Goodwill is an intangible asset acquired in a business combination, whenever the purchase price exceeds the fair value of net assets. IAS 36, the international accounting standard on the impairment of assets, requires that goodwill, and therefore the Cash Generating Unit ("CGU") to which it is allocated, be subjected to an impairment test at least annually, comparing its carrying value (i.e. the book value) to the recoverable value ("RA"), represented by the higher of:
the fair value less costs of disposal, and
the value in use.
To test goodwill for impairment, a company's management will estimate the CGU's value in use by applying the Discounted Cash Flow method (DDM for financial institutions), based on the future cash flows expected to be generated by the same. As per IAS 36.30, cash flow projections should be based on reasonable and supportable assumptions, the most recent budgets and forecasts, and extrapolation for periods beyond budgeted projections.
Furthermore, IAS 36 requires that internal and external qualitative and quantitative indicators tracked by the management (also known as impairment triggers or indicators) be monitored when preparing interim financial statements to verify whether conditions exist for carrying out an impairment test before the end of the reporting period. Impairment indicators include, among others (IAS 36.12):
a significant and more than expected decline in the entity's or CGU's market value,
increases in market interest rates, changes in foreign exchange rates and/or commodity prices,
a fall in the entity's market capitalization below the book value,
evidence from internal reporting of an economic performance (cash flows and/or operating profit) significantly worse than budgeted,
changes to the entity's operating model or plans to restructure/discontinue operations, and
an increase in the cost of capital.
For further information on IAS 36, have a look at BDO's manual IFRS In Practice: IAS 36 Impairment of Assets 2020/21 (link), and Deloitte's e-learning module (link).
List of Procedures to Perform
The Big 4 audit team will commission the corporate finance specialists to review the impairment test conducted by their client, which they will do by performing the following procedures:
1. Analysis of the impairment test process conducted by the client's management, also through the reading of the financial projections and the macroeconomic scenario underlying the company's budget and business plan
In the report prepared for the audit team, the corporate finance team will include a brief overview of the financial projections and the key underlying assumptions, as well as any significant deltas from previous impairment tests. Furthermore, with regards to the macroeconomic scenario, the corporate finance specialists will generally perform a benchmarking analysis based on the outlooks published by local and international organizations and authorities, including:
IMF
EIU
National Central Bank
European Commission
Bloomberg (or similar)
National statistics authority
Big 4 research papers
Analyst and broker reports.
The growth rates underlying the forecasted financial results and the macroeconomic assumptions considered by the client's management in performing the impairment test are deemed reasonable if they do not differ significantly from the most recent market consensus.
2. Assessment of the reasonableness of the valuation methodologies and key parameters used
With regards to the valuation methods, they are deemed reasonable if the management used a DCF (or a DDM for financial institutions) based on the latest available financial projections, and possibly the market approach as a cross-check methodology.
With regards to key valuation parameters, such as the discount rate and the g, the corporate finance specialists will provide the audit team with shadow estimations based on their own internal models. You can download the template models for estimating the cost of capital and the long-term growth rate at our Downloads & Links page.
3. Assessment of the mathematical correctness of the calculations made by the client's management
Depending on the file's size, it may be difficult (if not impossible) to check all of the formulae in a client's Excel model. What the corporate finance team does to gain more confidence in the client's results is re-perform the valuation using their own internal models and updating them with the management's inputs. You can download the DCF and DDM template models at our Downloads & Links page.
4. Sensitivity analyses to assess the impact on the recoverable amount of changes in the key parameters and assumptions underlying the impairment test
Starting from the client's model, the corporate finance team will perform sensitivity analyses to assess the impact of variations in key valuation parameters on the RA, and estimate the buffer (or headroom) existing between the RA and the carrying value. Examples of sensitivities include the estimation of:
the impact on the CGU's RA deriving from a +/- 1% change in the key valuation parameters (i.e. discount rate, g, EBITDA or net profit % growth rate, etc.), and/or
the % change in key parameters that would set the buffer between RA and carrying value to zero (i.e. RA = carrying value), which the corporate finance team does using the goal seek function in Excel.
We hope you found this article useful. For questions or clarifications, feel free to reach out. Thanks for reading, and good luck!
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