Pressure rising on impairment testing

Directors need to be alert to flawed or outdated assumptions behind asset valuations, as the focus on impairments continues.

Boards must ensure their organisation has robust systems for asset writedowns, as the market loses patience with impairment charges and their effect on reported profits. Few governance issues are more important – or complex – than impairment testing on non-financial assets. This involves reviewing asset values in the company’s balance sheet to determine if those values are fair or if they should be reduced.

Non-financial assets, often significant company assets, provide vital information on a range of company valuation and performance metrics for investors. Impairment charges for ASX 50 companies were $38 billion in the year to June 2016 – more than double the 2015 amount and the highest since the 2008 GFC, KPMG data shows. Falling commodity prices triggered heavy asset writedowns in resources companies.

BHP Billiton, Rio Tinto, Santos, Orica, Woodside Petroleum, Woolworths and Wesfarmers reported significant asset writedowns in the latest profit reporting season. These and other impairments contributed to a 43 per cent fall in combined annual statutory profit before tax (PBT) to $44 billion for ASX 50 companies for the year to June 2016, KPMG found.More than three-quarters of ASX 50 companies used alternative measures of financial performance in addition to their statutory profit, as permissible under Australian accounting standards and as explained in ASIC Regulatory Guide 230. Pre-tax alternative results – the figure that often headlines company earnings announcements and is picked up in the media – exceeded statutory PBT by 61 per cent, or $35 billion, said KPMG.

Impairments accounted for the main difference between alternative profit measures and statutory PBT, leading some investors to claim that large listed companies – and by default their boards – are “massaging” earnings to make them look better.

The prominent fund manager, Peter Morgan, told the Australian Financial Review in mid-September that top ASX companies were using “skulduggery” to boost their profits and executive bonuses, and hide billions of dollars of asset writedowns.

Proxy adviser Ownership Matters found almost two-thirds of companies adjusted profits higher than statutory earnings in their unaudited earnings disclosures, based on analysis of 253 companies in the ASX 300 index that reported in the latest earnings season. “The use of restated, underlying or adjusted profits is becoming too commonplace,” wrote Ownership Matters equity analyst, James Samson. “The market is becoming accepting of management’s version of profits and ignoring the audited accounts. The bias that shows through in restatement practices on the ASX should be a warning bell for any investor seeking to conduct due diligence on their investments.”

A leading fund manager, under the condition of anonymity, told me about his growing dismay at the blow-out in impairment charges and questioned whether boards are on top of the process. “All too often, companies write down assets when a new CEO starts, to lower market expectations and make it easier for the new CEO to achieve his or her performance targets,” he said. “Boards should do their job and ensure assets are written down as needed.”

This issue could intensify, given the prospect of rising United States interest rates in the next 12 months, which in turn will affect global rate settings. Record-low rates, used in discounted cash analysis to determine asset prices, have given companies more “wriggle room” in asset valuations. That could change if inflation expectations build and interest rates rise faster than expected.

The potential for further market shocks in the next 12 months could also test asset valuations. Britain’s surprise referendum decision in June to leave the European Union and sharemarket volatility in the lead-up to the US presidential election reinforced the fragility of investor sentiment and asset prices.

Moreover, the requirement to include communication on key audit matters in the audit report in the financial report for Australia listed entities could increase the spotlight on asset impairment testing. All ASX-listed entities have to provide information about Key Audit Matters (KAMs) from December 15, 2016.

If Australia follows United Kingdom trends on KAMs, an auditor might, for example, comment on a property valuation or goodwill impairment, and the approach used in the audit. The upshot is more information on the process to test valuations – and any differences between the view of the board and audit firm on KAMs - for investors to pour over. Clearly, investor angst is growing towards boards that have overseen billions of dollars in shareholder wealth destruction via asset writedowns, or where organisations have taken too long to revalue assets because companies were not on top of impairment testing.

But are these concerns warranted? Large impairment charges across a number of companies are often cyclical and lumpy: the response by resource companies to lower commodity prices, which had been falling for a few years before a 2016, is an example. Corporate Australia may have seen the bulk of asset writedowns, at least in the current business cycle.

Criticism about organisations writing down assets soon after a new CEO joins also warrants scrutiny. Often, an external CEO joins because of poor performance from the previous CEO. Asset writedowns are the result of previous bad strategic decisions.

Of more concern is when companies have heavy writedowns when an internal CEO replaces the incumbent in a smooth succession process. Investors deserve an explanation when large impairment charges occur and corporate strategy is unchanged.

Boards are on notice: the Australian Securities and Investments Commission (ASIC) has increased its market scrutiny of impairment testing and the approach of audit firms in this area. ASIC’s review of the December 31 2015 financial reports of 100 listed entities lead to 18 enquiries on 24 matters seeking explanation of accounting treatments. Eleven of these enquiries related to asset impairment. ASIC Commissioner John Price said in a statement: ‘The largest number of our findings continue to relate to impairment of non-financial assets and inappropriate accounting treatments. Directors and auditors should continue to focus on values of assets and accounting policy choices in preparing their … financial reports.’

My main concern is the growing growing difference between statutory PBT and alternative profit measures – and how those alternative measures are being used, such as in determining executive performance targets and pay.

One understands companies presenting a truer picture of their operating performance to the market by stripping out one-off impairment charges. But there are limits to how far this trend should be taken. Impairments are a recognition that funds invested in the past are worth less, or are worthless, today. They should not be glossed over in investor communication.

Companies that consistently promote inflated profit results, based on unaudited alternative profit measures that rely on management judgement, do investors a disservice.

The lesson for boards, as always, is to ensure their organisation has robust systems and processes to test the assumptions behind valuations of cash generating units (CGUs), and that there is appropriate market disclosure around impairments.

Although this is chiefly an issue for audit committees, all directors of listed companies should be across this issue as part of an annual or biannual formal impairment testing process, and regularly looking for red flags that suggest asset valuations are no longer realistic and should be reduced.

Good directors proactively probe and test management assumptions in a collegiate board environment – a skill that will be in even greater demand as asset valuations become more volatile and as market tolerance for large impairment charges wanes.

Tony Featherstone is Consulting Editor of the Governance Leadership Centre.