Until the announcement IAS 36, there had been a wide range of practices dealing with impairment recognition and measurement. Many jurisdictions—European at most—had statutory obligations to compare the carrying value of assets with their market value, but these requirements were not necessarily applied rigorously. Some other jurisdictions had no requirement to reflect impairment unless it was permanent and long-term. The much more rigorous approach of IAS 36 reflects awareness by regulators that this has been a neglected area in financial reporting.
Principal Requirements Of IAS 36
In general, the standard requires that the entity tests for impairment when there is an indication that an asset might be impaired (but annually for intangible assets having an indefinite useful life).
When carried out, the test is applied to the smallest group of assets for which the entity has identifiable cash flows, called a “cash generating unit.” The carrying amount of the asset or assets in the cash generating unit (cash generating unit) is compared with the fair value and the present value of the cash flows expected to be generated by using the asset (“value in use”). If the higher of these future values is lower than the carrying amount, an impairment is recognized for the difference.
According to IAS 36, at each financial reporting date the reporting entity should determine whether there are conditions that would indicate that impairments may have occurred. Note that this is not a requirement that possible impairments be calculated for all assets at each date of the statement of financial position, which would be a formidable undertaking for most enterprises. Rather, it is the existence of conditions that might be suggestive of a heightened risk of impairment that must be evaluated. However, if such indicators are present, then further analysis will be necessary.
The standard provides a set of indicators of potential impairment and suggests that these represent a minimum array of factors to be given consideration. Other more industry- or entity-specific gauges could be devised by the reporting enterprise.
At a minimum, the following external and internal signs of possible impairment are to be given consideration on an annual basis:
- Market value declines for specific assets or cash generating units, beyond the declines expected as a function of asset aging and use;
- Significant changes in the technological, market, economic, or legal environments in which the enterprise operates, or the specific market to which the asset is dedicated;
- Increases in the market interest rate or other market-oriented rate of return such that increases in the discount rate to be employed in determining value in use can be anticipated, with a resultant enhanced likelihood that impairments will emerge;
- Declines in the (publicly owned) entity’s market capitalization suggest that the aggregate carrying value of assets exceeds the perceived value of the enterprise taken as a whole;
- There is specific evidence of obsolescence or of physical damage to an asset or group of assets;
- There have been significant internal changes to the organization or its operations, such as product discontinuation decisions or restructurings, so that the expected remaining useful life or utility of the asset has seemingly been reduced; and
- Internal reporting data suggest that the economic performance of the asset or group of assets is, or will become, worse than previously anticipated.
The mere fact that one or more of the foregoing indicators suggests that there might be cause for concern about possible asset impairment does not necessarily mean that formal impairment testing must proceed in every instance, although in the absence of a plausible explanation why the signals of possible impairment should not be further considered, the implication would be that some follow-up investigation is needed.
Computing Recoverable Amounts
IAS 36 defines impairment as the excess of carrying value over recoverable amount, and defines recoverable amount as the greater of two alternative measures: net selling price and value in use. The objective is to recognize an impairment when the economic value of an asset (or cash generating unit comprised of a group of assets) is truly below its book (carrying) value.
In theory, and for the most part in practice also, an entity making rational choices would sell an asset if its net selling price (fair value less costs of disposal) were greater than the asset’s value in use, and would continue to employ the asset if value in use exceeded salvage value. Thus, the economic value of an asset is most meaningfully measured with reference to the greater of these two amounts, since the entity will either retain or dispose of the asset, consistent with what appears to be its highest and best use.
Once recoverable amount has been determined, this is to be compared to carrying value; if recoverable amount is lower, the asset has been impaired, and this impairment must be given accounting recognition. It should be noted that value in use is an entity-specific value, in contrast to fair value, which is based on market price.
Value in use is thus a much more subjective measurement than is fair value, since it takes account of factors available only to the individual business, which may be difficult to validate.
Determining Net Selling Prices
The determination of the fair value less costs to sell (i.e., net selling price) and the value in use of the asset being evaluated will typically present some difficulties.
For actively traded assets, fair value can be ascertained by reference to publicly available information (e.g., from price lists or dealer quotations), and costs of disposal will either be implicitly factored into those amounts (such as when a dealer quote includes pick-up, shipping, etc.) or else can be readily estimated.
Most common productive tangible assets, such as machinery and equipment, will not easily be priced, however, since active markets for used items will either not exist or be relatively illiquid. It will often be necessary to reason by analogy (i.e., to draw inferences from recent transactions in similar assets), making adjustments for age, condition, productive capacity, and other variables.
For example, a five-year-old machine having an output rate (for a given component) of 2,000 units per day, and an estimated useful life of eight years, might be valued at 30% (=3/8 × .8) of the cost of a new replacement machine having a capacity of 2,500 units per day. In many industries, trade publications and other data sources can provide a great deal of insight into the market value of key assets. As discussed above, the FASB expects to finalize guidance on measuring fair value and this may provide the model for the IASB’s own efforts.
Computing Value In Use
The computation of value in use involves a two-step process: first, future cash flows must be estimated; and second, the present value of these cash flows must be calculated by application of an appropriate discount rate. These will be discussed in turn in the following paragraphs.
Projection of future cash flows must be based on reasonable assumptions. Exaggerated revenue growth rates, significant anticipated cost reductions, or unreasonable useful lives for plant assets must be avoided if meaningful results are to be obtained. In general, recent past experience is a fair guide to the near-term future, but a recent sudden growth spurt should not be extrapolated to more than the very near-term future.
For example, if growth over the past five years averaged 5%, but in the latest year equaled 15%, unless the recent rate of growth can be identified with factors that demonstrate it as being sustainable, a future growth rate of 5%, or slightly higher, would be more supportable.
Typically, extrapolation cannot be made to a greater number of future periods than the number of “base periods” upon which the projection is built. Thus, a five-year projection, to be sound, should be based on at least five years of actual historical performance data.
Also, since no business can grow exponentially forever—even if, for example, a five-year historical analysis suggests a 20% annual (inflation adjusted) growth rate—beyond a horizon of a few years a moderation of that growth must be hypothesized. (Reversion to the mean growth rate for the industry as a whole, or of some other demographic trend, such as population growth, is usually assumed.)
This is even more important for a single asset or small cash generating unit, since physical constraints and the ironclad law of diminishing marginal returns makes it virtually inevitable that a plateau will be reached, beyond which further growth will be strictly constrained. Basic economic laws suggest that, if exceptional returns are being reaped from the assets used to produce a given product line, competitors will enter the market, driving down prices and limiting future profitability.
IAS 36 stipulates that steady or declining growth rates must be utilized for periods beyond those covered by the most recent budgets and forecasts. It further states that, barring an ability to demonstrate why a higher rate is appropriate, the growth rate should not exceed the long-term growth rate of the industry in which the entity participates.
The guidance offered by IAS 36 suggests that only normal, recurring cash inflows and outflows from the continuing use of the asset being evaluated should be considered, to which would be added any estimated salvage value at the end of the asset’s useful life.
Noncash costs, such as depreciation of the asset, obviously must be excluded from this calculation, since, in the case of depreciation, this would in effect double count the very item being measured. Furthermore, projections should always exclude cash flows related to financing the asset—for example, interest and principal repayments on any debt incurred in acquiring the asset—since operating decisions (e.g., keeping or disposing of an asset) are to be evaluated separately from financing decisions (borrowing, leasing, buying with equity capital funds).
Also, cash flow projections must relate to the asset in its existing state and in its current use, without regard to possible future enhancements. Income tax effects are also to be disregarded (i.e., the entire analysis should be on a pretax basis).
Corporate assets, such as headquarters buildings and shared equipment, which do not themselves generate identifiable cash flows, need to be tested for impairment as are all other long-lived assets. However, these present a particular problem in practice due to the inability to identify cash flows deriving from the future use of these assets.
A failure to test corporate assets for impairment would permit such assets to be carried at amounts that could, under some circumstances, be at variance with requirements under IFRS. It would also permit a reporting entity to deliberately evade the impairment testing requirements by opportunistically defining certain otherwise productive assets as being corporate assets.
To avoid such results, IAS 36 requires that corporate assets be allocated among or assigned to the cash generating unit or units with which they are most closely associated. For a large and diversified enterprise, this probably implies that corporate assets will be allocated among most or all of its cash generating units, perhaps in proportion to annual turnover (revenue).
Since ultimately an enterprise must generate sufficient cash flows to recover its investment in all long-lived assets, whether assigned to operating divisions or to administrative groups, there are no circumstances in which corporate assets can be isolated and excluded from impairment testing.
Accounting For Impairments [Based On IAS-36]
If the recoverable amount of the cash generating unit is lower than its carrying value, an impairment must be recognized. The mechanism for recording an impairment loss depends upon whether the entity is accounting for long-lived assets on the amortized historical cost or revaluation basis.
Impairments computed for assets carried at historical cost will be recognized as charges against current period profit, either included with depreciation for financial reporting, or identified separately in the statement of comprehensive income (or in the separate income statement, reporting components of profit or loss, if the presentation of comprehensive income is achieved in two statements).
For assets grouped into cash generating units, it will not be possible to determine which specific assets have suffered impairment losses when the unit as a whole has been found to be impaired, and so IAS 36 prescribes a formulaic approach. If the cash generating unit in question has been allocated any goodwill, any impairment should be allocated fully to goodwill, until its carrying value has been reduced to zero. Any further impairment would be allocated proportionately to all the other assets in that cash generating unit.
The standard does not specify whether the impairment should be credited to the asset account or to the accumulated depreciation (contra asset) account. Of course, either approach has the same effect: net book value is reduced by the accumulated impairment recognized. European practice has generally been to add impairment provisions to the accumulated depreciation account. This is consistent with the view that reducing the asset account directly would be a contravention of the general prohibition on offsetting.
If the entity employs the revaluation method of accounting for long-lived assets, the impairment adjustment will be treated as the partial reversal of a previous upward revaluation. However, if the entire revaluation account is eliminated due to the recognition of an impairment, any excess impairment should be charged to expense (and thus be closed out to retained earnings). In other words, the revaluation account cannot contain a net debit balance.
Reversals Of Previously Impairments Under Historical Cost Method
IFRS provides for recognition of reversals of previously recognized impairments, unlike US GAAP.
In order to recognize a recovery of a previously recognized impairment, a process similar to that which led to the original loss recognition must be followed. This begins with consideration, as of each date of the statement of financial position, of whether there are indicators of possible impairment recoveries, utilizing external and internal sources of information.
Data relied upon could include that pertaining to material market value increases; changes in the technological, market, economic or legal environment or the market in which the asset is employed; and the occurrence of a favorable change in interest rates or required rates of return on assets which would imply changes in the discount rate used to compute value in use.
Also to be given consideration are data about any changes in the manner in which the asset is employed, as well as evidence that the economic performance of the asset has exceeded expectations and/or is expected to do so in the future.
If one or more of these indicators is present, it will be necessary to compute the recoverable amount of the asset in question or, if appropriate, of the cash generating unit containing that asset, in order to determine if the current recoverable amount exceeds the carrying amount of the asset, where it had been previously reduced for an impairment.
If that is the case, a recovery can be recognized under IAS 36. The amount of recovery to be recognized is limited, however, to the difference between the carrying value and the amount which would have been the current carrying value had the earlier impairment not been given recognition.
Note that this means that restoration of the full amount at which the asset was carried at the time of the earlier impairment cannot be made, since time has elapsed between these two events and further depreciation of the asset would have been recognized in the interim.
Where a cash generating unit including goodwill has been impaired, and the impairment has been allocated first to the goodwill and then pro rata to the other assets, only the amount allocated to non-goodwill assets can be reversed.
The standard specifically prohibits the reversal of impairments to goodwill, on the basis that the goodwill could have been replaced by internally generated goodwill, which cannot be recognized under IFRS.
Reversals Of Previously Recognized Impairments Under Revaluation Method
Reversals of impairments are accounted for differently if the reporting entity employed the revaluation method of accounting for long-lived assets. Under this approach, assets are periodically adjusted to reflect current fair values, with the write-up being recorded in the asset accounts and the corresponding credit reported in other comprehensive income and accumulated in equity as revaluation surplus, and not included in profit or loss.
Impairments are viewed as being downward adjustments of fair value in this scenario, and accordingly are reported in other comprehensive income as reversals of previous revaluations (to the extent of any credit balance in the revaluation surplus for that asset) and not charged against profit unless the entire remaining, unamortized portion of the revaluation is eliminated as a consequence of the impairment.
Any further impairment is charged against profit in such case.
When an asset (or cash generating group of assets) had first been revalued upward, then written down to reflect an impairment, and then later adjusted to convey a recovery of the impairment, the required procedure is to report the recovery as a reversal of the impairment, as with the historical cost method of accounting for long-lived assets.
Since in most instances impairments will have been accounted for as reversals of upward revaluations, a still-later reversal of the impairment will be seen as yet another upward revaluation and accounted for in other comprehensive income and accumulated in equity account, not to be reported in profit.
In the event that an impairment will have eliminated the entire revaluation surplus account, and an excess loss will have been charged against profit, then a later recovery will be reported in profit to the extent the earlier write-down had been so reported, with any balance recognized in other comprehensive income and accumulated in equity.