The possible future economic impact of Covid-19 is creating a great deal of uncertainty for companies with imminent financial reporting requirements. Valuations of assets for financial reporting purposes which typically provide users with a valuation at a specific point in time are under pressure in a number of different ways.
Financial Reporting Valuations
In a recent letter to valuation practitioners, the technical standards boards of the International Valuation Standards Council (IVSC) addressed this issue directly, identifying three broad classes into which sources of valuation uncertainty can be categorised.
In this article, we will address the question of how these different types of valuation uncertainty should be considered by entities currently preparing their annual reports and financial statements.
Before considering the specific effect of Covid-19 on any valuation to be carried out for financial reporting purposes, it is important to note that the date of the valuation or assessment will have a significant impact on its magnitude.
There is a consensus that valuations and reporting as at 31 December 2019 should be unaffected by economic factors related to Covid-19. At this point in time, global supply chains and consumer behaviour were largely unaffected outside of China, and so the subsequent economic shutdown which took effect during the first quarter of 2020 is deemed to be a non-adjusting post-balance-sheet event for accounting purposes (unless there is a threat to an entity’s ability to continue as a going concern).
Likewise, in performing valuations as at 31 March 2020 or later, it is clear that this shutdown should be taken into consideration: economic conditions had shifted markedly by this point in time, and the impact of this change must be reflected appropriately in a company’s reporting.
However, entities with reporting dates which stand during the first quarter of this year – or otherwise having to perform valuations during this period – will be required to exercise judgement on the degree to which the economic conditions in which they operate had been affected at the relevant date.
These are certainly turbulent times which is having significant effect across many businesses and asset classes. This is, perhaps, best illustrated by the example of oil prices which plummeted into negative figures for first time in history as the coronavirus crisis impacted demand, ultimately wiping out hundreds of billions of dollars from company valuations.
Sources of valuation uncertainty
Where a company will have to reflect Covid-19-related valuation uncertainty in its valuations and reporting, this uncertainty will be caused by a number of different factors such as steps taken by the governments of countries to deal with the spread of the virus, the impact on supply chains or customer orders at that point in time and ultimately views on the duration and lasting impact of the virus.
In its letter, the IVSC identified market disruption, input availability and the choice of method or model as three different classes of uncertainty factor.
Valuations of financial assets
Market disruption factors could include panic buying or selling of – or a loss of liquidity in the market for – an asset, both of which would create significant uncertainty around the attitude of market participants to that asset. This is particularly pertinent for any financial assets held at fair value on a company’s balance sheet.
If the market for an asset is still active at the valuation date, then observable prices in that market must be used in assessing that asset’s fair value – regardless of any actual or expected future price movements after the valuation date.
However, a loss of liquidity could result in that market no longer being classed as active, meaning that the market price of that asset could no longer be classed as a Level 1 input in the fair value hierarchy set out in IFRS 13 ‘Fair Value Measurement’.
Level 2 and Level 3 inputs under IFRS 13 are self-evidently less robust measures of fair value than Level 1 inputs. Reliance on them in a valuation creates additional uncertainty because of factors in the IVSC’s two other identified classes, (i) method/model factors, as it will become necessary to value the asset under consideration in a different way, and (ii) input availability, as any Level 2 or Level 3 inputs used in such a model must be adjusted appropriately for the valued asset’s specific circumstances.
Valuations of non-financial assets
Input availability factors are similarly most likely to increase uncertainty in the valuation of non-financial assets, such as tangible fixed assets, intangible assets acquired in business combinations and goodwill.
This is most obvious in the case of goodwill, the recoverable amount of which is required to be assessed annually by IAS 36 ‘Impairment of Assets’. However, the economic consequences of Covid-19 during the first quarter of 2020 may have brought to a company’s attention indications of the potential impairment of other assets on its balance sheet.
One example of an indication of a potential impairment of a listed entity’s assets would be its market capitalisation falling below the book value of its net assets; this should be kept in mind even by companies that have recently completed their annual impairment test of goodwill, as such an indication would require another up-to-date assessment of its recoverable amount to be performed.
In assessing an asset’s recoverable amount, discounted cash flow calculations are often used to calculate its value in use (VIU). Where such calculations are performed for 2020 financial statements, it must be ensured that the inputs to the discounted cash flows are appropriately adjusted to reflect the economic impact of Covid-19.
This could cause a great deal of additional valuation uncertainty to arise: there may be insufficient objective, verifiable information available upon which to base updated projections of the asset’s future financial performance, or with which to adjust the discount rate used in the calculation to adequately reflect the increased level of risk to which it is exposed.
There is one alternative way to incorporate risk into a VIU calculation permitted by IAS 36, other than adjusting the discount rate. Rather than using a traditional cash flow approach – in which the most likely path for the asset’s future cash flows is selected and modelled, with any risk specific to the asset being reflected in the discount rate – a company could elect to use an expected cash flow approach.
This approach entails the preparation of an expected value calculation based on a number of different possible paths which the asset’s performance could follow and management’s estimated probability of each path being followed. If this exercise appropriately captures the impact of expected variations in the amount or timing of future cash flows as a result of economic risks (including Covid-19 risks) as accurately as possible, the discount rate used to translate the expected cash flows into a present-value figure will only be required to reflect the time value of money.
While this expected-value approach may lead to a potentially significant additional time costs and resources being incurred, doing so may more transparently reflect the uncertainty surrounding the future economic value of the asset in question. Entities will need to balance the cost of obtaining additional information for an expected cash flow approach against the reliability that information will bring to the measurement.
Whichever approach is taken, following the fundamental principles of valuation and reporting remains essential. Primarily, expectations around future performance employed for the purposes of IAS 36 reporting should be consistent with those presented in the rest of the company’s financial statements.
Disclosures relating to the sensitivity of a valuation to reasonably possible changes in assumptions may also take on additional importance in reporting; given increased valuation uncertainty, the range of scenarios deemed to be reasonably possible may be wider than usual. However, the IVSC has specifically stressed the need for caution in the presentation of quantified sensitivity analysis in the valuation of non-financial assets, as the disclosure of figures may imply a “false precision” to those relying on that valuation. Where quantified sensitivities are presented, it is paramount that they are accompanied by clear explanatory narrative disclosures which adequately address any heightened levels of uncertainty.
As a final point on non-financial assets, it is important to note that, while many companies will be making plans to restructure their business in expectation of a Covid-19-induced recession, under IAS 36 only restructuring plans which have been firmly committed to at a given valuation date may have their cost savings reflected in any VIU calculation.
Valuations of share-based payments
However, any such restructuring plans – whether committed or not – would require a company to reassess the number of awards expected to vest under its active share-based payment arrangements: redundancies or other terminations of employees may result in those individuals forfeiting their share options, and reduce the overall charge to be recognised in profit or loss in respect of the scheme.
Additionally, the expectations of future financial performance developed for other reporting purposes should be used in assessing whether or not non-market performance conditions (such as profit targets) attached to awards are likely to be achieved.
One circumstance in which share-based payments are required to be revalued is in the event of a modification to their terms and conditions; a company may wish to do so in the current environment in order to rebase any share-price targets to more achievable levels, thus mitigating the possibility that such a scheme would not provide an actual performance incentive. If the modification results in a higher fair value of the scheme, this additional amount must be recognised in profit or loss over the remaining vesting period – in addition to the original fair value over the original vesting period.
Finally, if a company elects to cancel an outstanding scheme, it will not avoid the profit and loss impact: such a cancellation is treated as an acceleration of vesting, with the remaining fair value recognised immediately in the income statement.
In summary, the economic impact of Covid-19 is clearly a cause of increased uncertainty among entities currently performing valuations for financial reporting purposes. While the degree of uncertainty will differ depending on the company’s individual circumstances and its valuation or reporting date, this is an inescapable fact in the current environment.
Uncertainty is not a reason to avoid updating relevant valuations or undertaking impairment tests. However, in seeking to mitigate the effects of this uncertainty as far as possible, it is essential that companies focus even more on a number of key principles of financial reporting valuation work:
- Seek to clearly understand specific risks to the business and reflect this understanding in the valuation inputs selected.
- Rely on external, observable data where possible in deriving these inputs.
- Use narrative disclosures in the notes to financial statements to explain assumptions, risks and degrees of uncertainty in words, rather than relying on quantification and the presentation of figures.
- Align the assumptions made in valuation work with the rest of the annual report and financial statements.
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