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■ ANALYSIS |  IMPAIRMENT TESTING

GOODWILL ANDI

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 UK’s 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

THE FTSE 100’S CUMULATIVE GOODWILL – SMALLER THAN MARKETFALL – MAY SIGNAL THAT THERE IS MORE BAD NEWS TO COME,WRITES SIMON JONES 

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IMPAIRMENT TESTING | ANALYSIS ■

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 cashflowforecasts have been adjusted appropriately, there

should not be a material change in discount rate year-

on-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 tobe revised downward.

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

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 Appraisal’s

methodology relies on unweighted measures of centraltendency, both collectively and individually):

Pre-tax rates 2007/8 2008/9

Average 10.84% 11.54%

Median 10.64% 11.33%

Maximum 20.31% 19.06%

Minimum 6.00% 6.00%

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 whatthey may stand accused of by adopting

certain positions and, if necessary, call onthe counsel of an independent expert

Simon Jones CFA is senior

manager at valuation advisory

experts, American Appraisal

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 2007/8 2008/9

Average 2.84% 2.83%

Median 2.65% 2.75%Maximum 9.00% 8.00%

Minimum 0.00% 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 reporteda 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.

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

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 growthrate 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

Lower discount rate – higher growth rate 5

Lower discount rate – unchanged growth rate 6

Unchanged discount rate – higher growth rate 3

Lower discount rate – lower growth rate 4

Unchanged discount rate – unchanged growth rate 4

Higher discount rate – higher growth rate 11

Unchanged discount rate – lower growth rate 2

Higher discount rate – unchanged growth rate 5

Higher discount rate – lower growth rate 8

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 7½ times smaller than the fall in market

value may signal there is more bad news to come.