Financial reporting challenges in an economic downturn

 

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Iain Selfridge:

The current environment, economically at least, isn’t actually much better than it was two or three years ago, but we still find there are an awful lot of companies with goodwill and intangible assets on their balance sheet that haven’t apparently suffered many impairments in the last couple of years. And as we start to look ahead to the next year end for December companies coming up it is probably a good time to pause and reflect and see if some of the things that you might have been building into your models might need to be adjusted. An example would be looking at external factors. So if you have a listed company, if its market capitalisation is less than its net assets that’s an indication that the market is valuing you at less than your assets are seemingly worth. So the question of course is who is wrong, are your assets overstated or does the market not see the value in your business? But it’s something to consider.

The next one is when you look at your discounted cash flow models, looking at the cash flows for the next two or three years, are they perhaps a little bit too aggressive, are you assuming increase in growth in cash flow rates when actually the market out there at the moment is pretty stagnant and is that a reasonable thing to choose.

The other one to look at are your terminal growth rates when you get to the end of your discounted cash flow forecasting. Are your terminal growth rates the right level, again maybe there has been a long-term shift in the economies of the world which means that those numbers are coming down and have you reflected that appropriately in your model.

In the current economic environment you not only have to worry about impaired assets; there are also other things that might well be affected as a result of the poor trading conditions we have at the moment. So some things that might affect your financial statements, either from an accounting or disclosure perspective would include, for example, whether you have changed your trading terms recently. If you’ve changed the way you deal with your customers that might have an impact on when you can recognise revenue and also on how much revenue you are allowed to recognise. There’s also an associated one which is around bad debts and whether or not you will actually be paid by your customers, so both of those have some impact perhaps on the top line but also on your operating expenses.

Another area to consider is the recoverability of deferred tax assets. If you have those and they’re on your balance sheet, you’re supposed to really look at the fact of whether or not you’re going to make taxable profits in the future. That’s tied with future cash flows which has a link back to your impairment testing. So you should expect to have consistent rationale behind whether or not you are assets are impaired or your deferred taxes are recoverable.

And then lastly, we have the spectre of the eurozone hanging over us. Will or won’t a country like Greece, or Ireland, or Spain exit? If they do what will that mean to your business? How heavily involved are you in trading with either suppliers or customers in the eurozone? And do you have a plan if the banks all suddenly freeze up and it stops for a bit? Most well organised companies have at least thought about whether or not they’re impacted and have some kind of idea about what they might do next. Although it is fair to say, I think, an awful lot of people are just waiting to see what happens. I think the better prepared of us will have at least thought about it before it does.

Despite the current economic downturn, companies and groups are still holding significant amounts of goodwill and intangible assets; relatively few companies are booking impairments. Here are some points to consider when performing your impairment reviews:

  • Are you considering external factors? A recent study showed that 89 companies in the FTSE 350 were trading at prices lower than their book values.
  • Are you forecasting rapid increases in cash flows despite a stagnant market? Sales derived from government spending are unlikely to grow for a number of years.
  • Do the terminal growth rates and discount rates fairly reflect the long-term expectations? Nominal long-term growth rates in excess of long-term nominal GDP growth imply the growth of the business will eventually exceed growth in the economy.

Other issues to consider for your financial statements are as follows:

  • Does changing the sale terms affect the timing of revenue recognition? Offering extended payment terms might delay the transfer of the risks and rewards of ownership if other conditions are also included.
  • Is there increased exposure to bad debts? Customers based in or heavily dependent on troubled economies might require an increased provision.
  • Are deferred tax assets recoverable? To recognise tax assets arising from previous losses brought forward, current forecasts should show sufficient taxable profits. Are the forecasts of future profits/cash flows used for assessing deferred tax assets and potential asset impairments applied consistently?
  • What would be the impact if one or more countries left the eurozone? A number of big companies are planning for the eventuality and identifying actions to mitigate the impact on the company.

For further information please contact your PwC contact.