[IMGCAP(1)]Because of challenging economic times and confusion in the audit review process, impairment testing has become a hot topic.
According to the Financial Accounting Standard Board’s ASC 350 (formerly SFAS 142), the first step in impairment testing of goodwill is to compare the fair value of a reporting unit to its carrying value. ASC 350 does not, however, define the value basis of the entity—which might, therefore, be determined at the enterprise, total asset or equity level. This article explores the advantages and disadvantages of each approach and then touches on the key topics of deferred taxes, long-lived assets, and discount rates.
Enterprise, Total Asset or Equity Level?
Enterprise value testing is often the most straightforward approach and involves no significant disadvantages. Enterprise value is often defined simply as debt plus equity. However, other approaches are justifiable, which gives some flexibility to the enterprise value approach to impairment testing. Another advantage is that enterprise value reflects the fair value of debt and equity. Market-derived information is often available. In fact, enterprise value multiples are often provided through publicly available transaction information. Finally, enterprise value offers a good starting point if a Step 2 calculation is ultimately required.
Total asset value testing involves comparing the carrying value of total assets with their fair value. Just looking at the left side of the balance sheet is an advantage over enterprise-level testing, but there are drawbacks too. Unlike enterprise value, calculating total assets is not a single-step process. We actually first have to calculate an enterprise value and then add debt-free liabilities and adjust for deferred taxes. Another drawback is market transactions are typically not reported in terms of a total asset purchase price, so relevant market multiples don’t exist.
Equity-level testing, the third approach, seems simple enough. If the equity market value is greater than the carrying (book) value of equity, then impairment may not be indicated.
[IMGCAP(2)]Conversely, if the carrying value is higher, impairment may be indicated. But in practice we find this approach problematic because enterprise value less debt might not yield a meaningful equity value. After all, what measure of debt should be subtracted? Fair value? Book value? Current obligations? Also, in some instances a company or reporting unit may show negative equity, which could suggest impairment is not called for, when in fact, at an enterprise level impairment is indicated. In our experience, audit review firms will often ask for re-testing at a different level if equity level testing is initially selected.
Many people struggle with ways to incorporate deferred taxes into fair value for impairment testing purposes. How will the deferred taxes affect the carrying value of the entity? And, if a Step 1 analysis dictates moving on to a Step 2 level, how do deferred taxes impact the fair value of goodwill?
First, determine the fair value of the relevant entity, which involves making an assumption about whether the sale of the entity would be taxable or nontaxable. This requires balancing hypothetical buyer and seller viewpoints and looking closely at any net operating losses that may be on the books. These have the potential to make a theoretical taxable sale nontaxable.
Second, consider any deferred income taxes outright. The Emerging Issues Task Force is vague about the treatment of deferred taxes, saying only that they should be included…but not precisely how. A benefit to working with carrying value is that at the enterprise level deferred taxes are already included.
Third, in a Step 2 analysis, consideration must be made of how deferred-tax issues impact the fair value of goodwill. Be consistent with your approach to Step 1 calculations. If you presumed a taxable transaction in Step 1, then don’t include the impact of deferred taxes now. Conversely, if you assumed a nontaxable transaction and deferred taxes are expected in that transaction structure, then include the impact as you derive a fair value of goodwill.
Under ASC 360 (formerly SFAS 144), an impairment loss is recognized when the carrying amount of a long-lived asset or asset group exceeds its fair value and is not recoverable. An asset group is the lowest level of assets for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities—such as a collection of customer relationships, technology, a trademark, working capital, property, plant and equipment, that are all working together.
The carrying amount of the asset group is not recoverable—and is impaired—if it exceeds the sum of the undiscounted pretax cash flows expected to result from the use and eventual disposal of the asset group over its remaining useful life. Once overall impairment is determined for the group, allocate impairment value to individual assets in the group. The floor value of any asset is its fair value, so allocate any residual impairment to goodwill.
Discount Rates and Valuation Methodologies
Now more than ever it is challenging to calculate an appropriate discount rate for cost-of-capital purposes. Perhaps the most critical assumption is the appropriate capital structure. In our view, it is best to take a market-participant perspective. For the risk-free rate, we have seen no consistency in whether to apply a historically low current rate or a more normalized rate.
Equity risk premiums are similarly troublesome—historically yielding a 5 to 7 percent range, while current empirical data reports about 5.2 percent.
Other thorny issues are size premiums and nonsystematic risk premiums. In practice, it is critical to support the assumptions selected. This is equally true for the approaches (cost, market or income) used for fair value calculations. Audit teams are applying close scrutiny to the selection of the fair value methods employed and the weight applied to each.
The careful selection and documentation of methodology is critical to impairment testing today. This will continue to be the case even after the profession receives additional guidance on accepted practices. A webcast entitled Lessons Learned: Impairment Testing in 2010 and Beyond is available at www.valuationresearch.com.
P.J. Patel is a managing director of Valuation Research Corporation and specializes in the valuation of businesses and intangible assets, including brands, in-process R&D, software, and patents for financial reporting purposes. Steve Schuetz, also a managing director at Valuation Research, provides valuation services for financial reporting, corporate finance and mergers & acquisitions.
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