Measuring goodwill in times of inflation and a turnaround in interest rates
Introduction
Goodwill can be created on the balance sheet in the course of the acquisition of another company and constitutes an intangible asset that cannot be sold independently. In subsequent accounting periods, the Commercial Code (Handelsgesetzbuch, HGB) provides for scheduled amortisation of the goodwill that has been recognised in the balance sheet; however, under IFRS an annual impairment test has to be performed in order to determine whether or not a write-down is necessary.
Please note: An unscheduled write-down of goodwill would be required if the carrying value exceeds fair value (HGB) or the recoverable amount (IFRS).
Inflation and the rise in interest rates as risk factors for unscheduled write-downs
Impairment testing is currently of great importance in view of the persistent inflation and increased interest rates. This is because, in practice, the fair value or the recoverable amount is frequently determined by discounting the expected future cash flows of the underlying cash generating unit by an adequate rate for the cost of capital.
If the starting point is such a calculation of the value and a consideration of the nominal value then, in theory, taking inflation into account would generally result in higher future cash flows and – when considered separately – would have a value-enhancing effect. By contrast, the rise in interest rates would lead to higher rates for the cost of capital and have a value-reducing effect.
In practice, the projection of future cash flows is normally based on an integrated forecast plan. Taking inflation into account can result in price increases being taken into consideration in the anticipated expenses. It is questionable whether these price increases would even be fully reflected in the sales revenues. They could definitely have negative implications for margins and ultimately for the cash flows to be valued. Moreover, in the face of persistently high inflation and, at the same time, a rise in interest rates, macroeconomic expectations are more likely to be subdued and would furthermore result in rather pessimistic projections. Ultimately, the impact on the forecast of expected future cash flows will depend on the sector, the competitive environment and the ability of individual companies to quickly adapt to the changing general conditions.
Besides inflation and the macroeconomic conditions, the increasing rates for the cost of capital, in particular, will have a considerable impact on the measurement of goodwill. For example, the base rate of interest went up from 0.1% as at 31.12.2021 to 2.75% as at 31.12.2023. This implies an increase in the rates for the cost of capital that are used in the valuation calculations and a decrease in the company value or the market value of the equity capital. Insofar as the market value of the debt capital remains the same, the debt ratio will go up.
Lower cash flow forecasts as well as higher rates for the cost of capital could thus result in the carrying value of the goodwill no longer being covered by its fair value or recoverable amount and unscheduled write-downs would then be necessary.
Please note: As a result, these write-downs would reduce the equity on the balance sheet and, thus, the equity ratio of the company.
Conclusion: Admittedly, when performing an impairment test in respect of the goodwill on the balance sheet a case-by-case analysis is required. However, the observed factors could generally result in unscheduled write-downs of the goodwill. In particular, companies that prepare accounts according to IFRS, where goodwill is not amortised on a scheduled basis, have a greater risk here.