Goodwill Impairment Testing in Egypt Under IAS 36

In today’s complex business world, companies are under more and more pressure from all types of investors, auditors, regulatory bodies, and other stakeholders in relation to carrying amounts stated in their accounting statements. When it comes to the issue of goodwill, the above-mentioned problem becomes especially acute since usually the asset constitutes one of the biggest assets recorded in a company’s financial statement and also involves much judgement on the part of accountants. It should be noted that unlike other assets, goodwill cannot be depreciated using IFRS guidelines. According to the latter, a company’s goodwill must be annually assessed for impairment using IAS 36, Impairment of Assets, as well as any time the need for the asset’s assessment emerges due to specific conditions. At first sight, the task of such assessment may appear rather simple. However, in fact it is very challenging for it requires making certain estimations, applying specific methods, and using considerable amounts of judgement. Under current economic conditions that include economic instability, inflation, fluctuating rates of interest, etc., companies have to provide sound reasoning in relation to carrying amounts of goodwill and prove the accuracy and reliability of their impairment assessments. 

Understanding Goodwill Under IAS 36

Goodwill occurs where there is a difference between the total consideration paid by the acquirer for the combination and the fair value of the identifiable net assets acquired from the combination. Such excess value generally arises out of the benefits like synergies, relationships with customers, expertise of the employees, market position, and future growth potential, among others, which could not be identified as separate items. Goodwill being non-amortizable and without any cash generating potential and being inseparable from the underlying business entity, IAS 36 states that goodwill should be allocated to one or more CGUs based on the synergies generated by the combination. In contrast to tangible and finite-lived intangibles, goodwill is not subject to any systematic reduction in value over time. Thus, until an impairment occurs in the carrying amount of goodwill, the amount continues to reside on the books of account.

The Objective of Goodwill Impairment Testing

The main purpose of conducting impairment tests on goodwill is the identification of whether the carrying amount of goodwill can still be recovered. According to IAS 36, this process entails comparing the carrying amount of the concerned CGU, which includes goodwill, with its recoverable amount. The recoverable amount is regarded as the higher of two values, namely value in use and fair value less costs of disposal. The value in use is considered the discounted value of the future cash flows expected to be received from the CGU. On the other hand, the fair value less costs of disposal is regarded as the net value that can be received from selling the concerned CGU after deducting the related expenses for disposal. In case the carrying amount of the CGU exceeds its recoverable amount, then impairment losses need to be reported immediately.

Increasing Pressure on Carrying Values

For enterprises engaged in business operations within Egypt, there is an increasing challenge in terms of backing up the carrying amounts provided in the financial statements with respect to the goodwill associated with previous acquisition activity. During the past years, the economic situation in Egypt has changed drastically due to repeated devaluation of the Egyptian Pound, high inflation rates, high borrowing costs, as well as uncertainty in the economy. The changes have been directly linked to the assumptions that are made during the impairment process, namely projections concerning cash flow, growth, margin, and discount rates. In addition, companies using foreign inputs in their business processes have been hit hard by the depreciation of currency since it has led to the increase of their expenses and reduction of profits.

The problem has intensified since high-interest rates have raised the WACCs for corporations, causing lower enterprise values and increased emphasis on good will account balances. For several EGX listed firms, instances of volatility in the market have caused the market value to get closer to, or even fall below, the accounting book value of the firm’s equity – a specific example pointed out in the IAS 36 standard for a potential impairment condition. Such a problem has been experienced by firms operating in the real estate industry, the healthcare sector, the educational industry, manufacturing sector and alternative energy industry, among others, due to changes in economic environment. Thus, stakeholders including investors, auditors, financial analysts and lenders have expected firms to present justifications for their impairment tests, which involve presenting realistic forecasts, reasonable discount rates, and a proper sensitivity analysis among other things.

Defining Cash-Generating Units

Another very significant yet highly complex issue when performing goodwill impairment test relates to the determination of cash-generating units. Cash-generating unit, also known as CGU, refers to the smallest identifiable asset group which generates cash flows that are largely independent of other assets or other asset groups. Since goodwill does not create any independent cash flows on its own, it has to be assigned to those CGUs which will enjoy the synergies from the acquisition. It may be difficult, however, to determine the appropriate CGU in cases where the acquired companies have already been incorporated into other, larger business operations, especially if organizational changes have taken place since then. Some companies tend to assign their goodwill to too large a CGU, thus making it less likely that an impairment loss would occur. At the same time, others are willing to make changes to CGU structure without adequate economic rationale for doing so.

Forecasting Future Cash Flows

Cash flow forecasting plays an important role in the testing for goodwill impairment, as it is an essential element in estimating recoverable amounts using either of the two acceptable methodologies specified in IAS 36. Regardless of whether VIU or FVLCD approach is adopted, future performance will be of great significance. It is worth mentioning that entities normally make cash flow forecasts based on budgets and strategic plans, and they include projections about revenue growth, profitability, capital expenditure, changes in working capital, and long-term outlook for the business. While the most common approach to impairment testing is probably the one involving the calculation of VIU, there will be instances where the latter is likely to provide the higher recoverable amount, as in a situation in which market participants would place a higher value on the business compared to what was forecasted internally.

A major difficulty in the application of both models is that of heavy dependency on long-term assumptions, which are utilized in order to calculate the terminal value. In many cases, the terminal value may account for around 50%-80% of the overall recoverable amount; thus, being one of the most important parts of valuations. Minor shifts in long-term growth rates, expectations of margins or discounting rates can lead to a large difference in value estimation and can result in an impairment loss recognition. It is especially important for markets like Egypt, where inflation, fluctuations of foreign currency, and other economic changes can influence the business outlook in the long term. Thus, professional assessment of impairments should not be based only on results from the use of DCF techniques. Reasonableness testing should be performed by cross-checking market multiples, transaction comparable, reconciliation of the market capitalization of listed entities, and sensitivity analysis of assumptions.

Discount Rates and Valuation Sensitivity

The rate at which the assets are discounted is yet another assumption made within the value in use assessment method that may greatly affect impairment conclusions. IAS 36 stipulates that the rate used for discounting should be reflective of current market estimates of the time value of money as well as risks associated with the particular CGU being tested. Even minor differences in discount rates may result in large differences in the amount recovered. One of the common problems encountered in choosing appropriate discount rates are those relating to accurately reflecting market conditions, industry risks, geographical risks, and risks unique to the entity. Discounting becomes an even greater challenge during times of increasing interest rates and uncertainty. Another common error is making the assumption of out-of-date information or over-risking through the inclusion of similar risk factors in the cash flows and discount rates used.

Common Pitfalls in Goodwill Impairment Testing

Even with the comprehensive set of guidelines presented by IAS 36, there are a number of persistent problems that show up from time to time. They include too rosy forecasts by companies, lack of consideration of changed circumstances in terms of updated assumptions, and discount rate that is not reflective of reality at all. At times, goodwill allocation might also be inappropriate in terms of CGUs, thereby making any impairments harder to detect. There is also insufficient sensitivity analysis when recoverable amount does not considerably outweigh the carrying value. Poor documentation and non-specific disclosure may also weaken the process, making it hard for stakeholders to see the logic in management’s decision-making.

The Importance of Valuation Expertise in Goodwill Impairment Testing

Goodwill impairment analysis has indeed become more complicated over the past few years as businesses run in an environment with inflation, fluctuating interest rates, exchange rate changes, and changing economic conditions. Valuation professionals are particularly helpful in questioning management estimates, judging the reasonableness of assumptions, analyzing industry trends, and determining proper discount rates and long-term growth rates. The typical work for these valuation professionals would involve building and reviewing DCF models, calculating WACC, carrying out sensitivity analysis, and carrying out market comparisons to determine reasonable recoverable amounts. Another important function of valuation professional is the interpretation of what is required in IAS 36 where there is need for judgmental decisions. Over time, there has been more regulatory pressure and more investor expectations from organizations making it very crucial to have valuation experts involved in goodwill impairments analysis.

Conclusion

Goodwill Impairment Testing under IAS 36 has emerged to be among the most important topics in financial reporting, especially in an economy that is faced with economic uncertainty, increasing interest rates, high inflation, and fluctuating market conditions. Although the accounting principle outlines a procedure for the impairment test, the success of the test ultimately lies in the reasonableness of the assumptions made by management, the strength of the valuation technique used, and the extent to which the test takes into consideration the current state of the economy. Given that goodwill continues to be an important element in the balance sheet of many companies, impairment testing is no longer just an accounting test but also an exercise of great importance.

Impairment testing of goodwill in modern business should no longer just be seen as an annual requirement. Instead, this process needs to be approached strategically, by continually assessing performance, trends in the marketplace, and other economic factors. Companies that are unwilling to question their own assumptions, reevaluate their forecasts, adjust their discount rates, and take account of changes in the marketplace will be at a disadvantage since it will result in overvaluation and delayed recognition of economic impairments. This can create a significant risk for the company since stakeholders’ trust will be weakened. On the contrary, when companies engage in proper valuation techniques, utilize competent valuation skills, have strong governance controls, and disclose the necessary information, it is much easier for them to prove their carrying values of assets are correct.

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