Six months after the deal, which forecast is used in the impairment test?

A business is acquired. The acquisition forecast includes growth and savings expected from bringing the businesses together. Six months later, the same business is tested for impairment, and the forecast looks quite different to the forecast that supported the deal. This was the example explored during a recent IVSC and CA ANZ panel on valuations for financial reporting in Australia and New Zealand, which Ishan Chopra, Partner, Deal Advisory, joined as a valuations expert.

The question: Which forecast is right?

Potentially both.

The acquisition forecast reflects what was expected at the transaction date. Whereas the impairment forecast needs to reflect the requirements of AASB 136 at the impairment testing date. Further detail on AASB 136/IAS 36 can be explored in our article, ‘Accounting for impairment of assets’.

The important question is not whether the forecasts are identical. It’s whether the differences can be explained.

The deal model: a starting point, not the impairment forecast

Goodwill arising from an acquisition is allocated to the cash-generating units (CGUs) expected to benefit from the business combination (AASB 136, paragraph 80). Once allocated, the relevant unit must be tested individually.

For businesses acquired late in the financial year, there may only be a matter of months between the acquisition valuation and the first impairment test.

That makes the acquisition model an obvious starting point, but it does not make it the impairment forecast.

For a value-in-use calculation, AASB 136 requires cash flow projections to be based on reasonable and supportable assumptions, with greater weight given to external evidence (paragraph 33). Importantly, the cash flows reflect the asset in its current condition.

Paragraph 44 excludes future cash flows expected to arise from a future restructuring to which the entity is not yet committed, or from improving or enhancing the asset's performance.

That distinction can matter soon after an acquisition.

The deal may have contemplated integration initiatives, operational changes or other benefits that do not belong in the value-in-use forecast.

There can also be a more fundamental allocation issue. Goodwill is tested in the units expected to benefit from the combination. If some acquisition benefits are expected to arise elsewhere in the group, they may not appear in the acquired business's stand-alone forecast at all.

And, of course, six months of actual trading and market movement may have changed the outlook.

The forecasts can legitimately differ. What should not differ without explanation is the story behind them.

A simple comparison between the acquisition and impairment forecasts is below:

Acquisition forecast	Impairment forecast
Supports the transaction decision	Supports the impairment assessment
Reflects expectations at the transaction date	Reflects conditions at the testing date
May incorporate expected integration benefits	Must comply with AASB 136 requirements
Starting point for comparison	Needs its own supportable assumptions

 

From deal model to impairment model

The auditor is likely to put the models side by side. This is where the issue becomes practical.

ASA 540 requires the auditor to consider whether significant assumptions are consistent with each other and with those used in other accounting estimates (paragraph 24(c)).

An acquisition valuation and the first impairment test of the same business are an obvious comparison.

Suppose the acquisition model assumed 10 per cent revenue growth and six months later the impairment model assumes 5 per cent. That does not necessarily indicate a problem.

But there should be an answer to the following questions:

• What has changed?
• Was it the actual performance?
• Was it the market environment?
• Was an assumption inappropriate for the relevant CGU?
• Or has management simply changed its view?

The explanation determines how that movement is classified. If it reflects an acquisition assumption that the impairment requirements do not permit, it is a required change. If it reflects actual trading or market evidence, it is a change supported by new information. If neither explanation is supported, it remains an unexplained change.

The difficult audit conversations tend to arise when that bridge has not been prepared and the explanation has to be reconstructed after the valuation is complete.

Build the bridge before building the valuation

For the first impairment test following an acquisition, one of the most useful pieces of analysis is also one of the simplest:

Reconcile the impairment forecast back to the acquisition forecast.

Assign each material movement to one of three buckets.

• Required change: The impairment requirements mean the acquisition assumption cannot be carried across in its original form.
• Change supported by new information: Trading, market conditions or other supportable evidence has changed since completion.
• Unexplained change: The movement does not yet have sufficient support and needs to go back to management.

An unexplained difference is not automatically wrong, evidence may exist but has not yet been brought into the reconciliation. Establish what supports the movement, then consider whether probability weighting, sensitivity analysis or additional disclosure is needed.

But it should not simply disappear.

That reconciliation can become an important part of the evidence supporting the first impairment test.

Only after the cash flows have been established should attention turn to the discount rate.

The discount rate

The discount rate reflects the time value of money and the risks associated with the expected cash flows, to the extent those risks are not already reflected in the cash flows themselves. The weighted average cost of capital (WACC) commonly informs the assessment of that rate.

There is often enormous attention on what the impairment discount rate is, for example, 11.0 per cent or 11.5 per cent.

The choice of rate deserves careful scrutiny. The point is not to give it less attention, but to assess it against a clearly established set of cash-flow assumptions.

The same risk should not be reflected twice. Once the cash flows are established, calibrate the discount rate consistently with those cash flows, checking which risks are already reflected in the forecast.

The practical takeaway

The first impairment test after an acquisition should not start with a blank spreadsheet.

Start with the acquisition case.

Build a bridge to the impairment forecast.

Identify what has changed because the accounting requirements demand it, what has changed because the business or market has moved, and what still does not have an explanation.

Then turn to the valuation mechanics.

Six months after a transaction, the question is rarely why the two forecasts are different. The important question is whether you can explain why.

A well-supported impairment assessment starts with understanding what has changed since the transaction, and why. Our valuation experts work with businesses to test assumptions, support valuation analysis and prepare for audit scrutiny.