The approach of this post is to discuss core concepts and other key elements of the “IMPAIRMENT OF ASSETS” standards, and maybe, a little material in the form of worked case studies and questions to support successful learning of the material. This post is adapted from IAS 36, Impairment Of Asset, comes with rich case studies as a practical guide. International Financial Reporting Standards (IFRS), are now being implemented in a large number of countries around the world. This is a major achievement on the road towards the global acceptance of a single set of accounting standards. For IFRS to be properly understood, implemented, and applied in practice, education and training of all relevant parties—including financial statement preparers, auditors, regulators, financial analysts, and other users of financial statements as well as accounting students—is essential. I hope this post become a little helpful tool in this regard.
The purpose of the standard 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 through selling the asset, then the asset is impaired and IAS 36 requires an entity to make provision for the impairment loss. IAS 36 also sets out the situations where an entity can reverse an impairment loss.
Certain assets ARE NOT covered by the Standard, including:
- Inventories (IAS 2)
- Assets arising from construction contracts (IAS 11)
- Deferred tax assets (IAS 12)
- Assets arising from employee benefits (IAS 19)
- Financial assets dealt with under IAS 39
- Investment property carried at fair value under IAS 40
- Biological assets carried at fair value (IAS 41)
- Assets arising from insurance contracts (IFRS 4)
- Assets that are held for sale (IFRS 5)
The Standard DOES APPLY to:
- Subsidiaries, associates, and joint ventures
- Property, plant, and equipment
- Investment property carried at cost
- Intangible assets and goodwill
Identifying An Impairment Loss
An entity has to assess at each balance sheet date whether there is any indication that an asset is impaired. Additionally, even if there is no indication of any impairment, these assets should be tested for impairment:
- An intangible asset that has an indefinite useful life
- An intangible asset that is not yet available for use
- Goodwill that has been acquired in a business combination
IAS 36 sets out the events that might indicate that an asset is impaired. These are:
- External sources, such as a decline in market value, increases in market interest rates, the carrying amount of net assets being valued at more than the stock market value of the entity, and economic, legal, or technological changes that have had an adverse affect on the entity
- Internal sources of information, such as physical damage to an asset, or its obsolescence, or an asset becoming idle, or if the asset is part of a restructuring, or if the entity’s performance has suffered during the period, or if there has been a significant decline or reduction in the cash flows generated or to be generated from the asset.
If there is an indication that an asset is impaired, the asset’s useful life, depreciation, or residual value may need adjusting.
Case Study: An entity has purchased the whole of the share capital of another entity for a purchase consideration of $20 million. The goodwill arising on the transaction was $5 million. It was planned at the outset that the information systems would be merged in order to create significant savings. Additionally the entity was purchased because of its market share in a particular jurisdiction and because of its research projects. Subsequently the cost savings on the information systems were made. The government of the jurisdiction introduced a law that restricted the market share to below that anticipated by the entity, and some research projects were abandoned because of lack of funding.
The question is; what are potential indicators of the impairment of goodwill in this case?
The entity would have paid for the goodwill in anticipation of future benefits arising there from. The benefit in terms of the cost savings on the information systems has arisen, but the market share increase and the successful outcome of the research projects has not occurred.
Therefore, these events may indicate the impairment of goodwill. Goodwill has to be impairment tested at least annually under IFRS 3.
Determination Of A Recoverable Amount
The recoverable amount of an asset is the higher of the asset’s fair value less costs to sell and its value in use. (The term “cash-generating unit” could be used as a substitute for the term “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 entity 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, the latter amount may be used as its recoverable amount. An example of this is where an asset is being held for disposal, as the value of this asset is likely to be the net disposal proceeds. The future cash flows from this asset from its continuing use are likely to be negligible.
In the case of an intangible asset with an indefinite useful life, it is possible to use a calculation of the asset’s recoverable amount that has been made in the preceding period as long as certain conditions are met. These conditions are that the intangible asset is part of a cash-generating unit whose value has not changed significantly since the most recent recoverable amount calculation.
Also, the recent calculation must have resulted in an amount that was substantially in excess of the asset’s carrying amount, and it would be unlikely that a current calculation of the recoverable amount would show a value less than the asset’s carrying amount.
Case Study: An entity is preparing its financial statements for the year ending November 30, 20×8. Certain items of plant and equipment were scrapped on January 1, 20×9. At November 30, 20×8, these assets were being used in production by the entity and had a carrying value of $5 million. The value-in-use of the asset at November 30, 20×8, was deemed to be $6 million, and its fair value less costs to sell was thought to be $50,000 (the scrap value).
Question: what is the recoverable amount of the plant and equipment at November 30, 20×8?
The recoverable amount is the higher of the assets’ fair value less costs to sell and its value-in-use. In this case, even though the assets were scrapped on January 1, 20×9, the value-in-use at November 30, 20×8, was $6 million, which was higher than the fair value less costs to sell and their carrying value.
Therefore, the assets ARE NOT impaired. The scrapping of the assets may be disclosed as a non-adjusting post–balance sheet event if material.
Fair Value Less Costs To Sell
IAS 36 sets out how an entity should determine the fair value less costs to sell. The Standard sets out these examples:
- Where there is a buying and selling agreement, the price in that agreement less the costs to sell can be used.
- The price in an active market less the cost of disposal can be used.
- The fair value less costs to sell can be based on the best information available which reflects the proceeds that could be obtained from the disposal of the asset in an arm’s-length transaction.
- The Standard says that the best evidence is the price in a binding sale agreement in an arm’s length transaction adjusted for the costs of disposal.
These elements should be used when calculating the value-in-use:
- Estimates of the future cash flows that the entity expects to get from the asset
- Any possible variations that may occur in the amount or timing of the future cash flows
- The time value of money represented by the current market risk-free rate of interest
- The uncertainty inherent in the asset
- Any other factors that should be borne in mind when determining the future cash flows from the asset.
Typically an entity should estimate the future cash inflows and outflows from the asset and from its eventual sale, and then discount the future cash flows accordingly. Read on…
Future Cash Flows
It is important that any cash flow projections are based on reasonable and supportable assumptions. They should be based on the most recent financial budgets and forecasts. The cash flows SHOULD NOT include any cash flows that may arise from future restructuring or from improving or enhancing the asset’s performance.
The Standard also says that any predictions incorporated into budgets and forecasts shall cover only a five-year period at maximum. Extrapolation should be used for periods beyond the five-year period. However, if management is confident that any projections beyond the five-year period are reliable, and management can demonstrate that, based on past experience, the cash flows that will be generated beyond this five-year period are likely to be accurate, then it is possible to use these forecasts.
Any future cash flows SHOULD NOT include inflows or outflows from financing activities or “income tax receipts and payments“. However, they should include the estimated disposal proceeds from the asset. If any future cash flows are in a foreign currency, they are estimated in that currency and discounted using a rate appropriate for that currency. The resultant figure will be then translated using the exchange rate at the date of the value-in-use computation.
Case Study: An entity is reviewing one of its business segments for impairment. The carrying value of its net assets is $20 million. Management has produced two computations for the value-in-use of the business segment. The first value ($18 million) excludes the benefit to be derived from a future reorganization, but the second value ($22 million) includes the benefits to be derived from the future reorganization. There is not an active market for the sale of the business segments.
The question is: should the business segment impaired?
The benefit of the future reorganization should not be taken into account in calculating value-in-use. Therefore, the net assets of the business segment will be impaired by $2 million because the value-in-use ($18 million) is lower than the carrying value ($20 million). The value-in-use can be used as the recoverable amount as there is no active market for the sale of the business segment.
Real Case Study: Nokia (2003) discloses that it plans to reconstruct its business. In connection with this reconstruction, it has reviewed the carrying values of capitalized development costs. An impairment loss of $275 million was recognized. Nokia had discounted the cash flows expected to arise from the continuing use of the assets and from disposal at the end of their useful lives at discount rates of 15% and 12%.
The discount rate to be used in measuring value-in-use should be a pretax rate that reflects current market assessments of the time value of money and the risks that relate to the asset for which the future cash flows have not yet been adjusted.
Case Study: Management of an entity is carrying out an impairment test on an asset. The post tax market rate of return from the asset is 7% and profits are taxed at 30%. Management intends to use the post tax rate of return in discounting the post tax cash flows from the asset of $2 million, as management says it will make no difference to the calculation of value-in-use.
The question: is the use of the post tax rate acceptable in the above circumstances?
In theory, discounting post tax cash flows at a post tax discount rate should give the same result as discounting pretax cash flows at a pretax discount rate. However, this depends upon future tax cash flows and deferred tax considerations.
Therefore, the post tax calculation will not always give the same results as a pretax computation. Also, the pretax discount rate is not always the post tax discount rate grossed up by a standard rate of tax. Management should gross up the post tax discount rate based on an assessment of what the long-term effective tax rate might be.
Recognition And Measurement Of An Impairment Loss
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. The impairment loss should be recognized in profit or loss unless the asset is carried at a revalued amount, in which case the impairment loss is treated as a revaluation decrease in accordance with the respective Standard.
If the impairment loss is greater than the carrying amount of the asset to which it relates, the entity shall recognize a liability if it is the requirement of another Standard. Where an impairment loss has been recognized, any depreciation charged for the asset will be adjusted to reflect the asset’s revised carrying value.
If an asset appears to be impaired, the recoverable amount for that asset should be calculated. However, if it is not possible to calculate the recoverable amount of an individual asset, the recoverable amount of the cash-generating unit to which the asset belongs should be calculated.
A cash-generating unit is the smallest identifiable group of assets that can generate cash flows from continuing use and that are mainly independent of the cash flows from other assets or groups of assets.
Case Study: A manufacturing entity owns several vehicles. The vehicles are several years old and could only be sold for scrap value. They do not generate cash independently from the entity.
The question is: how will the recoverable value of the vehicles be determined?
The entity cannot estimate the recoverable amount of the vehicles because their value-in-use cannot be determined separately, and it will be different from the scrap value.
Therefore, the entity would incorporate the vehicles into the cash-generating unit to which they belong and estimate the recoverable amount of that cash-generating unit.
Cash-generating units should be identified on a consistent basis, period to period, for the same asset or types of asset unless the entity can justify a change.
Goodwill that has been acquired in a business combination should be allocated to cash generating units. Normally internal management records will be used for the allocation of goodwill. The reported segments of the entity will be the minimum size of cash-generating units to which goodwill will be allocated.
Case Study: An entity operates an oil platform in the sea. The entity has provided the amount of $10 million for the financial costs of the restoration of the seabed, which is the present value of such costs. The entity has received an offer to buy the oil platform for $16 million, and the disposal costs would be $2 million. The value-in-use of the oil platform is approximately $24 million before the restoration costs. The carrying value of the oil platform is $20 million.
The question: Is the value of the oil platform impaired?
The fair value less cost to sell of the oil platform is $14 million, being $16 million offered minus the disposal costs. The value-in-use of the platform will be $24 million minus $10 million, which is $14 million. The carrying amount of the platform is $20 million minus $10 million, which is $10 million.
Therefore, the recoverable amount of the cash-generating unit exceeds its carrying amount, and it is not impaired.
If an entity disposes of an operation within the cash-generating unit, the goodwill associated with that operation will be included in the carrying amount of the operation when calculating the gain or loss on disposal. The amount included in the gain or loss on disposal will be based on the proportion of the cash-generating unit that is disposed of.
Sometimes an entity may reorganize its business so that changes will be made to the composition of the cash-generating units. If this is the case, goodwill will be reallocated to new cash generating units based on their relative values.
Case Study: An entity has an oil platform in the sea. The entity has to decommission the platform at the end of its useful life, and a provision was set up at the commencement of production. The carrying value of the provision is $8 million. The entity has received an offer of $20 million (selling costs $1 million) for the rights to the oil platform, which reflects the fact that the owners have to decommission it at the end of its useful life. The value-in-use of the oil platform is $26 million ignoring the decommissioning costs. The current carrying value of the oil platform is $28 million.
Required: Determine whether the value of the oil platform is impaired.
The fair value less costs to sell is $(20 – 1) million, or $19 million.
The value-in-use is $( 26 – 8 ) million, or $18 million.
The carrying value is $( 28 – 8 ) million, or $20 million.
Therefore, the recoverable amount ($19 million) is less than its carrying value ($20 million), and THE ASSET IS IMPAIRED.
A cash-generating unit to which goodwill has been allocated will be tested for impairment annually and also when there is an indication that the unit might be impaired.
Impairment Of Goodwill
Goodwill that relates to minority interests is not recognized currently in the parent’s consolidated financial statements. Part of the recoverable amount of a cash-generating unit is attributable to the minority’s interest in goodwill. For the purpose of “impairment testing“, the carrying amount of goodwill is grossed up to include the goodwill attributable to the minority interest. This notionally adjusted figure is then compared with the recoverable amount of the unit to decide whether the cash-generating unit is impaired.
Case Study: An entity (A) acquires 60% of the ownership interest in another entity (B). The goodwill arising on acquisition was $24 million, and the carrying value of entity B’s net assets in the consolidated financial statements is $60 million at December 31, 20×8. The recoverable amount of the cash-generating unit B is $80 million at December 31, 20×8.
Required: Calculate any impairment loss arising at December 31, 20×8, for the cash-generating unit B.
This impairment loss will reduce goodwill on acquisition to $12 million ($24 – 60% of 20 million).
Timing Of Impairment Test
The annual impairment test for the cash-generating unit can be performed at any time during the financial year, provided the test is carried out at the same time every year. Different cash-generating units can be tested for impairment at different times of the year. The exception to this is where the cash-generating unit was acquired in a business combination during the current period. In this case, the unit shall be tested for impairment before the end of the current financial year.
Group Or Divisional Assets (Corporate Assets)
Corporate assets should be allocated to cash-generating units. If the asset can be allocated on a reasonable and consistent basis, there is no problem. However, if the asset cannot be allocated on such a basis, then three processes should occur:
- An impairment test should be carried out on the cash-generating unit without the corporate asset.
- The smallest group of cash-generating units should be identified that includes the cash generating unit under review and to which part of the corporate assets can be reasonably allocated.
- This group of cash-generating units should then be tested for impairment.
Case Study: An entity has two cash-generating units, X and Y. There is no goodwill within the units’ carrying values. The carrying values are X $10 million and Y $15 million. The entity has an office building that has not been included in the above values and can be allocated to the units on the basis of their carrying values. The office building has a carrying value of $5 million. The recoverable amounts are based on value-in-use of $9 million for X and $19 million for Y.
Required: Determine whether the carrying values of X and Y are impaired.
Here is the determination:
The impairment loss will be allocated on the basis of 2/12 against the building ($0.5 million) and 10/12 against the other assets ($2.5 million).
Allocation Of Impairment Loss
Any impairment loss calculated for a cash-generating unit should be allocated to reduce the carrying amount of the asset in this 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 determined by the relative carrying value of each asset.
- 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, the impairment loss not allocated to the individual asset will be allocated on a pro rata basis to the other assets of the group.
Case Study: A cash-generating unit has these net assets:
Plant and equipment 30
The recoverable amount has been determined as $45 million.
Question: How to allocate the impairment loss to the net assets of the entity?
Here is the how:
Reversal Of An Impairment Loss
At each reporting date, an entity should determine whether an impairment loss recognized in the previous period may have decreased. This DOES NOT APPLY to goodwill.
In determining whether an impairment loss has reversed, the entity should consider the same sources of information as for the original impairment loss. An impairment loss may be reversed only if there has been a change in the estimates used to determine the asset’s recoverable amount since the last impairment loss had been recognized. 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 carrying amount would have been if the impairment had not occurred. Any reversal of an impairment loss is recognized immediately in the income statement unless the asset is carried at a revalued amount; in this case, the reversal will be treated as a revaluation increase.
The reversal of an impairment loss may require an adjustment to the depreciation of the asset in future periods.
Case Study: The calculation refers to an impairment loss suffered by subsidiary Lie at December 31, 20X7:
There has been a favorable change in the estimates of the recoverable amount of Lie’s net assets since the impairment loss was recognized. The recoverable amount is now $800 million at December 31, 20×8. The net asset’s carrying value would have been $720 million at December 31, 20×8. Assets are depreciated at 20% reducing balance.
Required: Show the accounting treatment for the reversal of the impairment loss as of December 31, 20×8.
The reversal of the impairment loss on goodwill cannot be accounted for under IAS 36. The carrying amount of Lie can be increased up to the lower of the recoverable amount ($800 million) and the carrying value ($720 million) of the net assets.
Carrying amount of Lie’s net assets at December 31, 20×8:
A reversal of an impairment loss for a cash-generating unit shall be allocated to the assets of that unit on a pro rata basis. Any impairment loss that relates to goodwill WILL NOT be reversed.
For each class of asset an entity shall disclose
- Impairment losses recognized in the income statement
- Impairment losses reversed in the income statemen
- The line item in the income statement in which the impairment losses are included
Additionally, any impairment losses recognized directly in equity should be disclosed, including reversals of impairment losses.
Each segment should disclose these items in terms of primary segments only: impairment losses recognized and reversed in the period both in the income statement and directly in equity.
If an individual impairment loss or reversal is material, then this information should be disclosed:
- The events and circumstances leading to the impairment loss
- The amount of the loss
- If it relates to an individual asset, the nature of the asset and the segment to which it relates
- For a cash-generating unit, the description of the amount of the impairment loss or reversal by class of assets and segment should be disclosed.
- If the recoverable amount is fair value less costs to sell, the basis for determining fair value must be disclosed.
- If the recoverable amount is the value-in-use, the discount rate should be disclosed.
If the impairment losses recognized or reversed are material in relation to the financial statements as a whole, the main classes of assets affected should be disclosed and the main events and circumstances that lead to the recognition of those losses should be disclosed. Detailed information about the estimates used to measure the recoverable amounts of the cash-generating units that contain goodwill or intangible assets with an indefinite useful life should also be set out.