Extraordinary challenges in connection with this year’s impairment tests
Various companies with high goodwill positions in the balance sheet
According to the applicable accounting standards, the recoverability of goodwill and intangible assets with an indefinite lifetime must be tested annually.
Among the 213 companies currently listed in the SPI, 123 companies prepare their financial statements in accordance with IFRS or US GAAP. At the end of 2019, 89 of these companies recognised goodwill in their financial statements. 45 companies, or 37% of all IFRS or US GAAP companies, reported goodwill amounting to more than 25% of book value of equity. For 20%, this proportion was even higher than 50%. For these companies, an impairment of goodwill can significantly reduce the equity base.
Goodwill as % of the book value of equity at the end of 2019
Source: Bloomberg, IFBC analysis.
Distribution by industry of companies with a goodwill to equity ratio > 25%
The companies with a high proportion of goodwill on the balance sheet are distributed relatively uniformly across the different industries. Only in the «Utilities/Energy» and «Services» sectors, less than five companies have recognised goodwill exceeding 25% of equity.
COVID-19 pandemic as a potential triggering event
In addition to the annual impairment tests, the value of goodwill as well as the value of intangible assets with an indefinite lifetime must also be tested during the year in case of triggering events. If necessary, an impairment loss must be recognised. In particular, such a triggering event occurs if there is a significant negative change in the company’s economic environment or if its market capitalisation declines below the book value of equity.
As expected, the current economic developments related to the COVID-19 pandemic are already reflected in the impairment tests for the current semi-annual financial statements of Swiss companies. In the first half of 2020, 14 of the 123 SPI companies which prepare their financial statements in accordance with IFRS or US GAAP already had to recognise impairment losses on goodwill or other intangible assets. In particular, companies operating in industries for which no sustainable recovery is expected (see our blog of 6 May 2020), are exposed to an increased impairment risk. Dufry, for example, which is particularly affected by the downturn in the travel industry, had to recognise a goodwill impairment loss in the amount of CHF 132 million in the first half of 2020. Overall, the company suffered a half-year loss of around CHF 1 billion due to the pandemic. The capital base is now to be strengthened by a planned capital increase of CHF 700 million, among other things.
Impairment tests particularly challenging in the current market environment
Against the background of the continuing uncertainties related to the COVID-19 pandemic and the resulting impact on the real economy, it is expected that further impairments of goodwill will have to be recognised in this year’s financial statements. The focus is mainly on companies operating in an industry that is particularly affected by the COVID-19 pandemic. In the current market environment, companies are facing additional challenges in the context of goodwill impairment testing. Especially in such a situation, we consider it essential that an impairment test is implemented correctly and consistently in terms of valuation. To ensure that a potential impairment is not misjudged, companies must answer the following particular questions when implementing this year’s impairment tests:
- Is the increased planning uncertainty with regard to the effects and duration of the pandemic adequately reflected in the impairment test?
- Are the assumptions in the business plan sufficiently supported by market data?
- Is the assumed cost of capital distorted by the current market turbulences? If so, how should such distortions be dealt with?
- Do additional risk premiums have to be taken into account in the cost of capital?
- On what basis is the sustainable level of earnings estimated in the valuation?
- Are any adjustments to the valuation methodology or to the determination of the relevant cost of capital also appropriate and adequate in the future?
Our experience in the implementation of impairment tests in the current year shows that risks in connection with the COVID-19 pandemic are often overestimated or not correctly reflected in the valuation. This results in a potentially overestimated need for impairment. Furthermore, the most recent calculations of the cost of capital have shown that beta factors, as a key parameter in determining cost of equity, have risen since March 2020, in some cases significantly. With the correct interpretation of such changes and the appropriate reflection in the cost of capital, misjudgements regarding impairment tests can be avoided.
We are gladly at your disposal to assist you with any questions relating to valuation techniques or the determination of the cost of capital in connection with impairment tests.