EPISODE 27: There's no doubt that COVID 19 has had and will continue to have a significant impact on the global economy. While it is anyone’s guess as to the depth and duration of that impact, it's important to remember that every situation is unique; the impact on companies and their assets' values will vary depending on industry, geographic location, and strategic response. Join Tanner Shaw as he discusses the impact that COVID-19 has had on financial reporting valuations.
[00:00:09] JL: Welcome to today's edition of DHG’s GrowthCast. I'm your host, John Locke. At DHG, our strength lies in our technical knowledge, our industry intelligence, and our future focus. We understand business needs and are laser-focused on company goals. In this ever-changing world, DHG's GrowthCast provides insights and thought-provoking conversations on topics and trends that address growth opportunities and challenges in the current and future marketplace. Thanks for joining us as we discuss tomorrow's needs today.
[00:00:42] ANNOUNCER: The views and concepts expressed by today's panelists are their own and not those of Dixon Hughes Goodman LLP. Always consult the advice of your legal and financial professional before taking any action.
[00:00:58] JL: Today, we’ll be talking with Brian Steen who is a principal in DHG’s Valuation Services group and is based out of our Winston-Salem, North Carolina office. Brian, on a previous episode, we talked to Gareth Montague-Smith about goodwill impairment testing and why it was on top of people's minds, especially amid the COVID-19 crisis. Can you tell us a little more about this type of impairment testing and specifically give us some details from a valuation services perspective?
[00:01:28] BS: Sure thing, John. Gareth did a great job summarizing what goodwill impairment tests are in a previous podcast episode. But to start things off, I'll just give a quick overview of goodwill impairment standards so that listeners can have an understanding of what it is. A goodwill impairment test is an accounting standard, ASC 350, for the accounting people out there, that requires a company to perform a test to determine if goodwill on the balance sheet is repaired or not. The test involves estimating the value of the company or a reporting unit of the company to determine if the value is greater than or less than the book value of the recording unit.
In the economic environment we are today, which is – Let’s just face it. It’s crazy and unprecedented. The issue will be a much greater importance than the recent past. In the recent past, we’ve had good economic times. Things are going well. The value of the companies had been going up. But today is different. We will be more likely to see counties reporting impairments than in any other time since the Great Recession of 2008, which I told my coworkers, “They said 2008, we’ve got a 100-year recession.” Well, I'm not quite 100 years old, and it seems like we are back to those times.
The companies are required to test for goodwill impairment annually or unless the company is allowed to amortize it as well under what’s called a private company election alternative. A private company test can make the choice of amortizing their goodwill instead of doing an annual test. More than likely, they will need to be doing testing.
[00:03:16] JL: Brian, could you share with our listeners really what's involved in testing for goodwill impairment?
[00:03:22] BS: The process involves a business valuation. That includes considering expected income of the company, the cash flows of the company, the outlook of the company itself. But also a factor in market rates of return and market multiples. For each company and each situation they are in, they’re different, and that would be even more so today. A prime example are retail stores. You have retail stores that do not have a strong online presence or required to shut down. Their near-term cash would significantly be impacted in a long-term impact very uncertain of the current situation and the times we’re dealing with today.
However, certain stores such as Lowe’s and Home Depot and similar type of stores, they have actually benefited from the COVID crisis. Retail stores such as Walmart and Amazon that had Walmart has been able to stay open where they’re offering their food but also other necessary items. In Amazon, I mean, more people are home, and they have more opportunities and need to buy things online. Those have had very strong performances in this environment. The former situation where the retail stores did not have an online presence and were required to shut down, they’re very likely to have impairment, whereas the home improvement companies and Walmart and Amazon and those retailers that were not impacted, they probably would not have goodwill impairment test issue.
[00:04:59] JH: How does management meet the requirements of a goodwill impairment test?
[00:05:04] BS: Very carefully and very thoroughly is what I would say is what management will need to do to meet the requirements to do impairment test. They may very well need expert assistance with a valuation person such as myself. In the recent past, management has been able to – It’s been easy to some degree, so I’ve been able to perform the test, a qualitative assessment where you document that there’s a greater than 50% chance goodwill is not impaired or performing a simple calculation such as price to earnings before interest, taxes, depreciation, and amortization. Most commonly known as EBITDA. A price to EBITDA taken at multiple unemployment to their earnings, that would show, “Okay, our value is greater than low value, which is kind of the standard you have to meet. Or there was that triggering event.
In the podcast Gareth performed, I think he talked about a good bit about a triggering event. In short, it’s when economic times and company performance and market factors suggest there may be a chance for impairment. Those are more common today and particularly important for public companies. For private companies, they typically would not perform a test quarterly or prepare financials quarterly, so they would not have to do the test due to the occurring event in between the yearend financials. For a public company, that’s not the case. For public companies, they report quarterly results. If a triggering event occurs in the second quarter, they would probably need to do a test in the second quarter if the situation met triggering events which, in this case, that is happening more and more.
Due to the current economic times in which the potential for impairment increasing due to triggering events and due to economic performance, due to the company's performance, the audit firms are now going to require the analysis performed for goodwill impairment test, but they also are going to be looking at things more closely. They’re going to be challenging the assumptions made and purchase used. One of the most important pieces of this will be projections of their future performance. Management will need to do a very detailed analysis of the near-term and long-term expected results.
In normal times that we’ve had, especially in the recent past and times are pretty good, the near-term outlook is fairly certain. People can kind of look and see, “Okay, our next is going to look like this. Our next quarter’s going to look like that.” They can forecast that. It’s the long-term projections that are probably more challenged. I’m not sure that’s the case right now. The near-term uncertainty is even greater than maybe perhaps the long-term. In many cases, if you're trying to project out the growth of 2020 or early 2021, that is highly uncertain. We do not know what the impact. We don’t know if there’s going to be another outbreak in the fall. We don’t – There's a lot of uncertainty and unknowns out there and we don't know how an individual company will react and have to be impacted by that. It’s so much easier to say, “Okay. In two or three years, we will be back to some level of normal.” Then we need to understand the timing and duration and impact in the short term of what’s going on here.
The other issue, we talk about projections. The other issue is the market. How do you structure in the market data? For example, it means that public companies are their stock price has fallen and decline below book value and maybe significantly below book value. One thing to look at is the analysis is looking at is somebody bought their reporting unit or the company today, what would they pay? Often times, a controlled premium is paid when a company buys another company. How much of a control premium is important? What type of synergies would a market participant assume if they were buying the company? Who are the market participants? Identifying if we were bought, who would be the most likely buyers. Then what kind of energies and other assumptions would they assume? What type of required rate of return would an investor acquire consider analyzing the company? Have you reconciled?
We have historically low low interest rates, especially for lower risk security such as treasuries securities, but you have high levels of uncertainty which would you be factored in the equity rates and then great return used in valuing a company. How do you reconcile that? How does that play into the analysis? If you're looking at transactions in the industry, how do you factor in what people paid in those “good times” that we've been experiencing in the past years? Would they pay that same multiple today? Those are some of the considerations you have to consider. Even if you look at the market transactions of the stock market, if you will, there is a wide range of variations and volatility. We were looking at a bank, for example, and their stock price or price to book multiple has ranged from .5 to almost book value today. A .5 to book means their value of their stock is active value of their equity for their financial statement.
At one point, it looked like it was almost full impairment. At the end of the month, you would say there’s no impairment. There’s just a lot of uncertainty, a lot of things that are changing, and it takes a lot of care, concern, and effort to factor all that into the analysis and come to a reasonable conclusion of whether the company is impaired or not.
[00:11:32] JL: Right. These are valuable insights and I really appreciate you sharing them with our listeners today. As a wrap up, what might be two or three things that a business owner or someone really concerned with an ongoing institution should really be thinking about as they move forward over these next few months?
[00:11:51] BS: The very first thing is determining if it is an issue, if doing impairment is a potential issue. Either approaching the goodwill impairment test annual date or if there is a triggering event and identifying if there is a triggering event are two of the first things that you need to consider. Start that process early. In the process when you're looking at approaching either the testing date or a quarterly or reporting date, one of the first things I will do within that would be talking with your audit firm. Talk to them about what they're considering as far as whether there is a triggering event or where there’s potential for impairment. Then develop a plan to meet the requirement. If you’re needing an expert, you need to start looking for who that might be to help you with the impairment test. You need to be looking at what projections. If you have been preparing projections, that will be something that will need to be prepared. Basically starting the process early, especially talking to the audit firm, and making sure you proactively address the issue so that it’s not an issue and it doesn’t, say, delay your audit or cause any issue later on.
Second, management may need to utilize experts in the analysis in the valuation process. The auditors will be more challenging of the assumptions, the approaches utilized, and then result. Often times, management does not have necessary expertise to perform the analysis themselves to the level that will be required by the auditor, so they may need to consider utilizing experts, and that may take time to find. If they don't have someone they use, so they need to go ahead and consider that need. But also, you can't hire an expert and then hand if off and then look at the end result. Management needs to take ownership of the process. They need to understand what assumptions are being used, what market data is being used, and be comfortable that they're comfortable with those assumptions. But in particular, the projections are used. Those should come from management. They will need to provide a lot of documentation into the core for the assumptions. If the projections are reasonable and that they really reflect the best guess of what they expect to go going forward in the short term and in the long term.
Finally, the management should be conscionable and be able to support their overall conclusion, whether it's no impairment, full impairment, or somewhere in between. At the end of that day, it is management’s – Their product even though if they hire experts, they need to take ownership of the end result to be comfortable with the conclusion and be comfortable enough to tell the audit firm, “Here’s what we think the answer is,” whether it’s, like I said, full impairment, no impairment, or somewhere in between. It’s up to management to make sure that the process and the result is accurate.
[00:15:19] JL: Great points, Brian. Thanks so much for your time today. We look forward to having you back on a future edition of GrowthCast. Thanks for being here.
[00:15:27] BS: Sure. Thank you, John.
End of Interview
[00:15:29] JL: You have been listening to DHG GrowthCast with our special guest, Brian Steen, a principal with DHG’s Valuation Services group. We hope that you have gained additional insights into what goodwill and goodwill impairment looks like during the COVID-19 era and how to meet the requirements and manage the process of a goodwill impairment test. I'm your host, John Locke, and I look forward to reconnecting with you soon on our next episode of DHG GrowthCast.