01 Sep 2020
Impairment of Assets Cannabis Industry Canada
In this blog post, our Manning Elliott tax experts take a look at the impairment of assets in the cannabis industry following the cannabis market crash.
Up to and after the legalization of cannabis in Canada on October 2018, the industry was buzzing with M&A1 activity. The uptick in acquisition activity amongst industry constituents did not come as a surprise as many entities saw value in acquiring other companies that had a license in place or was in process of obtaining a license2 approved by the Federal Government of Canada.
Optimistic analyst forecasts and estimates further fueled the cannabis market frenzy during this time.
For acquisitions that qualify as a business combination, as defined in IFRS 3 – Business Combinations, we usually see a large portion of the purchase price (i.e. fair value of consideration) allocated to goodwill and license(s). Depending on the acquisition target, there may also be value allocated to brand and customer relationships.
However, significant market declines in major cannabis companies starting in April 2019 have shone a spotlight on these intangible assets and whether any qualify as an impairment of assets.
Impairment of Assets IAS 36
Under IAS 36 – Impairment of Assets, the acquiring company that have reported goodwill and indefinite life intangible assets are required to test for impairment at least on an annual basis. While the impairment test date does not need to be at the year-end date, the year-end date typically is the most common date for the impairment of assets test.
Companies are also required to assess, for each reporting date, whether there were any indicators of impairment in place.
While goodwill and indefinite life intangible assets are assessed on an annual basis or whenever there is an indication that the asset may be impaired, intangible assets subject to amortization (i.e. limited life intangible assets) are assessed for impairment when there is an indication of impairment (IAS 38).
Typical impairment of assets indicators in the cannabis industry may include:
- Market capitalization is below book value of equity
- Market value declines
- Negative changes in technology, markets, economy or laws
- Worse economic performance than originally contemplated whereby sales and earnings were below what was forecast at the acquisition date
At a high level, an assessment for impairment in the cannabis industry involves testing individual assets in a cash generating unit (“CGU”) for impairment and comparing the recoverable amount of the CGU with its carrying.
A CGU is defined as the “smallest identifiable group of assets generating cash inflows that are largely independent of the cash inflows from other assets or groups of assets.”
The recoverable amount of an asset or CGU is defined as the greater of its fair value less costs of disposal (“FVLCD”) and its value in use (“VIU”).
While FVLCD reflects what an asset/CGU would be what a seller can realize in the open market, net of any disposal costs and can incorporate market participant synergies, VIU reflects the present value of future cash flows expected to be derived from the asset or CGU through the company’s operations.
When there is no active market for the asset, therefore no basis for making a reliable estimate of the amount achievable from the sale of the asset in an arm’s length transaction, VIU would be the alternative in deriving the fair value (“FV”) of an asset.
As a result, a forecast (typically five years) of the CGU’s operations is necessary in assessing for impairment of assets in the cannabis industry, including management’s estimates for annual capital expenditures and net working capital requirements. Any impairment losses on the identifiable intangible assets are recognized prior to the determination of the carrying amount of the CGU.
Next, the CGU’s carrying amount is compared to the CGU’s recoverable amount (i.e. the higher of FVLCD or VIU). Goodwill impairment arises when the CGU’s recoverable amount is less than its carrying amount.
The methodologies involved in determining the FV of an intangible asset and the discount rates applied can vary depending on the asset and the CGU. There is also an element of professional judgement in assessing the different rates and methodologies used.
While we will cover off the more frequently encountered valuation methodologies and derivations of the discount rates in a subsequent blog, an important take away from this blog is to highlight the importance of the forecast itself as the forecast drives the overall valuation and impairment analysis.
If the forecast is unrealistic, the fair values calculated would be inconsistent with the overall analysis and ultimately, a revision would be needed. As a result, for many cannabis companies preparing for their impairment of assets analyses, the vital first step would be to derive a realistic forecast of the CGU’s operations.
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1Mergers and acquisitions
2Granted under the Cannabis Act
If you have any questions on how to value your business at this time, please contact William Tam, CPA, CA, CBV directly.
This content is believed to be accurate as of the date of posting. Canadian Tax laws are complex and are subject to frequent change. Professional advice should be sought before implementing any tax planning. Manning Elliott LLP cannot accept any liability for the tax consequences that may result from acting based on the information contained therein.