Impairment testing

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Impairment Testing

Impairment Testing under IFRS

Impairment testing under International Financial Reporting Standards could be framed out

as follows:

Note: IAS 39 and IFRS 9 Financial Instruments.

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International Accounting Standards 36 on Impairment on Assets sets out the requirements

for testing assets for impairment. Although the overarching principle in the standard is

straightforward, that is the assets should not be carried at above their recoverable amount, it

is in the application of it often proves challenging because of the judgements and

estimates required.

IAS 1 on Presentation of Financial Statements emphasizes the importance of disclosing the

judgements and estimations in the preparation of financial statements.

IAS 1.122

An entity shall disclose, in the summary of significant accounting policies or another notes,

the judgements, apart from those involving estimations, that management has made in the

process of applying the entity’s accounting policies and that have the most significant effect

on the amounts recognized in the financial statements.

IAS 1.125

An entity shall disclose information about the assumptions it makes about the future, and

other major sources of estimation uncertainty at the end of the reporting period, that have a

significant risk of resulting in a material adjustment to the carrying amounts of assets and

liabilities within the next financial year. In respect of those assets and liabilities, the notes

shall include details of:

(a) Their nature, and

(b) Their carrying amount as at the end of the reporting period.

IAS 1.126

Determining the carrying amounts of some assets and liabilities requires estimation of the

effects of uncertain future events on those assets and liabilities at the end of the reporting

period. For example, in the absence of recently observed market prices, future-oriented

estimates are necessary to measure the recoverable amount of classes of property, plant

and equipment, the effect of technological obsolescence on inventories, provisions subject

to the future outcome of litigation in progress, and long-term employee benefit liabilities such

as pension obligations. These estimates involve assumptions about such items as the risk

adjustment to cash flows or discount rates, future changes in salaries and future changes in

prices affecting other costs.

IAS 1.127

The assumptions and other sources of estimation uncertainty disclosed in accordance with

paragraph 125 above relate to the estimates that require management’s most difficult,

subjective or complex judgements. As the number of variables and assumptions affecting

the possible future resolution of the uncertainties increases, those judgements become more


subjective and complex, and the potential for a consequential material adjustment to the

carrying amounts of assets and liabilities normally increases accordingly.

IAS 1.129

An entity presents the disclosures in paragraph 125 [above] in a manner that helps users of

financial statements to understand the judgements that management makes about the future

and about other sources of estimation uncertainty. The nature and extent of the information

provided vary according to the nature of the assumption and other circumstances. Examples

of the types of disclosures an entity makes are

(a) the nature of the assumption or other estimation uncertainty;

(b) the sensitivity of carrying amounts to the methods, assumptions and estimates

underlying their calculation, including the reasons for the sensitivity;

(c) the expected resolution of an uncertainty and the range of reasonably possible

outcomes within the next financial year in respect of the carrying amounts of the

assets and liabilities affected; and

(d) an explanation of changes made to past assumptions concerning those assets and

liabilities, if the uncertainty remains unresolved.

In addition to the application of judgements and estimations in IAS 36, the frequency of

impairment testing is a challenge as well for the preparers of the financial statements.

IAS 36 requires the recoverable amount of an asset to be measured whenever there is an

indication that the asset may be impaired, yet the standards do not stop there, since the

standards also requires:

(a) the recoverable amount of an intangible asset with an indefinite useful life to be

measured annually, irrespective of whether there is an indication that it may be

impaired. The most recent detailed calculation of recoverable amount made in a

preceding period may be used in the impairment test for that asset in the current

period, provided specified criteria are met.

(b) the recoverable amount of an intangible asset not yet available for use to be measured

annually, irrespective of whether there is any indication that it may be impaired.

(c) goodwill acquired in a business combination to be tested for impairment annually.

IASC acknowledged that an enterprise would use judgement in determining whether an

impairment loss needed to be recognized. For this reason, IAS 36 included some

safeguards to limit the risk that an enterprise may make an over-optimistic (pessimistic)

estimate of recoverable amount:

(a) IAS 36 requires a formal estimate of recoverable amount whenever there is an

indication that:

(i) an asset may be impaired; or


(ii) an impairment loss may no longer exist or may have decreased.

For this purpose, IAS 36 includes a relatively detailed although not exhaustive list of

indicators that an asset may be impaired.

(b) IAS 36 provides guidelines for the basis of management’s projections of future cash

flows to be used to estimate value in use.

IAS 36 provides guidance on impairment testing, which is summarized as follows:

an entity shall assess at the end of each reporting period whether there is any

indication that an asset may be impaired. If any such indication exists, the entity shall

estimate the recoverable amount of the asset.

Impairment testing will involve comparing the carrying amount of that asset with is

recoverable amount. The recoverable amount of an asset or a cash-generating unit

is determined to be the higher of its fair value less costs to sell and its value in use.

If the asset is impaired, the entity must write it down to its recoverable amount and

recognize an impairment loss in the statement of comprehensive income. The only

exception is if the impaired asset is a revalued asset. In this case, the value changes

are recognized directly in equity to the extent that a revaluation surplus for that asset

exists in equity.

For an entity that has goodwill and indefinite lived intangible assets, a mandatory

impairment test must be performed on these assets annually. The impairment test

can be performed at any time during the period, provided it is performed at the same

time each year. Goodwill and indefinite lived intangible assets must also be tested for

impairment when impairment indicators exist.

IAS 36 provides a list of external and internal sources of information that could be indicators

of impairment. Minimum, there are seven sources of information that an entity should

consider.

1. during the period, there is a significant decline in an asset’s market value not

resulting from the passage of time or normal use.


2. during the period, or in near future, there are significant changes in the technological,

market, economic or legal environment in which the entity operates or in the market

to which an asset is dedicated with an adverse effect to the entity.

3. During the period, there is an increase in the market interest rates impacting the

discount rate used in calculating an asset’s value in use, resulting in the material

decrease in the asset’s recoverable amount.

4. Market cap of the net assets of the entity is lower than their carrying amount.

5. There is evidence for obsolescence or physical damage of an asset.

6. During the period or in near future, significant changes with adverse effect on the

asset value. These changes among others include the asset becoming idle, plans to

discontinue or restructure the operation to which an asset belongs, plans to dispose

of an asset before the previously expected date, and reassessing the useful life of an

asset as finite rather than indefinite.

7. Expected economic performance of an asset is worsening.

All in all, to test an asset for impairment, the recoverable amount of the asset needs to be

measured.

As defined above, the recoverable amount will involve the determination of:

fair value less costs to sell and

value in use

Both items in the recoverable amount is given further definition in the standards, however,

the application of that definition will necessitate the preparers of the financial statements to

use valuation specialists on their staff or hire outside consultants to provide the

measurements.

Both items are defined as follows:

Fair value less costs to sell is the amount obtainable from the sale of an asset or

cash-generating unit in an arm’s length transaction between knowledgeable, willing

parties, less the costs of disposal.

Value in use is the present value of the future cash flows expected to be derived from

an asset or cash-generating unit.

Another issue that complicates the application of impairment testing is that most assets in a

business typically generate cash inflows by working together as a group of assets rather

than generating assets individually. As such, it is often impossible to measure the value in

use for an individual asset. This means that unless the fair value less costs to sell of an


asset is greater than its carrying amount, the asset must generally be tested for impairment

as part of the value in use of the cash generating unit to which it belongs.

Then the next question is what is a cash-generating unit? Definitely, we can not see cash-

generating unit on the balance sheet or statement of the financial position. However, IAS 36

said that a cash-generating unit is the smallest identifiable group of assets that generates

cash inflows that are largely independent of the cash inflows from other assets or group of

assets. Identification of an asset’s cash-generating unit will involve judgement. If recoverable

amount cannot be determined for an individual asset, an entity identifies the lowest

aggregation of assets that generate largely independent cash inflows.

Then we are faced to two things: what is meant with cash inflows and how we know they are

independent, and to what extent?

The standards provides guidance for that:

Cash inflows are inflows of cash and cash equivalents received from parties external

to the entity.

In identifying whether cash inflows from an asset (or group of assets) are largely

independent of the cash inflows from other assets (or groups of assets), an entity

considers various factors including:

how management monitors the entity’s operations (such as by product lines,

businesses, individual locations, districts or regional areas);

how management makes decisions about continuing or disposing of the

entity’s assets and operations.

Although the concept of a cash-generating unit seems straightforward and the standards

give illustrative examples of identification of a cash-generating unit, yet identifying the lowest

level of independent cash inflows for a group of assets requires, again, judgement, which is

where difficulties can arise.

Further to this complexity, is the presence of goodwill in a business combination. As we

know that goodwill does not generate cash flows independently of other assets or groups of

assets. Most likely, goodwill will contribute to the cash generation of multiple cash-

generating units, and not only one single cash-generating unit.

For the purpose of impairment testing, goodwill acquired in a business combination shall,

from the acquisition date, be allocated to each of the acquirer’s cash-generating units, or

groups of cash-generating units, that is expected to benefit from the synergies of the

combination, irrespective of whether other assets or liabilities of the acquiree are assigned to

those units or groups of units. Each unit or group of units to which the goodwill is so

allocated shall:


(a) represent the lowest level within the entity at which the goodwill is monitored for

intenal management purposes; and

(b) not be larger than an operating segment as defined by paragraph 5 of IFRS 8 on

Operating Segments before aggregation.

Yet, by requiring the recoverable value of an asset or cash-generating unit to be measured

at the higher of fair value less costs to sell and value in use, then it is not always necessary

to calculate BOTH fair value less costs to sell and value in use as long as one of them (fair

value less costs to sell might be easier to measure) exceeds its carrying amount, then in this

case, the asset or cash-generating unit is not impaired and there is no need to calculate the

asset’s value in use.

IAS 36 provides a hierarchy of sources to obtain fair value less costs to sell:

The best evidence is a price in a binding sale agreement in an arm’s length

transaction, adjusted for incremental costs that would be directly attributable to the

disposal of the asset.

If there is no binding sale agreement, but an asset is traded in an active market, fair

value less costs to sell is the asset’s market price less the costs of disposal.

If there is no binding sale agreement or active market for an asset, fair value less

costs to sell is based on the best information available to reflect the amount that an

entity could obtain, at the end of the reporting period, from the disposal of the asset

in an arm’s length transaction between knowledgeable, willing parties, after

deducting the costs of disposal. In determining this amount, an entity considers the

outcome of recent transactions for similar assets within the same industry.

As a consequence of the definition of value in use, that is the present value of the future

cash flows expected to be derived from an asset or cash-generating unit, the following

elements shall be reflected in the calculation of an asset’s value in use:

(a) An estimate of the future cash flows the entity expects to derive from the asset;

(b) Expectations about possible variations in the amount or timing of those future cash

flows:

(c) The time value of money, represented by the current market risk-free rate of interest;

(d) The price for bearing the uncertainty inherent in the assets; and

(e) Other factors, such as illiquidity, that market participants would reflect in pricing the

future cash flows the entity expects to derive from the asset.

Thus estimating the value in use of an asset will involve the following steps:


(a) Estimating the future cash inflows and outflows to be derived from continuing use of

the asset and from its ultimate disposal; and

(b) applying the appropriate discount rate to those future cash flows.

The standards noted that detailed, explicit and reliable financial budgets or forecasts of

future cash flows for periods longer than five years are generally not available. For this

reason, management’s estimates of future cash flows are based on the most recent budgets

or forecasts for a maximum of five years. Management may use cash flow projections based

on financial budgets or forecasts over a period longer than five years if it is confident that

these projections are reliable and it can demonstrate its ability, based on past experience, to

forecast cash flows accurately over that longer period.

Two notes given in the standards, that:

to estimate cash flow projections beyond the period covered by the most recent

budgets or forecasts, the entity shall extrapolate the projections based on the

budgets/forecasts using a steady or declining growth rate for subsequent years, unless

an increasing rate can be justified. This growth rate shall not exceed the long-term

average growth rate for the products, industries, or country or countries in which the

entity operates, or for the market in which the asset is used, unless a higher rate can

be justified.

Cash flow projections until the end of an asset’s useful life are estimated by

extrapolating the cash flow projections based on the financial budgets or forecasts

using a growth rate for subsequent years. This rate is steady or declining, unless an

increase in the rate matches objective information about patterns over a product or

industry lifecyle. If appropriate, the growth rate is zero or negative.

The standards requires that estimates of future cash flows shall

Include the following: Exclude the following:

(a) projections of cash inflows from the

continuing use of the asset;

(b) projections of cash outflows that are

necessarily incurred to generate the

cash inflows from continuing use of the

asset (including cash outflows to

prepare the asset for use) and can be

directly attributed, or allocated on a

reasonable and consistent basis, to the

asset; and

(c) net cash flows, if any, to be received

(a) estimated future cash inflows or

outflows that are expected to arise from

a future restructuring to which an entity

is not yet committed;

(b) estimated future cash inflows or

outflows that are expected to arise from

improving or enhancing the asset’s

performance;

(c) cash inflows from assets that generate

cash inflows that are largely

independent of the cash inflows from


Include the following: Exclude the following:

(or paid) for the disposal of the asset at

the end of its useful life.

the asset under review (for example,

financial assets such as receivable);

(d) cash outflows that relate to obligations

that have been recognized as liabilities

(for example, payables, pensions or

provisions);

(e) cash inflows or outflows from financing

activities;

(f) income tax receipts or payments.

Unlike the cash flows used in an impairment test that are entity-specific, the discount rate is

supposed to appropriately reflect the current market assessment of the time value of money

and the risks specific to the asset (or cash-generating unit) for which the future cash flow

estimates have not been adjusted.

A rate that reflects current market assessments of the time value of money and the risks

specific to the asset (or cash-generating unit) is the return that investors would require if they

were to choose an investment that would generate cash flows of amounts, timing and risk

profile equivalent to those that the entity expects to derive from the asset. This rate is

estimated from the rate implicit in current market transactions for similar assets or from the

weighted average cost of capital of a listed entity that has a single asset (or a portfolio of

assets) similar in terms of service potential and risks to the asset under review.

When a specific rate for an asset or cash-generating unit is not directly available from the

market, which is usually the case, the entity’s Weighted Average Cost of Capital (WACC),

the entity’s incremental borrowing rate or other market rates can be used as a starting point.

While not prescribed, WACC is by far the most commonly used based for the discount rate.

The appropriate way to calculate the WACC is a complex subject, and one about which

there is much academic literature and no general consensus. The selection of the rate is

obviously a crucial part of the impairment testing process and, in practice, it will probably not

be possible to obtain a theoretically perfect rate. Therefore, the objective must be to obtain a

rate which is sensible and justifiable.

IAS 38 requires the discount rate used to be a pre-tax rate. Therefore, when the basis used

to estimate the discount rate is post-tax, that basis is adjusted to reflect a pre-tax. In

addition, the discount rate is independent of the entity’s capital structure and the way the

entity financed the purchase of the asset, because the future cash flows expected to arise


from an asset do not depend on the way in which the entity financed the purchase of the

asset.

Value in use, as defined by IAS 36, is primarily an accounting concept and not necessarily a

business valuation of the asset or cash-generating unit. For calculating value in use, IAS 36

requires pre-tax cash flows and a pre-tax discount rate.

WACC is a post-tax rate, as are most observable equity rates used by valuers. Because of

the issues in calculating an appropriate pre-tax discount rate and because it aligns more

closely with their normal business valuation approach, some entities attempt to perform a

value in use calculation based on a post-tax rate and post-tax cash flows.

It is possible for a post-tax approach to give the same answer as a pre-tax approach.

Indeed, IAS 36’s Basis for Conclusions states that, in theory, discounting post-tax cash flows

at a post-tax discount rate and discounting pre-tax cash flows at a pre-tax discount rate

should give the same result, provided the pre-tax discount rate is the post-tax discount rate

adjusted to reflect the specific amount and timing of the future tax flows.

The general principles behind calculating a pre-tax discount rate are that:

no account is taken of tax losses (because these are accounted for separately) and

the tax base of the asset is equal to its value in use, so there are no timing

differences associated with the asset that will affect the entity’s future tax charge.

Goodwill and impairment

The asset of goodwill does not exist in a vacuum; rather, it arises in the group accounts

because it is not separable from the net assets of the subsidiary that have just been

acquired.

The impairment review of goodwill therefore takes place at the level of a cash-generating

unit, that is to say a collection of assets that together create an independent stream of cash.

The cash-generating unit will normally be assumed to be the subsidiary. In this way, when

conducting the impairment review, the carrying value will be that of the net assets and the

goodwill of the subsidiary compared with the recoverable amount of the subsidiary.

When looking to assign the impairment loss to particular assets within the cash-generating

unit, unless there is an asset that is specifically impaired, it is goodwill that is written off first,

with any further balance being assigned on a pro rata basis.


The goodwill arising on the acquisition of a subsidiary is subject to an annual impairment

review. This requirement ensures that the asset of goodwill is not being overstated in the

group accounts. Goodwill is a peculiar asset in that it cannot be revalued so any impairment

loss will automatically be charged against income. Goodwill is not deemed to be

systematically consumed or worn out thus there is no requirement for a systematic

amortization.

Impairment testing

Economy & Finance

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