Intangible assets are sometimes the most significant asset on a company’s balance sheet. In the technology and life sciences sectors, those assets, which are specifically identifiable, include licenses, patents, intellectual property, and in-process research and development (“IPR&D”), among others. These assets are recorded on the balance sheet through a variety of means, including, but not limited to, business combinations, asset acquisitions, and internal development. Regardless of the means, once recorded, they all have one thing in common – they are subject to impairment analyses.
Those assets with finite lives (e.g. patent and technology licenses) are amortized over their estimated useful lives and analyzed for impairment whenever events or circumstances indicate the carrying amount of the asset may not be recoverable. Indefinite-lived intangible assets (e.g. IPR&D) are considered indefinite-lived until the project has been completed or abandoned and include those assets that have not reached technological feasibility and have no alternative future uses. These assets are tested for impairment annually or more frequently if events or changes in circumstances indicate the fair value of the asset is less than its carrying amount. The economic impact of COVID-19 is considered a triggering event under accounting principles in the United States, which has forced many companies into the “more frequently” category of an impairment analysis.
Qualitative vs. Quantitative Analysis
Impairment analyses take two forms – qualitative and quantitative. Companies are permitted to perform a qualitative analysis first. It is only when the qualitative analysis indicates it is more likely than not, or there is more than a 50% probability, that an asset is impaired that a company is required to perform a quantitative analysis, which requires an estimate of the fair value of the related asset. Estimating this fair value can be based on numerous assumptions and forecasts about future events, which is extremely difficult to prove to your auditors. The fair value of indefinite-lived intangible assets, for example, which has not been completed, generate no revenues, and have not been placed into production, is based entirely on something that may or may not happen. A well-thought-out and supportable qualitative analysis many times will eliminate the need for and cost of quantitative analysis.
Effect of COVID-19
The COVID-19 pandemic has raised the question from virtually all auditors to their clients, “What effect has the pandemic had on your intangible assets?” We are all aware of the stay-at-home orders and travel restrictions, as well as the general economic impacts of the pandemic. The key to answering the question about impairment and preparing a supportable qualitative analysis is for a company to have a strong understanding of its intangible assets. Suffice it to say, most accountants do not know or understand what a protein synthesis inhibitor is or what the technology is underlying a software-related intangible asset.
The mere existence of COVID-19 does not imply an intangible asset is impaired. In fact, the need for advances in technology and life sciences is probably at an all-time high. COVID-19 has forced companies to reevaluate their impairment analyses. More often than not, the process results in a more robust qualitative analysis, resulting in a single question to be answered: Was the company forced to abandon a project because of the pandemic? If so, your intangible asset is likely impaired. For a start-up company or one in the capital-raising phase, the effects of an impairment charge can be devastating.
Accountants and auditors are not scientists nor IT professionals. The accounting rules were written by accountants for accountants and are difficult for scientists and IT professionals to understand. It is important for the accounting department of a company to work with its scientists, valuation experts, and IT professionals to bridge that communication gap. In these situations, accountants and auditors will require additional time to work with groups that are normally not part of the accounting function to collect data, provide supportable analyses and assumptions and determine the effect of COVID-19 on both a micro and macro basis.
Additionally, impairment analyses require management to make estimates that can be subjective, which are generally more difficult to audit, and requires time for auditors to gain an understanding of and challenge the assumptions made by management. As a result, companies should begin the impairment analysis process early, have discussions with their auditors, scientists, valuation experts, and IT professionals, and be sure to document the entire assessment process.
If you have any more questions about COVID-19 affecting Impairment Analysis, please contact DMJ.