Impairment in the Age of COVID-19

What is Impairment?

Impairment is when an asset’s fair value¹ is less than the value listed on the company’s balance sheet. When this occurs, that asset needs to be written down on the company’s balance sheet to its current fair value. For this discussion, I will focus on the impairment of intangible assets including goodwill.

In determining the value of an intangible asset, an appraiser or company management will typically follow guidance from the Financial Accounting Standards Board (“FASB”) under ASC 350. Additionally, the American Institute of Certified Public Accountants (“AICPA”) provides for different methods of determining fair value, including the income, market and cost approaches.

When an impairment occurs, the impaired asset’s fair value is reduced by the amount of the impairment, and that reduction hits the income statement as an impairment expense, thus reducing earnings. Typically, news outlets focus on intangible asset impairment and with reason. Currently, 84% of S&P 500 company value is comprised of intangible assets. This means that only 16% of S&P 500 company value is comprised of tangible assets such as working capital, machinery and equipment or real estate.²

Businesses develop intangible assets through one of two ways: they are either created internally or acquired. If they are internally created, they generally will not appear on the company’s balance sheet. However, if they are acquired, intangible assets are generally recorded on the company’s balance sheet and are subject to impairment testing.

For example, in 2015 Heinz merged with Kraft³, and part of the total $52.6 billion transaction included an acquisition of $86 billion⁴ in assets, of which $78.3 billion were intangible assets and were recorded on the balance sheet. From 2015 through 2019, Kraft Heinz operations — and correspondingly, the market capitalization of the business — declined by roughly 65%⁵ . As the market capitalization (or plainly speaking, the value of the company) declined, Heinz Kraft eventually became unable to support the book value (i.e., recorded amount on the balance sheet) of several of its assets, notably numerous brand names and goodwill. This deterioration of company value has resulted in over $20 billion of impairment charges to date.

The Effects of COVID-19

The pandemic has produced unimaginable change over the last few months. Many things that we used to take for granted, such as going out to see a movie or sitting in the stands at a sporting event, suddenly became impossible. Effects of the pandemic quickly hit the public equity markets, and in March, the world stock markets were down more than 30% from their February highs. Additionally, many businesses and their assets became impaired overnight.

From an impairment perspective, situations such as a rapid decline in stock price would typically be a triggering event for intangible asset impairment testing. At the conclusion of the first quarter, some companies determined that an asset impairment may be temporary and passed on impairment testing. During this time, there were daily discussions on whether the recovery would be shaped like a “V,” a “U,” a “W,” or an “L.” As the second quarter closed in June, the S&P 500 essentially rebounded to where it started at the beginning of the year, and the NASDAQ was up almost 20% year-to-date. So the recovery was V-shaped, right? Not exactly. I would argue that “it depends.”

For example, large capitalization technology companies seem to be setting new market capitalization records almost daily and have managed to have an almost “checkmark” shaped recovery. Companies in other industries, such as hospitality, airline, and energy, are still near their March lows and have followed more of an “L”-shaped path. In fact, outside of the technology industry, the situation is still quite poor.

This divergence becomes very apparent if you look at the S&P 500. At the time of this writing⁶, five technology companies, or 1% of the S&P 500 constituents, including Apple, Microsoft, Amazon, Facebook and Google, account for approximately 22% of the S&P 500’s⁷ market capitalization. Year-to-date, those five companies are currently up an average of more than 30%⁸. What does this mean for the remaining 495 companies?

On average, they have underperformed the index, and their market capitalizations have declined year-to-date. Obviously, there is large variation in the performance of individual companies. The technology companies mentioned above have seen their market capitalization increase in 2020. On the other extreme, the market capitalization of Norwegian Cruise Line has fallen by approximately 75% this year.⁹

What does this all mean from an impairment perspective? Again, it depends. If you are Norwegian Cruise Lines and your ships are all docked indefinitely, Coronavirus was a clear trigging event for impairment testing. Their intangible assets have been nearly written off entirely, and their tangible assets have been written down. If you are one of the aforementioned technology companies, intangible asset impairment testing may not occur until the end of your fiscal year. For everyone else, it is very industry and company dependent.

Finally, the companies in the S&P 500 are some of the largest, most well capitalized companies in the world. For many private, non-technology companies, the risks are far greater. This incremental risk, relative to the pre-COVID-19 market, reduces value for those companies even further. All of this should make for a very interesting next nine months of impairment testing.

Coronavirus Resource Center

Have more questions about the impact of the coronavirus on your business? Visit Marcum’s Coronavirus Resource Center for up-to-date information.

Sources

1. For accounting purposes, fair value is defined in ASC 820 as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
2. https://ipcloseup.com/2019/06/04/21-trillion-in-u-s-intangible-asset-value-is-84-of-sp-500-value-ip-rights-and-reputation
3. For accounting purposes H. J. Heinz Holding corporation was the accounting acquirer of Kraft.
4. https://www.sabrientsystems.com/blog/kraft-heinz-case-study-soft-asset-write-downs
5. S&P Capital IQ
6. July 31, 2020
7. https://www.slickcharts.com/sp500
8. Returns from https://finance.yahoo.com/
9. https://www.slickcharts.com/sp500