As we usher in the New Year, individuals and companies are surely looking forward to having a better and more prosperous year. It is not uncommon, therefore, for companies to find good investment opportunities.
Growing up, I subscribed to the Filipino concept of investment, which would either be acquiring properties, or investing in education. However, investment nowadays has become so diverse. Recently, investing in mutual funds and other investment bank products, and even trading in stocks, has become more common. While investment choices have developed over the years, weighing out risks and rewards is still key to making a wise decision to invest. Taking on an investment requires finding out which ones will provide the best returns, and deciding whether to hold or sell a particular investment.
Most of my clients find a similar situation when making an investment decision. For multinationals, investment policies are in place in order to explain to investors why certain investments have been made—usually to provide strategic value and drive company growth. Acquiring shares of stocks is not simply made to earn cash from dividends. It is either to gain a foothold on new potential businesses that will complement their objectives, or to integrate existing businesses to improve a company’s existing value chain. Such strategic measures give companies (investor) significant influence or control over other corporations (investee).
In making an investment, it is critical for companies to consider its accounting implications. For example, investors should know that having significant influence over a company is demonstrated not just by holding an ownership percentage of between 20 and 50 percent. It is also measured by qualitative factors, such as board representation, participation in the investee-company’s policymaking process, and material agreements or transactions that will allow accounting for such an investment as an associate by the investor. Presumptively, having more than 50 percent ownership in an investee-company is a clear evidence of control used to influence the investee’s relevant activities to generate returns. This investment is accounted for as a subsidiary.
Regardless of the type of investment, a fair value exercise must be performed upon acquisition. But when an investment in a subsidiary is recognized, this will potentially lead to a goodwill take-up in the consolidated financial statements, subject to impairment testing at least on an annual basis.
In a goodwill impairment testing, the accounting question is always whether or not an impairment has to be taken up. If an impairment is recognized, the resulting impairment charge is recognized as an expense and is not necessarily a deductible expense for tax purposes.
From my local and overseas audit experience, companies approach goodwill impairment testing differently. When applying International Accounting Standard (IAS) 36 impairment rules, the market value of investments in listed companies may be easily determined, compared with investments in private companies. If the market value is not calculable, the recoverable amount will usually be determined using discounted cash flow. It is in coming up with discounted cash flow where the accounting becomes complicated. Assumptions and parameters are embedded in doing the cash flow forecast, and in getting the discount rate and terminal value.
The discounted cash flow model uses internal and external information that should be understood and interpreted correctly in order to align the model with the company’s business.
Since internal information is directly embedded in any discounted cash flow model, it is important that discussions with different levels of management happen to support assumptions built into forecasts. For example, if a significant amount of revenues is based on fixed-term contracts, how likely are such contracts to be renewed to secure steady cash inflows?
External data, such as market or industry information, influences the discounted cash flow model when there are expectations on how a company will react to external developments—for example, projected revenue growth rates would ordinarily be comparable to industry growth rates.
It is easy to get lost when discussing goodwill impairment testing, yet it should not be taken in isolation. Test results will tell various stakeholders whether the investment made by the company was a good or a bad one. If it was a bad investment, then why does the company hold on to it? Management and the Board should be able to explain to various stakeholders the company’s investment strategies and decisions.
Goodwill impairment testing is also a test of recoverability. Investors are concerned about earning a greater return on investment (ROI). Impairment testing attempts to quantify that expectation. If the original ROI is projected to be lower than originally expected, goodwill is impaired. If ROI is better than expected, goodwill is not impaired but is not adjusted upward. That is being conservative for accounting purposes.
More than a compliance exercise, it is the responsibility of the company to report to stakeholders its investment performance and business synergies. While there is no way of opting out of a goodwill impairment testing, the best tips that I can offer is to start the impairment test early, involve the right people across different management levels and consider professional accounting and valuation assistance.
Accounting for investments and goodwill impairment testing does take a lot of effort to perform. It may be a ‘dip’ in financial reporting “to-dos,” but as with investing, dips only present opportunity.
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Ma. Lois G. Abad is a partner from Assurance, Accounting Consulting Services and Human Capital of Isla Lipana & Co./PwC Philippines. Email your comments and questions to firstname.lastname@example.org. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.