ANALYSIS | IMPAIRMENT TESTING

GOODWILL AND
THE FTSE 100S CUMULATIVE GOODWILL SMALLER THAN MARKET FALL MAY SIGNAL THAT THERE IS MORE BAD NEWS TO COME, WRITES SIMON JONES

n the year to 31 March 2009, goodwill impairment charges wiped over 50bn off the book value of FTSE 100 constituents. Since an already fragile economy was sent into a tailspin by the collapse of Lehman Brothers in September 2008, all but four of the FTSE 100 have published annual reports. This has provided the opportunity to analyse the assumptions applied in goodwill impairment testing and the extent to which the economic malaise has impacted on the UKs largest companies. The headline figure of over 50bn cumulative goodwill impairment charges is significant. It represents over 15% of the cumulative goodwill carried on the books of FTSE 100 companies and 6% of net asset value. And it is some 150 times greater than the goodwill impairment reported in the year to 31 March 2008. It has also served as a major drag on profit before tax, reducing the cumulative reported level by 36%. However, 50bn is relatively minor in the context of the fall in market value of FTSE 100 companies of some 373bn, or 23%, between their annual reporting dates. Analysis of the top 100 companies indicates that while 32 FTSE 100 companies reported goodwill impairment charges, most of the 50bn is accounted for by just four (RBS: 30.1bn; HSBC 7.3bn; Vodafone 5.9bn and Rio Tinto 4.5bn). However, these four, while accounting for 95% of reported goodwill impairment, accounted for only 44% of market goodwill and 31% of the fall in market value.

THE IMPAIRMENT TESTING PROCESS

Testing goodwill for impairment under IAS 36, Impairment of Assets, involves comparing the carrying amount to the recoverable amount, as represented by the highest of value in use and fair value less cost to sell. It is most common to apply the value in use methodology, which in essence involves discounting expected future cashflows. The key assumptions, therefore, are future cashflow forecasts, the discount rate applied and the long-term growth rate. The accounting standards recognise this and require disclosure of both the discount rate applied and the long-term growth rate. IAS 36 also requires disclosure of sensitivity to key inputs, where no impairment is taken but a reasonably possible change in assumption would result in impairment.

DISCOUNT RATES
The choice of key value in use assumptions should not be made in isolation, with the choice of one input

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HARMONY?
being a determining factor in the choice of others. Since the Lehman collapse, one would expect most companies to have revised cashflow forecasts downward, at least in the medium-term, to reflect the economic realities they face. As regards the discount rate, provided the cashflow forecasts have been adjusted appropriately, there should not be a material change in discount rate yearon-year, except in exceptional circumstances. This is because cashflow forecasts are long-term and therefore inputs into the discount rate should be long-term too. Short-term market cycles will impact on discount rate inputs, such as Beta observations (through, for example, recent extreme volatility in the financial services sector), and the market risk premium. But it seems that the most appropriate long-term view, in the absence of evidence to the contrary, is that these factors are mean reverting over the long-term. Yields at the long end of the risk-free yield curve have decreased, but not to the extent of short-term risk-free yields. And countering this decrease we see an increase in specific risk factors, such as lack of liquidity, credit risk and industry volatility. Views on long-term growth, meanwhile, depend on how the recovery from the current recession is expected to pan out, together with inflation expectations. A short, sharp V-shaped recession, with a return to historical real growth, would indicate not much change in long-term real growth assumptions year-on-year, except in exceptional circumstances. Similarly, an L-shaped recession, mirroring that of Japan, would indicate that long-term real growth forecasts need to be revised downward. by management (flushing out as much bad news as possible), especially if the change in discount rate or growth rate is material.

DISCLOSURE
Despite the requirements of the accounting standards, there were nine FTSE 100 companies that failed to disclose the discount rate used for goodwill impairment testing (or the disclosure fell short of accounting standard requirements). Of these, two wrote off their entire goodwill balance. Surprisingly, between 2009 and 2008, Kingfisher advises that it revised its methodology for converting a post-tax discount rate to a pre-tax discount rate. This change resulted in a reasonably significant increase to the observed rate. Shortcomings in 2009 disclosures are, however, an improvement on the previous year, when 17 of the current FTSE 100 constituents failed to disclose the discount rate they had used. The level of disclosure on growth rates is worse, with 17 FTSE 100 companies either failing to disclose the long-term growth rate applied or not making it clear that they are only using a finite number of years cashflows. Again, though, disclosure is an improvement on the previous year, when 23 companies failed to disclose.

DISCOUNT RATES
The following shows that, collectively, the FTSE 100 increased the discount rates applied for the purposes of impairment testing (American Appraisals methodology relies on unweighted measures of central tendency, both collectively and individually): Pre-tax rates Average Median Maximum Minimum 2007/8 10.84% 10.64% 20.31% 6.00% 2008/9 11.54% 11.33% 19.06% 6.00%

GAMING TACTICS
Sensitivity analysis is crucial. Taken with changes in key assumptions, it can guide how accounting policies are interpreted in general. Take, for example, a situation where no goodwill impairment charge is reported and there is only a small level of goodwill headroom (excess of recoverable amount over carrying amount). If the discount rate applied is lower than in previous years, or the growth rate is higher, this may be interpreted as an indication of aggressive accounting, especially if the change in discount rate or growth rate is material. Similarly, if there is a large impairment charge and the discount rate applied is higher than in previous years, or the growth rate is lower, this might be interpreted as an indication of big bath behaviour

Of the 32 companies reporting a goodwill impairment charge, four took the impairment while reporting a lower average discount rate, while 16 took the impairment and reported a higher average discount rate. The average change in discount rate for the 16 in this latter category was an increase of 1.5%. Four of this group increased the average discount rate applied by more than 3%. Of the 66 companies (two investment trusts in the

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 ANALYSIS | IMPAIRMENT TESTING

Management need to be aware of what they may stand accused of by adopting certain positions and, if necessary, call on the counsel of an independent expert

FTSE 100 have been excluded from this analysis), reporting no goodwill impairment charges, 16 did so while reporting a lower average discount rate, and 20 did so while reporting a higher average discount rate. The average change in discount rate for the 16 in the former category was a decrease of 1.1%. Two of this group decreased the average discount rate applied by more than 3%.

GROWTH RATES
The following shows that, collectively, the FTSE 100 applied broadly the same growth rate as in the prior year for the purposes of impairment testing: Pre-tax rates Average Median Maximum Minimum 2007/8 2.84% 2.65% 9.00% 0.00% 2008/9 2.83% 2.75% 8.00% 0.00%

Of the 32 companies reporting a goodwill impairment charge, four took the impairment while reporting a lower average growth rate, while seven took the impairment and reported a higher average growth rate. The average change in growth rate for the four in the former category was a decrease of 0.6%. The largest change was 1.3%. Of the 66 companies reporting no goodwill impairment charges, 10 did so while reporting a lower average growth rate, while 13 did so and reported a higher average growth rate. The average change in discount rate for the 13 in this last category was an increase of 1.1%. Four of this group increased the average growth rate applied by 2% or more.

companies, in the year to 31 March 2009, was 8.7%. This represents an increase from 8% in the prior year. Of those companies reporting an impairment, the reported spread between discount rate and growth rate increased by an average 0.9%, while for those companies not reporting an impairment, the reported spread increased by an average 0.4%. There were 10 companies reporting goodwill impairment for which the spread between discount rate and growth rate increased, while there were six companies reporting goodwill impairment for which the reported spread decreased. Of those 10 companies reporting goodwill impairment and an increase in spread, the average increase was 1.7%. Two of these companies reported an increased spread of over 3%. There were 13 companies reporting no goodwill impairment for which the spread between discount rate and growth rate increased, while there were 15 companies reporting no goodwill impairment for which the reported spread decreased. Of those 15 companies reporting no goodwill impairment and a decrease in spread, the average decrease was 1.2%. Three of these companies reported a decreased spread of 2% or more. This analysis of discount rates and growth rates can be summarised as follows: No. reporting 5 6 3 4 4 11 2 5 8

Lower discount rate higher growth rate Lower discount rate unchanged growth rate Unchanged discount rate higher growth rate Lower discount rate lower growth rate Unchanged discount rate unchanged growth rate Higher discount rate higher growth rate Unchanged discount rate lower growth rate Higher discount rate unchanged growth rate Higher discount rate lower growth rate

DISCOUNT RATES AND GROWTH RATES

It is common for cashflow models with a short explicit forecast period (five years, say), to produce most of their value in the terminal period (the value into perpetuity). The terminal period value is commonly calculated via a capitalisation of terminal year cashflows, with the capitalisation factor being the discount rate minus the growth rate (the Gordon Growth model). The narrower the gap between the discount rate and growth rate, the higher is the terminal value and value in use, and vice versa. The average reported spread between discount rate and growth rate for FTSE 100

Impairment testing is far from straightforward. Management need to be aware of what they may stand accused of by adopting certain positions and, if necessary, call on the counsel of an independent expert. While goodwill is but one component of market value, a cumulative goodwill impairment charge for the FTSE 100 that is 7 times smaller than the fall in market value may signal there is more bad news to come.

Simon Jones CFA is senior manager at valuation advisory experts, American Appraisal

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