Q3 2020 - Private Equity Managers: Are Your Portfolio Companies Properly Evaluating Assets for Impairment?
September 01, 2020
Over the past five months, the economy has experienced an unprecedented shutdown in response to the COVID-19 pandemic, and governments have responded with record stimulus packages and incentives, with more possibly on the way. While the ultimate impact of the pandemic on businesses and asset prices is unknown, there are important accounting and financial reporting considerations that private equity managers should focus on now in evaluating portfolio company financial statements and estimating fair values of private equity investments. This article discusses the unique accounting requirements around asset impairment and illustrates how timely recognition and measurement of impairment is a critical input to portfolio company valuation.
EiserAmper has prepared the following frequently asked questions (FAQs) based on conversations with clients and colleagues, to assist entities in staying abreast on impairment considerations when accounting and reporting to confirm with generally accepted accounting principles in the United States (U.S. GAAP).
What do you mean by impairment?
U.S. GAAP defines impairment as the condition that exists when the carrying amount of a long-lived asset (or asset group) exceeds its fair value.
Do we need to recognize a loss when an asset meets the definition of impairment?
Not necessarily. U.S. GAAP specifies that an entity recognizes an impairment loss only upon meeting both of the following conditions:
- The carrying amount of an asset exceeds its fair value (i.e., meets the definition of impairment); and
- The carrying amount of the asset is not recoverable.
What do you mean by recoverable?
U.S. GAAP explains that the carrying amount of an asset is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset.
What happens if we determine that an asset meets both conditions for recognition of an impairment loss?
When an asset meets both conditions, recognize a loss measured as the amount by which the carrying amount of the asset exceeds its fair value.
What do we do if we determine that an asset meets the first condition (i.e., meets the definition of impairment), but, in our assessment of recoverability, we conclude that the asset is recoverable?
When an asset is determined to be impaired but the carrying value is recoverable, no loss is recognized. In such an instance, management should monitor and update its assessment of impairment and recoverability as events and conditions warrant.
When should management test a long-lived asset for recoverability?
U.S. GAAP requires that management test a long-lived asset for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. Examples of such events or changes in circumstances include:
- a significant decrease in the market price of a long-lived asset (asset group);
- a significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used or in its physical condition;
- a significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset (asset group), including an adverse action or assessment by a regulator;
- accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset (asset group);
- current period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset (asset group); and
- a current expectation that, more likely than not, a long-lived asset (asset group) will be sold or otherwise disposed of significantly before the end of its previously estimated useful life.
Now that we have reviewed the requirements of impairment recognition and measurement, we turn our attention to how impairment informs fair value measurement of private equity investments.
If portfolio-company investment valuation is a function of expected future cash flows, we appreciate the importance of timely impairment recognition and measurement in portfolio company financial statements as a signal of expected cash flows with implications for overall valuation of the portfolio company. This is because, as explained in the FAQs, recoverability drives recognition of an impairment loss, and recoverability entails an estimate of cash flows expected to result from the use and eventual disposition of the asset. Accordingly, the focus on expected cash flows in determining asset impairment aligns with investment valuation theory in a broader sense.
From a financial reporting perspective, the events of the past five months indicate that private equity managers face an especially challenging task evaluating portfolio company financial statements when determining investment valuation in the current environment. For the reasons explained in this article, private equity managers should pay particular attention to the carrying value of portfolio company assets, with a focus on timely recognition and measurement of impairment. Whereas audited portfolio-company financial statements can provide comfort about recognition and measurement of impairment, unaudited portfolio company financial statements require a much deeper due diligence analysis. When audited financial statements are unavailable, private equity managers may need to engage experts to assist with assessing whether a portfolio company has appropriately recognized impairment in its financial statements in connection with developing the estimated fair value of its investment in the portfolio company.
As in many aspects of accounting and reporting in U.S. GAAP, evaluation of impairment requires considerable judgment. With all the uncertainties associated with the COVID-19 pandemic, communication is key – both internally, including those involved in portfolio management and asset valuation, and externally, including valuation specialists and auditors.
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