Impairment implications of COVID-19
This article is part of a series on financial reporting and auditing in the shadow of COVID-19.
The Coronavirus pandemic and its impact on the wider economy is placing unprecedented pressures on the business community. The immediate priorities of management will have been to focus on liquidity and potential going concern issues. However, the carrying value of assets, some of which may have already been impaired due to adverse economic conditions arising from Brexit, may need critical reappraisal. This means that impairment testing is more important than ever. This is a consideration for management regardless of industry sector but particular attention should be paid to those entities that have large property, plant and equipment balances, goodwill or intangible assets.
The general requirements of both the UK GAAP and IFRS accounting frameworks are fundamentally the same when it comes to the impairment of assets. An impairment test is required for all assets where there is an indication of impairment at the reporting date. Indicators may be internal or external and both frameworks contain a list that an entity must consider, as a minimum, when assessing whether there is any indication that an asset may be impaired. In the current economic climate, common indicators are likely to be as follows, but this list is by no means exhaustive:
- Facilities closed (including assets becoming idle)
- Reduced demand leading to decreases in revenue and profitability
- Operational disruptions to supply chains
- Customers in financial difficulty (cancelling or delaying orders or unable to settle debts)
- Stock market falls and declines in quoted asset values
It seems hard to imagine that there will not be an impairment indicator triggered for most companies. COVID-19 has caused a significant deterioration in economic conditions for a lot of companies, and an increase in economic uncertainty for others, which may constitute impairment triggering events.
Assets potentially affected
The assets most likely to be affected by the pandemic are as follows:
- Goodwill and other intangibles
- Property, plant and equipment
- Investments (including investments in subsidiaries, associates and joint ventures)
The approach to impairment testing for fixed assets will differ to the approach for current assets.
Adjusting or non-adjusting at the reporting date?
Determining when the effects of COVID-19 should be reflected within the impairment calculations will depend on:
- The period end of the financial statements (the balance sheet date); and
- The sector and geographical area in which the entity operates.
The effects of COVID-19 are generally a ‘non-adjusting’ post balance sheet event as of 31 December 2019. The outbreak was declared as a pandemic on 11 March 2020 and so for 31 March 2020 year ends, any asset impairments arising as a direct result of the pandemic will be an ‘adjusting’ event. Entities with year ends in between will need to consider the timelines more carefully to assess the conditions which existed at the relevant balance sheet date.
Where the effects of COVID-19 are considered to be a non-adjusting event, there are a couple of important points to consider as follows:
- The impact of Coronavirus should not be included within cash flow forecasts prepared for impairment calculations. This will make them inconsistent with forecasts prepared for going concern purposes, which must include any adjustments; and
- For stock and debtors, management will need to carefully consider whether any post-year-end recoverability problems are as a direct result of Coronavirus or indicative of conditions that already existed at the year-end (e.g. a customer that went into liquidation a few weeks after lockdown was probably unlikely to have continued trading regardless of the pandemic).
Impairment testing and cash flow forecasts
It should be noted that FRS 102 deals with the impairment of stock separately from other assets whilst IFRS has more prescriptive rules for goodwill and other intangible assets.
There is a long-established general principle that assets should be carried in the accounts at no more than their recoverable amount. An asset or cash-generating unit (CGU) is impaired when its carrying amount exceeds the recoverable amount, which is the higher of:
- Value in the use – the present value of the future cash flows expected to be derived from an asset or CGU.
- Fair value less costs to sell – amount obtainable from sale in an arm’s length transaction between knowledgeable, willing parties, less the costs of disposal.
For many assets used within the business the value in use is likely to be higher than the fair value less costs to sell, which makes cash flow forecasting even more important. Some of the challenges and considerations for management are as follows:
- Consider using an expected cash flow approach and adopting multiple scenarios and attaching different probabilities to each.
- Do not double-count risk. If it is included within the projected cash flows, it should not also be factored into the discount rate.
- Cash flows must be based on the most recently approved forecasts and should not include cash flows from events to which the entity was not committed at the year-end (e.g. restructurings).
- Are your cash flow models agile, robust and reliable enough to reflect changes to key inputs as well as further sensitivities?
- Have you assessed liquidity needs, debt covenants and refinancing headroom?
- IFRS has a rebuttable five-year cap on the budget period.
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