Impairment assessment - Considerations related to valuations amid COVID-19 - EY
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Impairment assessment Considerations related to valuations amid COVID-19
Advent of COVID-19 may trigger impairment testing
Impairment of an asset/CGU ► Advent of COVID-19 from January 2020 onwards has
resulted in adverse economic environment for many
Asset or cash businesses.
generating unit (CGU) ► As per ICAI and other valuation bodies, companies may
have to test their respective assets/CGUs for
impairment/revisit fair valuation given the impact of
COVID-19.
► Companies are to test for impairment if any of the
following indicators exist:
Fair value less costs ► temporary ceasing of operations, immediate decline
Value in use
to sell (FVLCS) in demand or prices
► Disrupted supply chains and workforce arrangements
Higher of the two ► Legal issues (force majeure clauses being invoked by
vendors, customers)
► Working capital (lower probability of receivable
recovery) and other funding issues
Recoverable amount
(RA) ► Trade with countries significantly affected by
COVID-19
RA < carrying amount RA > carrying amount ► Since COVID-19 cases were identified in January 2020
and caused economic impact thereafter, only disclosures
in the financial statements of 31 March 2020 would not
suffice.
► This presentation covers impairment testing pertaining to
Recognize impairment No impairment
CGUs (including goodwill and intangible assets)/equity
instruments.
Page 2Key takeaways from valuation bodies and regulators’ guidance
ICAI and valuation bodies (such as IVSC, RICS, IPEV*) issued various guidance on navigating the
challenges in estimating FVLCS or VIU. The following are the key takeaways from the same:
There is significant valuation uncertainty due to the impact of COVID-19.
Management of companies need to consider multiple methods and scenarios (e.g., base case,
optimistic case, pessimistic case) for cash flows to arrive at value.
Despite volatility, prices quoted in active market are still relevant for listed securities.
Assumptions are to be made basis the best estimate of events/scenarios that are likely to occur.
*IVSC: International Valuation Standards Council, RICS: Royal Institution of Chartered Surveyors, IPEV: International Private Equity and Venture Capital
Sources:
ICAI Accounting and Auditing Advisory March 2020, Impact of Coronavirus on Financial Reporting and the Auditors Consideration
Letter from the IVSC Technical Boards Regarding Valuation and Uncertainty, March 2020
International Private Equity and Venture Capital Valuation Guidelines, IPEV Board, Special Valuation Guidance – 31 March 2020
Impact of COVID-19 on valuation, UK guidance for RICS-regulated members, 27 March 2020
Page 3Possible red flags for impairment testing amid COVID-19
The following areas may raise red flags for impairment:
High acquisition premium paid in the past
Low headroom in past impairment studies
Aversely impacted industries (travel, airlines, hotels, etc.)
Companies with high financial leverage (i.e., higher insolvency
risk)
Businesses with high operating leverage
Companies involved in international trade with countries
significantly impacted by COVID-19
Page 4Economic impact in India and globally
According to the International Monetary Fund’s World Economic Outlook report (April 2020), global economy is projected to contract by 3% in 2020,
much worse than what it was during the 2008-2009 financial crisis. Assuming that the pandemic fades in the second half of 2020, the global economy
is likely to grow at 5.8% in 2021.
Global India
Industrial production by region Revised economic growth
5%
4% Previous forecast Revised forecast
3% Agencies/institutions (%) (%)
2% Fitch Ratings (FY21) 5.6 2.0
1%
% year
0% Moody’s Investors (CY20) 5.3 2.5
-1% S&P Global Ratings (FY21) 5.7 3.5
-2%
-3% Oxford Economics 6.0 -1.0
-4%
World China Asia-Pacific United States Eurozone Goldman Sachs (FY21) 3.3 1.6
November
November Baseline
baseline February
FebruaryBaseline
baseline Current
CurrentBaseline
baseline Sources: Fitch Ratings forecasts, sourced from Fitch Rating’s Global Economic Outlook Datasheet
(March-April); Moody’s Investor’s growth forecasts, Global Macro Outlook Reports (November
Source: Oxford Economics 2019 and March 2020); Oxford Economics forecasts from “Global Economic Updates” database;
Forecasts of S&P Global Ratings and Goldman Sachs, sourced from media publications.
Expected duration of the pandemic
70%
Insights from FICCI Survey (Report titled Impact of Coronavirus on
% of forecasters
60%
50% Indian Businesses, March 2020) of 317 companies (conducted
40% between March 15-19)
30%
20% 53% indicated marked impact on
80% experienced decrease in cash
10% business operations even at early
flows
0% stages
11Quarter
quarter 2
2 Quarters
quarters 3
3 Quarters
quarters 4 quarters
Quarters
Duration 66% felt big reduction in order 63% cited reduction in supply
books chain
Source: Oxford Economics (based on a survey conducted on 23-24 March 2020)
Page 5The pandemic crisis will impact most industries negatively, albeit
some themes may have a positive impact
► Immediate lockdown along with ensuing recession will imply negative impact on almost all
industries.
► Government stimuluses may only help in reducing the pain, and may not be independent
positive drivers.
► Some themes may play out positively for some industry segments such as:
► Work from home culture with positive impact on Internet, communication and
Technology (ICT) services, virtual education, home automation products, etc.
► Increased focus on essential/new essential services such as agriculture, health
food/immunity foods, processed foods, personal hygiene, low cost housing.
► Changes in consumer behavior and lifestyle with focus on OTT platforms, e-commerce
with last mile delivery, insurance (especially health), digital payments, etc.
► Increase in mobility services such as food delivery (vs. eating out), private transport
(e.g., possible demand uptick for two-wheelers and mid range cars in long run)
Page 6Evaluation criteria can vary depending upon the extent and timeline
of impact
Short to medium-term negative impact when sales/cash
Long-term negative impact
flows are delayed
► Significant impact, although exceptional in nature ► Evaluate the steps considered by the company to
► One needs to evaluate the ability of the company to ensure the continuity of the business
survive the impact ► Low risk of impact
► Companies with:
► Weaker operating and financial performance
► Marginal or small industry players in terms of
market share, brand share, access to capital, etc.
Short to medium-term negative impact in case there is
Positive impact
loss in revenue/cash flow
► Loss of revenues/cash flows in the interim period ► Essential commodity sector, e-commerce (business-to-
► Evaluate the capability of the company to survive business/business-to-customer), security industry, etc.
through the interim period and take steps to minimize ► May be a temporary impact that may reverse/stabilize
the losses with time
► Low to moderate risk of impact
There will also be some mitigating factors in form of government action/stimulus
Page 7Commodity price forecasts in the midst of the crisis reflect long-term
views
Even visible in the commodity prices forecast: short-term forecast have reduced while long-term remains intact
Crude oil – Brent (US$ per BBI) Iron ore – CFR* China (US$ per dry metric ton)
75 85
65
80
55
75
45
70
35
25 65
Spot Jun-20 Sep-20 Dec-20 2021 2022 2023 2024 2025-29 Spot Jun-20 Sep-20 Dec-20 2021 2022 2023 2024 2025-29
price (long- price (long-
term) term)
Analyst consensus - 16 Dec 2019 Analyst consensus - 14 Apr 2020 Analyst consensus - 16 Dec 2019 Analyst consensus - 14 Apr 2020
Steam coal (US$ per ton) Aluminium (US$ per ton)
85 2,450
80
2,150
75
1,850
70
1,550
65
60 1,250
Spot Jun-20 Sep-20 Dec-20 2021 2022 2023 2024 2025-29 Spot Jun-20 Sep-20 Dec-20 2021 2022 2023 2024 2025-29
price (long- price (long-
term) term)
Analyst consensus - 16 Dec 2019 Analyst consensus - 14 Apr 2020 Analyst consensus - 16 Dec 2019 Analyst consensus - 14 Apr 2020
*CFR-Cost and Freight
Source: Consensus Economics Inc.
Page 8In the current times, DCF is a preferred approach over other valuation
methods
Asset or cash DCF post COVID-19
generating unit (CGU) 1,500 When dip is sharpest, multiples may
not represent a correct long-term view
1,200
Cash flows
900
Fair value less costs to 600
Value in use
sell (FVLCS)
300
0
0 1 2 3 4 5 6 7 8 9 10
Generally Discounted Year
Generally Comparable
Cash Flows (DCF)
Multiples method Incremental cash- flow
Short term V
method
Incremental lossesMedium term - U
cash flow losses
Long term - L
► In times of uncertainties, DCF provides a more robust basis to analyze valuations than Comparable Multiples method or Asset
values method:
► It permits valuations after considering various scenarios.
► Extreme uncertainties in the short to medium-term, however impact tapers out over a period of time.
► Comparable Multiples has limited relevance since earnings collapse. Even future earnings for comparable companies are
difficult to predict. However, Comparable Multiples should still be evaluated for a minimum reasonableness check.
Generally, control premiums increase during market crashes.
Page 9Multiple scenarios vs. single cash flow approach
Challenges in estimating cash flows Uncertain macroeconomic outlook has led to higher estimation uncertainty,
thus wider range of cash flow projections, with scenarios ranging from
► Evolving situation
► Academic research shows that Economic disruption for Disruption triggering
pandemics often have significant few months significant recession
short-run impact and more
uncertain long-run impact on GDP
growth
Approach to be followed
► Difficult to assess long-run impact Two approaches can be used to project cash flows:
of pandemics on GDP growth.
Countries generally recover from
a pandemic situation, and there is Traditional
often a catch-up period of growth ► Single cash flow projection, or most likely cash flow.
approach
following a pandemic
► Difficult to understand the Impact
of fiscal stimulus, liquidity ► Multiple, probability weighted cash flow projections.
provisions and financial support Expected cash
flow approach ► Uncertainty is reflected through probability weighted
committed by governments
projections.
► Multiple expected paths of
recovery and a likelihood of
recession Given the high degree of uncertainty, it may be helpful to consider using
the expected cash flow approach as opposed to the traditional approach.
Page 10Cash flow scenarios: pre- and post-COVID-19
Scenarios Key cashflow assumptions
Pre-COVID-19
Cash flows
A growing company with slightly higher than
Pre-COVID-19 cash flow
industry growth.
Year
Post-COVID-19 scenarios Recovery
U-shaped
Cash flows
Scenario 1 Cashflows forecast may have a negative impact for
the next two years; thereafter, growth rates are
(Medium-term recovery)
assumed to broadly restore to pre-COVID-19 levels.
Year
V-shaped
Cashflows forecast may have a negative impact for
Cash flows
Scenario 2 the first two quarters in FY21; thereafter, growth
(Short-term recovery) rates are assumed to broadly restore to
pre-COVID-19 levels.
Year
L-shaped
Cashflows forecast may have a negative impact for
Cash flows
L - Shaped
Scenario 3 the next three to four years; thereafter, growth
(Long-term recovery) rates are assumed to broadly restore to
pre-COVID-19 levels.
Year
Page 11Impact of COVID-19 on discount rates
► Impact on discount rates would vary industry-wise and would be company-specific.
► Risk-free rate has adjusted downwards, given that repo rate has declined.
► Increase in market volatility is expected to push market risk premium upwards.
► Given betas are backward-looking and do not reflect the current volatility correctly,
one may consider mid-higher end of the range, depending on the industry
► Alpha to be based on company-specific factors
► It is important to holistically assess discount rate in context of subject industry and risk in
prospective financial information.
► The expectation of falling risk-free rate and cost of debt does not automatically translate
into a lower cost of capital.
► As per special guidelines of IPEV1, “Greater uncertainty may translate into greater risk which may
translate into greater required returns which may translate into lower asset values”.
1 International Private Equity and Venture Capital Valuation Guidelines - IPEV Board, Special Valuation Guidance – 31 March 2020
Page 12Key takeaways
► Uncertainty in the economic environment and volatility due to COVID-19 has triggered
the need for impairment testing.
► Disclosures not suffice, companies to test for impairment; red flags for impairment: low
headroom, adversely impacted industries, weak operational/financial position.
► Evaluation criteria can vary depending upon the industry, extent and timeline of impact.
It may vary significant to low or even positive in some cases.
► DCF is preferred instead of Comparable multiples or Asset value.
► DCF with probability weighted cash flows seems to be a better approach given the
uncertainty.
► Discount rate to be evaluated holistically in context of subject industry and risk in
prospective financial information.
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