Impairment Testing Methods for Goodwill

In the dynamic world of mergers and acquisitions (M&A), goodwill often represents a significant portion of a company’s balance sheet. However, economic volatility, regulatory changes, or operational setbacks can erode its value, necessitating rigorous impairment testing. In India, where sectors like telecom, banking, and IT have witnessed high-profile acquisitions and subsequent impairments, understanding testing methodologies is crucial for compliance with Indian Accounting Standards (Ind AS) and maintaining financial transparency. This blog explores the methods prescribed for goodwill impairment testing in the Indian context, their practical challenges, and sector-specific applications.

The Regulatory Framework: Ind AS 36

Under Ind AS 36 – Impairment of Assets, companies must test goodwill for impairment at least annually or whenever indicators of impairment arise. Unlike tangible assets, goodwill cannot be amortized; instead, its value is preserved unless impaired. The standard mandates a structured approach:

1. Identify Cash-Generating Units (CGUs): Goodwill is allocated to CGUs (or groups of CGUs) expected to benefit from synergies.
2. Determine Recoverable Amount: Compare the carrying value of the CGU (including goodwill) to its recoverable amount—the higher of:
   • Value in Use (VIU): Present value of future cash flows from the CGU.
   • Fair Value Less Costs of Disposal (FVLCD): Estimated selling price minus disposal costs.
3. Recognize Impairment Loss: If the carrying amount exceeds the recoverable amount, the difference is recognized as an impairment loss.

For goodwill, a two-step impairment test is applied:

• Step 1: Test the CGU (with allocated goodwill) for impairment.
• Step 2: If impaired, allocate the loss first to goodwill, then to other assets proportionately.

Key Impairment Testing Methods

Key Impairment Testing Methods provide structured approaches to assess asset recoverability, ensuring financial statements reflect true economic value. The primary methods include:

1. Value in Use (VIU)

VIU is a forward-looking metric based on discounted cash flow (DCF) projections. It reflects the CGU’s capacity to generate cash flows in its current state, excluding future restructuring or improvements.

Steps to Calculate VIU:

• Forecast Cash Flows: Use budgets/estimates for up to 5 years, approved by management.
• Terminal Value: Estimate cash flows beyond the forecast period using a stable growth rate.
• Discount Rate: Apply a pre-tax rate reflecting current market assessments (e.g., Weighted Average Cost of Capital (WACC)).

Indian Context:

• Challenges:
  • Volatile Markets: Sectors like renewables or infrastructure face unpredictability in cash flows due to policy shifts (e.g., GST, FDI rules).
  • Data Reliability: Startups or niche sectors lack historical data, complicating forecasts.
• Example: A Tata Group subsidiary in the EV sector might project lower VIU due to delayed FAME-II subsidies or supply chain bottlenecks.

2. Fair Value Less Costs of Disposal (FVLCD)

FVLCD estimates the price a CGU would fetch in an orderly transaction between market participants. This method is preferred when active markets exist.

Valuation Techniques:

• Market Approach: Use comparable transactions (e.g., recent M&A deals in the sector).
• Income Approach: Capitalize future earnings (similar to VIU but from a market participant’s perspective).
• Cost Approach: Replacement cost of assets (rarely used for goodwill).

Indian Context:

• Challenges:
  • Liquid Markets: Few sectors (e.g., IT, pharma) have active buyers, making FVLCD subjective.
  • Regulatory Hurdles: SEBI’s strict valuation norms require independent appraisers, increasing compliance costs.
• Example: During the 2020 Yes Bank reconstruction, FVLCD estimates for its subsidiaries were revised downward due to eroded investor confidence.

3. Two-Step Impairment Test

Unique to goodwill, this method ensures that impairment losses are allocated systematically.

Step 1 – CGU Impairment Testing:

• Compare CGU’s recoverable amount (VIU/FVLCD) to its carrying value (including goodwill).
• Impairment exists if carrying value > recoverable amount.

Step 2 – Loss Allocation:

• Write off goodwill first.
• Remaining loss (if any) is allocated pro-rata to other assets in the CGU.

Example:
If a Bharti Airtel CGU (with ₹1,000 crore carrying value, including ₹300 crore goodwill) has a recoverable amount of ₹800 crore:

• Impairment Loss: ₹200 crore.
• Allocation: Entire ₹200 crore is deducted from goodwill, reducing it to ₹100 crore.

Sector-Specific Applications in India

Sector-Specific Applications highlight how different industries in India face unique challenges in impairment testing due to market dynamics, regulatory changes, and economic conditions. Key sectors include:

1. Telecom Sector

The Indian telecom industry, marred by pricing wars and AGR dues, has seen massive goodwill impairments.

• VIU Challenges: Jio’s disruptive pricing forced incumbents to revise cash flow projections.
• FVLCD Challenges: Reliance Communications’ asset sales faced delays due to litigation, lowering FVLCD.

2. Banking & Financial Services

Post-NPA crises, banks like ICICI and Yes Bank reassessed goodwill from acquisitions.

• VIU Focus: Stress-testing cash flows against RBI’s NPA resolution timelines.
• FVLCD Limitations: Weak buyer appetite for stressed assets during COVID-19.

3. IT & Startups

High valuations in India’s startup ecosystem (e.g., Paytm, Byju’s) raise impairment risks.

• VIU Adjustments: Downward revisions due to funding winters or regulatory scrutiny (e.g., ED investigations).
• FVLCD Uncertainty: Few buyers for loss-making unicorns.

Challenges

Challenges in the Indian Context highlight the complexities businesses face in accurately assessing impairment, driven by data limitations, economic instability, regulatory oversight, and subjective assumptions. Key challenges include:

1. Data Scarcity: Limited market data for niche sectors (e.g., green energy) complicates FVLCD.
2. Economic Volatility: Currency fluctuations (INR vs. USD) and inflation impact discount rates.
3. Regulatory Scrutiny: NFRA mandates detailed documentation of assumptions, inviting auditor pushback.
4. Subjectivity in Projections: Overly optimistic management forecasts (common in family-run businesses) skew VIU.

Best Practices for Indian Companies

Best Practices for Indian Companies ensure a robust approach to impairment testing, enhancing accuracy, compliance, and financial transparency. Key recommendations include:

1. Stress-Test Assumptions: Model worst-case scenarios (e.g., policy changes, commodity price shocks).
2. Engage Independent Experts: Use third-party valuers to validate FVLCD in contentious sectors.
3. Align with Ind AS 36: Document discount rates, growth assumptions, and sensitivity analyses.
4. Regular Monitoring: Track CGU performance quarterly, not just annually.

Questions to Understand your Ability

Q1.) Under Ind AS 36, how is goodwill impairment tested?

A) Through annual amortization of goodwill
B) By comparing the carrying value of the CGU with its recoverable amount
C) By applying a fixed depreciation rate to goodwill
D) By revaluing goodwill based on inflation rates

Q2.) What is the primary difference between Value in Use (VIU) and Fair Value Less Costs of Disposal (FVLCD)?

A) VIU is based on market prices, while FVLCD is based on internal projections
B) VIU focuses on discounted future cash flows, while FVLCD estimates market-based selling price minus disposal costs
C) VIU is always higher than FVLCD
D) FVLCD considers future restructuring plans, while VIU does not

Q3.) Why is the two-step impairment test applied to goodwill under Ind AS 36?

A) To ensure impairment losses are first allocated to goodwill before other assets
B) To allow companies to reverse goodwill impairment later
C) To apply different discount rates for VIU and FVLCD
D) To amortize goodwill over time

Q4.) What is a key challenge in applying FVLCD in the Indian context?

A) Lack of active buyers in many sectors, making valuations subjective
B) Frequent changes in Ind AS 36 regulations
C) Absence of discount rates in Indian markets
D) FVLCD is not applicable in India

Q5.) Why is impairment assessment particularly challenging for Indian startups and IT companies?

A) Startups do not generate cash flows, making impairment tests unnecessary
B) High initial valuations and funding uncertainties impact future cash flow projections
C) Startups do not follow Ind AS 36 regulations
D) Goodwill impairment for startups is automatically reversed within five years

Conclusion

In India’s fast-evolving economy, impairment testing of goodwill is not just a compliance exercise but a strategic tool to safeguard stakeholder interests. While VIU and FVLCD offer structured methodologies, their success hinges on realistic assumptions, sector-specific adaptations, and regulatory adherence. As Indian companies navigate post-pandemic recovery and global uncertainties, robust impairment testing will remain pivotal to financial integrity and sustainable growth.