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COVID-19: Impairment test considerations

  • Johannes Post, Partner |

It seems hard to imagine that the COVID-19 outbreak has not had a significant adverse effect on the economic environment as well as on the value of equities and assets worldwide. However, a misalignment between stock market performance and earnings expectations has been observed over the past few months. This misalignment has led to a significant challenge in assessing the value of equities and assets as well as concluding whether or not an asset may be impaired.

Nevertheless, if an indicator of impairment has been identified at the (interim) reporting date, an impairment test must be performed. Accounting standards are prescriptive on how to conduct an impairment test, but in light of the COVID-19 pandemic, there are a number of significant challenges in properly applying these standards.

Is there an impairment indication?

Over the past few months, we have witnessed exceptional developments in equity capital markets. Shortly after the global COVID-19 outbreak in mid-February, the MSCI Europe stock index, for example, dropped by 35%. More surprisingly, though, is the stark increase of this index of 28% towards the end of May. These swings, in combination, equate to a drop in the MSCI Europe index of 17% over the period since mid-February to the end of May, which seems like a normal market correction.

The question remains: Does the current state of the MSCI Europe index and these swings accurately reflect the real impact on value, or is this simply the result of market overreactions? A necessary distinction should be made here between ‘price’ and ‘value’. As we know, the market price of any equity security is simply driven by “supply and demand,” which may or may not reflect the reality of the underlying economic fundamentals of the business. Value, on the other hand, is a function of such fundamentals, i.e. cash flows, future growth, and risk (i.e., volatility).

Examining the analyst consensus forecasts in the MCSI Europe index (between December 2019 and May 2020), the plunge in earnings expectations is clearly misaligned with the relatively lower net decrease of the index itself. The chart on the right further illustrates the impact on the various sectors.

This misalignment is combined with a rapidly changing macroeconomic overlay and uncertainty about the long-term economic impact of COVID-19. These considerations make it particularly challenging to assess the ‘value’ of equities and assets as well as concluding whether or not an asset is impaired.

Impairment testing continues to remain a key focus for companies in Switzerland. Activity in this area depends primarily on the industry in which an individual company operates, as well as the characteristics of the company itself. While many companies have been severely affected and have been focused on liquidity and potential going concern issues, many have also shown strong Q1 2020 results with significant cash balances and have even been considering investing in new assets. We anticipate more impairment testing activity to begin starting August once companies seek further clarity around the true impact of COVID-19 on their operations.

Next steps: if impairment is indicated, what’s next?

If the effects of COVID-19 have led to an impairment indication for any of a company’s assets, an impairment test must be performed already at an interim reporting date.

An impairment test requires, at minimum, the following:
 

  • Revisiting cash flow forecasts: the budget and cash flow projections must be updated to reflect the impact of COVID-19. This may include updating the supply of and the demand for products and services affected by restrictions on transport, travel and quarantine; reflecting changes in expectations over exchange rates, commodity prices and other assumptions. As it is unclear as to what is to come after COVID-19, this task remains a considerable challenge. Many analysts expect a global recession despite the current governmental stimulus programs around the globe. In addition, thoughts on the shape and magnitude of the economic impact (V, U, W, or L shaped curves) may vary. We believe it is necessary to consider adjustments to cash flows in light of short-term, medium-term and long-term effects. It is also recommended to develop multiple scenarios and probability-weighted cash flow projections
  • Recalculating the discount rates: Discount rates to be used in recent valuations need to be updated to reflect the risk environment at the reporting date. Due to increased volatility and uncertainty in the expected cash flows, discount rates will increase. Many valuation practitioners have already increased their equity risk premium estimates by at least 50 bps. In addition, it is worth mentioning that a specific COVID-19 risk premium (alpha) cannot be quantified. It is preferable to reflect such risks in the cash flows rather than in the discount rate

In any case, to produce robust impairment test results in the current economic environment requires enhanced consideration of individual facts and circumstances as well as a significant informed judgement even in the best of times.

Read the full publication to find more details and considerations on impairment testing in light of COVID-19.

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