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Buyer Beware — or How to Prepare for an Impairment Test

23/12/2019


Old enough to remember the big dot-com boom and bust of the late 1990s? You’ve seen this before; Canada may now be reliving those days with the cannabis industry. Which means your external auditor will have “the talk” with you soon.

The impairment talk, to be exact. We all like to talk about revenue and profits, but, the impairment talk is your auditor discussing your balance sheet to see if the book value of your assets continues to be supported. Then your auditor will request you prepare an impairment test to see if the expected economic benefits of the asset continue to support book value.

For those companies which were aggressively acquisitive, the expectations for that promising cannabis concern might be less than were expected. And, because the industry was just starting out when the acquisition was made, a lot of your investment was recognized as goodwill, with fair value based on the promise of eager consumers.

For publicly traded companies, audit season – January to May – is coming up, and in some cases, auditors already are starting preliminary work to get ahead of the post-holiday rush. For many cannabis companies, that preliminary work translates into providing an impairment test to your auditors.

Future’s So Bright

In heady anticipation of the legalization of marijuana in Canada October 2018, analysts projected the industry would hit $6.5 billion in revenue by 2020, rising to $7.5 billion a year later. However, estimates were speculative because of a lack of historical data and statistics around cannabis consumption and production to base them on.

A year into legalization, CIBC analyst John Zamparo estimates producer sales will top out at $2.2 billion in 2020 – a third of consensus revenue estimates issued in 2018. A number of reasons are behind the dimmer outlook, including evolving federal and provincial legislation, supply chain challenges, lower than anticipated yields and sales and higher than expected taxes.

Companies such as Aurora Cannabis Inc., Canopy Growth Corp and Tilray Inc. have experienced reduced market capitalizations and their stocks have been challenged because of the headwinds. As a publicly traded cannabis company that acquired one or more other cannabis companies in the past year, you, too, will be expected to provide impairment tests to evaluate the fair value of those assets.

An impairment tests if you paid more for an asset than it’s now worth. If an impairment is confirmed by your auditors, a company’s reported net income is reduced because the impairment is recognized with an expense – a write down – on your income statement.

How Does It Work

In auditing your impairment test, your auditor will review your forecasted financial results for the next five years. The numbers need to be supported by ‘auditable’ information such as historic growth of product, yields, business activities, market-based studies and long-term contracts.

If your auditor can’t corroborate your support for the forecasts, they may consider last year’s projections and how they compare to what’s happened recently. If your forecasts can’t be audited, your auditor may reduce them substantially.

What does that mean for your company? Often, challenges facing a company are already factored into its share price. As well, since audits occur once a year, the market generally anticipates the likelihood of an impairment. In the case of cannabis concerns, the market has become well aware of disappointing sales, higher taxes and other issues pressuring companies.

But an impairment can also be a shock to your market price. One major cannabis producer writing off US$500 million at year end saw its share price tumble by 18 percent the following day.

Be Ready

When faced with an impairment test, your chief financial officer may choose to rethink how to proceed. Rather than preparing an impairment test yourself and stick-handling the audit process, many companies benefit from hiring a third-party. An experienced Chartered Business Valuator (CBV) who is well versed in fair value concepts and auditor interaction will simplify your impairment testing, reduce audit stress and ultimately your audit fee.

An experienced CBV will ensure the impairment test is done properly and is technically correct. They will work directly with the external auditor, allowing the CFO or controller to focus on the business itself.

For more information, contact Michael Sileika, National Leader, Valuations Services, at 604.637.1585 or [email protected]​​​.