In addition to falling leaves and holiday festivities, the fourth quarter brings for many financial reporting professionals another tradition: the annual goodwill impairment assessment. Each year requires a thoughtful review of new economic factors and other considerations that could impact an impairment analysis. Whether the annual impairment test is performed during the fourth quarter or at a different time, it’s critical for finance teams to maintain awareness of activities and events that could trigger an impairment.
U.S. Generally Accepted Accounting Principles require goodwill to be tested for impairment on an annual basis or, more frequently, when events or changing circumstances would “more likely than not” reduce the fair value of a reporting unit below its carrying amount. This impairment test is performed at a reporting unit level. The accounting requirements for goodwill are outlined in Accounting Standards Codification® Topic 350, Intangibles—Goodwill and Other, which goes into additional detail on the determination of reporting units.
In a rare instance of flexibility, the accounting guidance allows for the impairment test to be completed using either a quantitative or qualitative approach. A quantitative test requires estimating the fair value of each reporting unit and comparing the estimated fair value to the carrying value of the unit to ensure the fair value hasn’t declined below carrying value. A qualitative test is performed by evaluating relevant events and circumstances to determine whether it’s more likely than not that the fair value of a reporting unit is less than the carrying amount. The economic and operating environment at the time a goodwill impairment test is performed directly impacts the inputs and conclusions, regardless of whether a quantitative or qualitative approach is used.
Assessment and Inflation
Since 2022, inflation has been one of the top economic considerations for finance professionals. Although inflation has tempered in 2023, costs continue to increase. Inflation impacts an impairment analysis in multiple ways. Notably, inflation expectations will be reflected in a business’s financial forecast. Goodwill impairment tests often use financial forecasts as a key data point, particularly when a discounted cash flow analysis is performed for reporting unit valuation in a quantitative test. Increasing costs that drive down margins will result in decreased free cash flows, decreasing the value of a business.
Financial reporting professionals should understand and challenge the inflation assumptions utilized in forecasts. Inflation may materialize in different ways for individual reporting units based on cost structure and ability (or inability) to pass increased expenses on to customers through higher prices. It’s also helpful to consider how each reporting unit will perform through a full economic cycle, which may extend beyond management’s forecast horizon. Over the full cycle, discrete items pressuring costs such as supply chain issues often normalize.
Assessment and Interest Rates
High inflation leads to another consideration for goodwill impairment analysis—interest rates. During 2022 and 2023, the Federal Reserve increased interest rates at a bristling pace in its aggressive fight against inflation. As the Fed has increased rates, yields on U.S. Treasuries have followed a similar upward trajectory. U.S. Treasury yields are often used to represent a risk-free rate of return. Without consideration of other factors, higher risk-free rates drive up discount rates in a discounted cash flow analysis. Higher discount rates decrease the value of future cash flows resulting in a lower value when performing a discounted cash flow to value a reporting unit for goodwill impairment.
Outside of discount rates, higher interest rates impact capital allocation decisions. For example, in early 2022, an entity plans to use debt to fund a significant multiyear capital investment to modernize operations, resulting in long-term expense savings. Then in 2023, this project is delayed or abandoned when it could no longer be funded with low-cost debt. These changes in business strategy can be particularly meaningful to a qualitative goodwill assessment, making it more challenging to bridge back to assumptions used in previous valuations that no longer apply to the current operating strategy.
Public Company Valuations
Looking at the valuations of public companies is a helpful data point in assessing the value of a reporting unit and evaluating goodwill for impairment. Public company valuations are often used in an impairment analysis as a benchmark for the valuation of reporting units. Specifically, valuation multiples of relevant comparable companies can be applied to determine the value of a reporting unit in a market-based valuation approach. However, valuation multiples aren’t perfect as public equities markets move in unpredictable ways, particularly as they quickly absorb constantly changing narratives about the economy.
Market volatility creates another challenge in performing a goodwill impairment test. The stock prices of companies in an entire industry may move in unison even when the factors driving market movement only relate to specific entities. For example, the first half of 2023 saw a significant drop in valuations of banks due to the failure of certain regional financial institutions. The entire banking industry was impacted by market volatility, although the failed institutions had idiosyncratic risks that weren’t systemic.
In a volatile market environment, it can be helpful to assess stock price trends, or valuation multiples as of different dates, to provide the additional context of valuations over time. Additionally, benchmark companies and relevant valuation multiples should be carefully selected to reflect the unique characteristics of each reporting unit to minimize the risk of comparing apples to oranges.
Navigating these variables to assess goodwill for impairment is challenging. As an additional step, a third-party valuation expert can be engaged. Valuation firms provide a broad scope of services from a full reporting unit valuation to a targeted assessment of key assumptions and inputs. A third party offers an unbiased view of the value of a business and may provide market data or industry insights not readily available to management. Supplemental support from a third-party expert strengthens a goodwill analysis and gives external auditors additional confidence over management’s conclusions.
Although testing goodwill for impairment can be performed as a “check-the-box” procedure, it represents an opportunity for financial reporting professionals to engage with stakeholders across their company and develop a deeper understanding of the business, economic risks, and current operating environment. The knowledge gained during a goodwill impairment assessment can be leveraged in the financial reporting process to ensure disclosures reflect current risks and provide context to reported results. Maybe this year, financial reporting teams can come together to celebrate a newly beloved annual tradition: the goodwill impairment test. I’ll bring the hot cocoa.