Big changes in market conditions and tax rules could drive some added rigor into the annual year-end test of goodwill sitting on corporate balance sheets.

Valuation and advisory firm Mercer is telling companies to start early and prepare for more questions from auditors about their conclusions regarding goodwill, which is an intangible asset on the balance sheet resulting from business combinations, like an acquisition. Although impairments, or writedowns, of goodwill smoothed out in recent years as the economy improved, changing conditions and mixed indicators suggest companies will have to give it more thought and scrutiny this year.

Under Accounting Standards Codification Topic 350, companies are required to test the value of goodwill sitting on their balance sheet at least annually to be sure it is holding up over time. Investors like to assess goodwill as a way of understanding whether a business acquisition is delivering value. The $22 billion impairment at General Electric, for example, suggests the company’s acquisition of a French power and grid business is not panning out.

“Really pay attention to how the market has been treating companies in your industry since the tax bill was passed,” says Travis Harms, senior vice president at Mercer, referring to the Tax Cuts and Jobs Act. “Be specific, and start planning early.”

Goodwill impairment testing has evened out a bit over the past few years after the Financial Accounting Standards Board simplified the testing exercise in 2016. Companies are now allowed to perform a qualitative test of goodwill to determine if it needs to be reduced on the balance sheet, and they are no longer required to perform a full fair-value measurement of all the assets and liabilities in a business unit to calculate the markdown.

Companies have had some practice with the newer approaches to testing goodwill, says Andrew Winters, a partner at Deloitte. “Since this is an established framework, it does help that people have been through several tests,” he says.

“You don’t want to go into impairment testing saying we’re going to pass because generally tax reform was favorable to us. Auditors are going to want concrete benefits that are accruing to the reporting unit. You need to be prepared to identify and quantify what those benefits are.”

Travis Harms, Senior VP, Mercer

While the rules around performing the test have not changed this year, the market conditions companies will have to assess to help them determine if their goodwill is holding up have changed dramatically. Tax reform, trade issues, and market volatility have produced plenty of big swings, some supporting values and some squeezing them. And if corporate values are moving up or down, that will have implications for the carrying value of goodwill sitting on the balance sheet.

“There are cross currents,” says Harms. “Tax reform was generally positive to values, but uncertainties regarding the economy are perhaps offsetting some of that.”

The Tax Cuts and Jobs Act reduced the top corporate income tax rate from 35 percent to 21 percent, which directionally supports valuations in general and therefore carrying values for units with goodwill. “With the drop in effective tax rates, that would seem to be a lift for companies when assessing goodwill for impairment,” says Winters.

Taxpayer friendly provisions in the tax law around depreciation also support valuations, and therefore goodwill, says Harms. Certain capital expenditures can be deducted from income immediately, which produces a faster tax benefit.

Where depreciation is accelerated, that generally suggests an acceleration of cash flow, which is also good news for valuations and goodwill, says Harms. “All else being equal, getting a dollar sooner than later is accreted to value,” he says.

Other effects from the tax bill, like changes in interest deduction limitations and a potential increase in the after-tax cost of debt, can put pressure on valuations, which add weight to the likelihood of a goodwill impairment. On balance, Mercer is predicting changes in tax law will generally indicate companies are less likely to have impairments to goodwill, but companies will have to go through their own processes to arrive at their own conclusions.

While tax rules qualitatively support goodwill carrying values, market volatilities can have the opposite effect. “Market volatility we’ve seen the past several months does reflect perhaps on the part of investors some uncertainty as to the economy,” says Harms. A flattening yield curve suggesting little difference between short-term and long-term bond rates also raises an eyebrow about market conditions. “That casts a little bit of a shadow over valuations," he says.

Uncertainties with respect to trade policies can also factor into the goodwill analysis, says Harms, and there’s plenty of uncertainty to consider, even after the mid-term elections. Tariff interventions on China are not settled, and negotiations or agreements are expected in 2019 with respect to the European Union, Japan, the United Kingdom, Mexico, and Canada. “The markets are still absorbing what the long-term ramifications of the change in trade policies will really be on cash flows,” he says. “Until we get a little further into this, it’s going to be really hard to say what the net outcome is going to be.”

According to Mercer’s analysis of S&P 1500 companies, which represent roughly 90 percent of market capitalization in U.S. exchanges, impairments are more likely in sectors such as energy and telecommunications. Data would suggest impairments are less likely in real estate, utilities, and industrials.

Nearly 40 percent of companies in the telecommunications sector that are carrying goodwill, for example, have cushions of less than 25 percent. Cushion is the amount by which market value of equity exceeds book value, so small cushions mean thin margins by which a company could pass the goodwill impairment test.

Given numerous indicators both supporting and undermining values, companies should expect no easy pass from auditors on goodwill impairment testing, especially based on qualitative factors alone. “You don’t want to go into impairment testing saying we’re going to pass because generally tax reform was favorable to us,” says Harms. “Auditors are going to want concrete benefits that are accruing to the reporting unit. You need to be prepared to identify and quantify what those benefits are.”