ACCA Technical article on IAS 36

This article is a reprint from ACCA's website

Companies with substantial intangible assets may find themselves under the impairment disclosure spotlight - and facing significant charges - as the financial crisis continues.

The UK's Financial Reporting Review Panel intends to review impairment disclosures in 2008 accounts and will give advance notice to a number of listed companies that their accounts will be subject to review. It is uncommon for the panel to do this, but it claims that 'these are unusual times'.

The aim of IAS 36, Impairment of Assets, is to ensure that assets are carried at no more than their recoverable amount.

If an asset's carrying value exceeds the amount that could be received through use or selling the asset, then the asset is impaired and the standard requires a company to make provision for the impairment loss.

An impairment loss is the amount by which the carrying amount of an asset or cash-generating unit (CGU) exceeds its recoverable amount. The recoverable amount of an asset or a CGU is the higher of its fair value less costs to sell and its value in use.

IAS 36 also outlines the situations in which a company can reverse an impairment loss. Certain assets are not covered by the standard and these are generally those assets dealt with by other standards, for example, financial assets dealt with under IAS 39.

A company must assess at each balance sheet date whether an asset is impaired. Even if there is no indication of any impairment, certain assets should be tested for impairment, for example, an intangible asset that has an indefinite useful life.

Additionally, the standard specifies the situations that might indicate that an asset is impaired. These are external events, such as a decline in market value, or internal causes, such as physical damage to an asset.

If it is not possible to determine the fair value less costs to sell because there is no active market for the asset, the company can use the asset's value in use as its recoverable amount. Similarly, if there is no reason for the asset's value in use to exceed its fair value less costs to sell, then the latter amount may be used as its recoverable amount.

For example, where an asset is being held for disposal, the value of this asset is likely to be the net disposal proceeds. The future cashflows from this asset from its continuing use are likely to be negligible.

IAS 36 also explains how a company should determine fair value less costs to sell. The best guide is the price in a binding sale agreement, in an arm's length transaction adjusted for costs of disposal.

When calculating the value in use, typically a company should estimate the future cash inflows and outflows from the asset and from its eventual sale, and then discount the future cashflows accordingly.

It is important that any cashflow projections are based upon reasonable and supportable assumptions over a maximum period of five years unless it can be proven that longer estimates are reliable. They should be based upon the most recent financial budgets and forecasts. The cashflows should not include any that may arise from future restructuring or from improving or enhancing the asset's performance.

The discount rate to be used in measuring value in use should be a pre-tax rate that reflects current market assessments of the time value of money, and the risks that relate to the asset for which the future cashflows have not yet been adjusted.

Where the recoverable amount of an asset is less than its carrying amount, the carrying amount will be reduced to its recoverable amount. This reduction is the impairment loss, which should be recognised immediately in profit or loss, unless the asset is carried at a re-valued amount. In this case, the impairment loss is treated as a revaluation decrease in accordance with the respective standard.

If it is not possible to calculate the recoverable amount of an individual asset, then the recoverable amount of the CGU to which the asset belongs should be calculated. A CGU is the smallest identifiable group of assets that can generate cashflows from continuing use, and that are mainly independent of the cashflows from other assets or groups of assets.

Any impairment loss calculated for a CGU should be allocated to reduce the carrying amount of the asset in the following order:

• the carrying amount of goodwill should be first reduced then the carrying amount of other assets of the unit should be reduced on a pro rata basis, which is determined by the relative carrying value of each asset; then
• any reductions in the carrying amount of the individual assets should be treated as impairment losses. The carrying amount of any individual asset should not be reduced below the highest of its fair value less cost to sell, its value in use, and zero.
• If this rule is applied then the impairment loss not allocated to the individual asset will be allocated on a pro rata basis to the other assets of the group.

Example

Facts

A cash-generating unit has the following net assets:

The recoverable amount has been determined and is $135m.

Question

Allocate the impairment loss to the net assets of the entity (for answer see the following diagram).

At each reporting date a company should determine whether or not an impairment loss recognised in the previous period may have decreased.

This does not apply to goodwill. An impairment loss may only be reversed if there has been a change in the estimates used to determine the asset's recoverable amount since the last impairment loss had been recognised. If this is the case, then the carrying amount of the asset shall be increased to its recoverable amount. The increase will effectively be the reversal of an impairment loss.

However, the increase in the carrying value of the asset can only be up to what the depreciated historical cost would have been if the impairment had not occurred. Any reversal of an impairment loss is recognised immediately in the income statement, unless the asset is carried at a revalued amount, in which case the reversal will be treated as a revaluation increase.

Pratical issues

Impairment testing is time intensive and includes:

• the identification of impairment indicators;
• assessing or reassessing the cashflows;
• determining the discount rates;
• testing the reasonableness of the assumptions; and
• benchmarking the assumptions with the market.

Companies should plan ahead. Market capitalisation below net asset value is an impairment trigger, and calculations of recoverable amount are required. If the market capitalisation is lower than a value-in-use calculation, then the VIU assumptions may need challenging, as the cashflow projections might not be as expected by the market, and the reasons for this must be determined.

In a VIU test, the cashflows exclude the costs and benefits of future reorganisations (unless the reorganisation has been provided under IAS 37) and also the costs and benefits of future enhancement capital expenditure. Therefore, the cashflow forecasts for a VIU test may differ from the cashflows in the approved budgets.

Certain intangibles such as goodwill can be tested for impairment at an earlier date than at the end of the year with any changes updated in the year-end valuation. Regulators have stated that many companies are not fully complying with the somewhat onerous disclosure requirements of IAS 36. Therefore, it is essential to disclose the discount rate and long-term growth rate assumptions in the discounted cashflow models used. There are no exemptions from the disclosure requirements.

The discount rate used must be plausible. Interest rates are falling in many jurisdictions, but other factors affect discount rates in impairment calculations. These include corporate lending rates, cost of capital and risks associated with cashflows, which are all increasing in the current environment.

Purchased goodwill has to be allocated to all the CGUs which benefit from the acquisition. Before finalising the allocation of goodwill, it is useful to think about how goodwill is going to be tested. The cashflows being tested should be consistent with the assets that they relate to and the final position must make sense by comparison to any market data available.

Forecasts need to be based on the latest budgets or forecasts, be reasonable and supportable and consistent with analysts' forecasts for the sector and the views of third-party experts.

Graham Holt is an ACCA examiner and principal lecturer in accounting and finance at Manchester Metropolitan University Business School