A complex issue

Understanding the impairment of non-financial assets must be a key priority for boards of directors as they enter 2017, writes Tony Featherstone.

The governance of impairments will be an even bigger issue for boards in 2017 as new audit rules lead to more information on asset valuations, and investor angst builds over the size and timing of writedowns, and their link with executive pay.

Few governance issues are more important or complex for boards than impairment testing on non-financial assets. This involves reviewing asset values to determine if they are fair or if they should be reduced. The requirement for all ASX-listed entities to provide information on Key Audit Matters (KAMs) in their audit report, from 15 December 2016, is expected to shine a spotlight on the processes and assumptions used to test and support asset values.

Several early adopters of this change in Australia have focused on asset valuations as KAMs, mirroring the experience of companies in the UK, which is three years ahead of this market in the provision of expanded audit commentary. Under the change, auditor commentary will describe why certain matters in the audit report were most significant and how the audit firm addressed them. The auditor, for example, might comment on why a cash-generating unit in a company was revalued, or not.

That, in turn, will give investors more information to scrutinise and greater scope to cross-reference KAMs against asset valuations in the balance sheet. The upshot: boards will need to be on top of their game with impairments.

Shifting landscape

“The landscape for boards on impairment testing is changing,” says Graham Bradley AM FAICD. “Impairments could be a real ‘sleeper’ issue for boards in 2017.” Bradley is non-executive chairman of HSBC Bank Australia and EnergyAustralia Holdings and a former chair of Stockland Corporation.

He says the process of reviewing asset values is among the most challenging governance tasks. “Decisions around impairments are often the most controversial judgements that the executive team, board and external audit firm have to make.”

The publication of KAMs, says Bradley, will add to the complexity of impairment testing in 2017. “There will be much more information in the public domain on this issue, and extra pressure on boards to justify asset valuations or any failure to impair them.” Bradley says every director must understand the accounting principles behind asset valuations. “Impairment testing is not something directors can just leave to the audit committee. Every director must be capable of questioning his or her organisation’s asset values and identify possible ‘red flags’.”

The landmark Centro decision in 2011, which said that all directors must have a workable knowledge of basic accounting principles, is applicable to asset impairments, says Bradley. “Directors, by law, must be able to understand the basics of asset valuations and impairment processes. I suspect we could see more boards challenged in this area in coming years.”

Australian Shareholders’ Association (ASA) chair, Diana D’Ambra MAICD, believes the publication of KAMs in audit reports will expand investor focus on asset impairments. “This information will prompt investors to ask more questions about impairments at annual general meetings, and lead to greater focus on this issue from fund managers, financial analysts and business journalists. Impairments have become a bigger issue in the UK since the adoption of KAMs there, and I expect to see the same trend in Australia.”

Misunderstanding impairment

D’Ambra says there is a lot of misunderstanding in the investment community about impairment testing. “It’s often a mystery as to when and why companies reduce the value of their assets and the processes and information used to get there. It’s almost impossible for investors to reconcile the size of a writedown using published company information.”

She welcomes greater disclosure of the process and assumptions used in the valuation of certain assets. “Investors should be better informed on the more contentious audit matters and how the organisation and audit firm approached those issues. Impairments rely on a series of judgement calls by the board and investors put their faith in directors. New information that better discloses the processes behind those judgements is a positive for investors.”

Whether this extra disclosure is a positive for boards remains to be seen. The potential gain is broader discussions between the board’s audit committee and the organisation’s external auditor, further elevation of the role of audit committees, and new insights for other directors into key audit risks and how they are being addressed.

Enhanced disclosure on impairment testing processes could also prompt more meaningful discussions between boards, institutional investors and proxy advisers on asset valuations, and feed into discussions on related issues, such as executive pay.

But the risk is this information exposes organisations and their boards to potential liability around the governance processes for impairments. Although the market typically factors in the likelihood of asset writedowns in a share price – often well before the impairment announcement – the writedown can affect the organisation’s balance-sheet strength, credit rating, cost of capital and capacity to raise debt or equity finance.

George Clapham MAICD, managing director of Arnhem Investment Management, a top-rated fund manager, says there is potential for shareholder class actions against organisations that are shown to have grossly overpaid for assets and had lax governance processes to value assets upfront and on an ongoing basis. “Boards are ultimately on the hook for organisations that are serial impairers of assets and destroyers of shareholder wealth,” says Clapham. “Directors are custodians of these assets on behalf of shareholders. It’s incumbent on boards to understand what these assets are worth, the main drivers of value creation, and be alert to anything that could reduce asset valuations.”

Market and regulatory pressure on impairments is not a new issue for boards. The ASX and Australian Securities and Investments Commission (ASIC) have increased their focus on the impairment of non-financial assets since the 2008–09 Global Financial Crisis (GFC). In 2015, ASIC published Information Sheet 203: Impairment of non-financial assets: Material for directors, a resource to help directors better understand asset impairments and the carrying value of non-financial assets in their organisation’s financial report.

ASIC’s review of the 31 December 2015 financial reports of 100 listed and other public interest entities led to 18 enquiries on 24 matters seeking explanation of accounting treatments. ASIC said the largest number of its findings continued to relate to impairment of non-financial assets and inappropriate accounting treatments.

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 2008–09 GFC, KPMG data shows. Twenty three companies recorded an impairment charge greater than $50 million.

Lower commodity prices, which led to heavy asset writedowns in the resource sector, explained just over half of the increase in impairment charges. Nevertheless, the jump in asset writedowns reflected some uncomfortable truths for corporate Australia: tens of billions of dollars of shareholder wealth destroyed; poor alignment between impairments and executive pay; and the potential for continued high volatility in asset values in the next few years.

Deborah Page AM FAICD, says the prospect of higher global interest rates in 2017 will add to governance pressures on impairment testing.

“Very low interest rates in the past few years have given boards more flexibility on asset valuations. Discount rates used in net present value calculations to support asset values have been pretty generous. Rising interest rates will test asset values and be another pressure point for boards.”

Page is a non-executive director of BT Investment Management and Brickworks. She says high-performing boards analyse impairments bi-annually and have directors who are always looking for indicators that the value of a cash-generating unit may need to be reduced.

“Typically, the audit committee leads the process, but all directors need to be prepared to ask the chief financial officer or chief executive officer (CEO) for clarification on whether an asset value is still supportable. Directors need to join the dots if they see trends that could affect the operating performance of a particular asset.”

Boards of large listed companies, generally, are adept at impairment testing, says Page. “Boards recognise this is a key issue. Their audit committees spend a lot of time on impairment testing, and external audit firms will work with boards on the issue and have sharpened their focus on the issue, partly as a result of regulatory surveillance.” The challenge, says Page, is shortening timeframes for asset impairments. “The fundamentals for asset valuations have not become harder, it’s just that there is less time for boards to move on impairments. The days of audit committees looking at asset values once a year are long gone.”

Further challenges

The volatility of inputs that support asset valuations, and determine impairments, is an ongoing challenge for boards. For example, resource companies in 2015–16 wrote off billions of dollars of asset value because of lower commodity prices. But minerals prices have roared back to life this calendar year and the writedowns cannot be reversed.

Rising regulatory risk is another factor. Britain’s referendum decision in June to leave the European Union, and Donald Trump’s ascension to US President-elect, add to market uncertainty about asset values.

Digital disruption is another impairment challenge. Banks, in particular, are expected to have larger writedowns in coming years for some technology investments that are quickly superseded by new software or have a shorter shelf life than expected. Further, the digitisation of business models is reshaping competitive landscapes and influencing asset values in industries where incumbent companies are prone to disruption from insurgent firms. More boards will have to question whether stated asset values are supportable if digital disruption makes some products redundant.

Bradley says the cyclical nature of impairments, and the fact that many writedowns are because of factors beyond the company’s control, strengthen the case to report underlying profit in addition to statutory net profit.

“It’s quite proper for companies to use underlying profit, which strips out one-off events such as impairments, so that investors can better compare operating performance across trading periods,” says Bradley. “The caveat is that the processes boards approve to determine underlying profit are applied consistently and transparently, and appropriately communicated to the market.”

But the use of underlying profit, as explained in ASIC’s Regulatory Guide 230, is becoming a bigger sticking point among proxy advisers and institutional investors. More than three-quarters of ASX 50 companies used alternative measures of financial performance in addition to their statutory profit in the year to 30 June 2016. Underlying profit exceeded statutory profit by 61 per cent, or $36 billion, found KPMG.

Impairments accounted for the main difference between underlying profit and statutory profit, leading some investors to claim that large listed companies – and by default their boards – are “massaging” earnings to make them look better. And worse, that the growing use and size of underlying profit, which relies on management and board discretion and is not audited, is creating too much potential conflict in executive pay.

There are arguments for and against the recognition of impairments in long-term incentive plans for executives. Asset writedowns are often the result of decisions taken years ago by previous management teams: for example, resource sector writedowns today for assets built before the 2008–09 GFC. Punishing executives for decisions made by others, years ago, is unfair. But investors want executives who oversaw the creation, expansion or purchase of assets – and their subsequent writedown – to share the pain with shareholders through lower pay.

“There is a reasonable argument that management should be bearing some of the cost of impairments in their long-term incentives,” says Michael Robinson MAICD, director of Guerdon Associates.

“If they (management) were there when the asset was bought, and if it is written down on their watch, the impairment should be recognised in measures for their long-term incentives.”

This is a grey area in corporate Australia. Statutory earnings per share accounts for asset impairments, but many companies use underlying earnings per share in calculations for performance hurdles for long-term incentives, which excludes impairments Some companies that use underlying earnings per share in executive pay plans still factor impairments into long-term incentives; others say they have discretion to recognise impairment in executive pay, based on the circumstances of the asset writedown.

Asset writedowns

A related issue is the criticism of boards for approving large asset writedowns when a CEO starts. Cynics say new management has too much incentive to clean up the balance sheet early in its tenure, reset market expectations and make it easier to lift the return on assets and achieve performance hurdles for their pay. A particular concern is a new CEO, appointed from inside the company, overseeing large asset writedowns where strategy has not changed.

However, there can be good reasons why the appointment of a new CEO triggers impairments. He or she may have been appointed to clean up a predecessor’s failed strategy, or might bring a new strategy to the organisation that affects its asset values.

“New CEOs tend to be quite aggressive on impairments,” says Robinson. “Increasingly, new CEOs are writing off some of the capital investment made by their predecessor in technology. Boards recognise an impairment is needed to reflect the true value of that technology.”

Robinson says departing CEOs should be required to impair assets before they leave, to present their successor with a cleaner balance sheet. “The assets are going to be impaired anyway. It makes more sense for departing CEOs to oversee the impairment and be incentivised to ensure the company performs well after they leave, by having long-term incentives that remain ‘on foot’ after their departure.”

AICD senior policy adviser, Kerry Hicks, says boards must be prepared for greater market and regulatory scrutiny on impairments, particularly with the introduction of long-form audit reports. “ASIC, appropriately, has increased its focus on the impairment of non-financial assets, which tend to be very material when they go through the financial accounts. Directors need to be aware of a range of indicators that can trigger impairment calculations and be across what can be a very complex issue.”