determined by taking a long-term view and considering all such impacts. There are no definite answers. Every aspect would need an evaluation thoroughly exercising a logical and informed judgement considering the facts and circumstances of each case. A conclusion on every aspect would need to be supported by concrete analysis and documentation. Of course, the exercise of conservative discretion at every stage would aid arriving at an optimum solution.