COVID-19 & Bank Goodwill Impairment
One of the many financial reporting considerations facing banks amid the SARS-CoV-2 virus and the incidence of COVID-19 pandemic is goodwill impairment. Do current economic events and market conditions signal a triggering event? If so, when and how is impairment measured? How does the current expected credit loss (CECL) affect goodwill impairment?
Bank Goodwill Climbing
Following a lengthy period of record M&A activity, the industry has seen a related increase in the amount of goodwill. According to S&P Global Market Intelligence, aggregate goodwill carried by all U.S.-based banks is approximately $370.7 billion. This compares to $422.4 billion in 2007, just prior to the financial crisis that led to record-high levels of goodwill impairment from 2008 to 2009. Goodwill as a percentage of common equity among U.S. banks has remained relatively stable, maintaining levels at about half of those leading into the financial crisis.
Identification of a Triggering Event
Most banks do not amortize goodwill unless they have elected the Private Company Council alternative. Instead, it is tested for impairment annually or upon a triggering event at the reporting unit level. Though most companies have recently completed the annual testing date, banks now must evaluate whether current events constitute a triggering event. Accounting Standards Codification (ASC) Topic 350, Intangibles—Goodwill and Other, provides these examples in 350-20-35-3C:
- Macroeconomic conditions, such as a deterioration in general economic conditions, limitations on accessing capital, fluctuations in foreign exchange rates or other development in equity and credit markets
- Industry and market considerations, such as a deterioration in the environment, a decline in market-dependent multiples or metrics, a change in the market for an entity’s products or services or a regulatory or political development
- Cost factors such as increases in raw materials, labor or other costs that have a negative effect on earnings and cash flows
- Overall financial performance, such as negative or declining cash flows or a decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periods.
- Other relevant entity-specific events such as changes in management, key personnel, strategy, or customers; contemplation of bankruptcy; or litigation
- Events affecting a reporting unit such as a change in the composition or carrying amount of its net assets, a more-likely-than-not expectation of selling or disposing of all, or a portion, of a reporting unit, the testing for recoverability of a significant asset group within a reporting unit, or recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit
- If applicable, a sustained decrease in share price (both in absolute terms and relative to peers)
For SEC filers, the evaluation of share price and its relationship to book value will be an important factor. The volatility associated with today’s equity markets does not change the fact they’re still active and remain a relevant measurement of fair value. If, after considering the totality of all indicators, a triggering event is determined, then share price also plays a role in the impairment testing process.
While many institutions operate as a single reporting unit, others have multiple reporting units or segments with goodwill for which impairment is evaluated. For example, some institutions have separate reporting units for nonbanking operations such as insurance, trust or wealth advisory. This analysis must be performed and documented at all reporting units of the institution in which goodwill is recorded.
Impairment Testing Process
If a triggering event is identified, a company has the option to perform a qualitative analysis (Step 0) to determine if a comprehensive analysis of events or changes in circumstances indicate that it is more likely than not that goodwill is impaired using the same indicators under ASC 350-20-35-3C, among others. If a company performs a quantitative assessment (Step 1) or if Step 0 indicates that it is more likely than not that goodwill is impaired, the fair value of the reporting unit is measured to determine the amount of impairment, if any.
For SEC filers, a quantitative test is performed under Accounting Standards Update (ASU) 2017-04, Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. Public business entities (PBE) and privately held banks can elect early adoption. Under ASU 2017-04, goodwill impairment is a single step, whereby goodwill impairment is measured as the difference between the fair value and the carrying value of the reporting unit. If a Step 1 test fails, then Step 2 is no longer required to measure goodwill impairment. If the fair value of the reporting unit exceeds its carrying value, no impairment exists. If ASU 2017-04 is not adopted, then goodwill impairment testing requires a two-step process. If Step 1 fails, a hypothetical purchase price allocation under Step 2 measures the fair value of goodwill to be compared to the carrying value of goodwill to determine the amount of impairment, if any.
Keep in mind the determination of a triggering event may or may not result in subsequent impairment. The identification of a triggering event creates the need to consider that a potential impairment could exist. The optional Step 0, if performed, requires documented goodwill impairment testing to conclude whether it is more likely than not that goodwill is impaired based on consideration of all events and circumstances. Step 1 may result in no impairment if the fair value exceeds the carrying value. If a reporting unit has other long-lived assets, then goodwill impairment should be measured last, after the evaluation and/or quantification of impairment, and any related adjustment to the carrying values for indefinite-lived intangibles first, then amortized intangibles or long-lived assets next.
Quantitative Test Considerations
The standard of value used is fair value under ASC 820, Fair Value Measurements, which provides observable to unobservable levels of input to follow. A reporting unit’s valuation will require the consideration of all three approaches to value (cost, market and income), which in turn rely on different levels of input. In addition to stock price, any relevant transactions or guideline public company indicators of value should be considered. A discounted cash flow analysis also should be considered, relying on updated assumptions known as of the measurement date.
ASC 350 requires the consideration of synergies and other benefits that flow from control over an entity. Elements include the reduction of costs, growth in new markets and greater diversification. The synergies can be captured either through the application of a control premium or in the adjustment of a benefit stream. In addition, a solution for today’s environment may be to create multiple scenarios for a discounted cash flow and perform a probability weighting of each under an expected cash flow approach.
ASC 326, Financial Instruments—Credit Losses, adds additional complexity for goodwill impairment assessments specific to the banking industry. Increased care in selecting market participant data will be warranted, as financial reporting will differ between those who adopt CECL and those who do not. For those who adopt CECL, prospective financial information should be based on reserve estimates developed under ASC 326.
CECL also will affect the carrying value of the reporting unit at the measurement date of the quantitative impairment test. All other things equal, an increase in the reserves would result in a lower carrying value and vice versa. This will affect the initial quarter of CECL implementation, as well as subsequent quarters, potentially increasing carrying value volatility. It also will potentially create volatility in the percentage of equity held in goodwill in future quarters.
The current environment requires that attention is placed on evaluating goodwill impairment for banks. Management should exercise considerable judgment in identifying the best course of action to comply with financial reporting requirements, including those listed below.
- ASC 350
- AICPA Guide to Goodwill Impairment
- ASU 2017-04
- Valuations in Financial Reporting Valuation Advisory 3: The Measurement and Application of Market Participant Acquisition Premiums
As with most topics related to COVID-19, changes are being made rapidly. Please note that this information is current as of the date of publication.
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