Impairment of Assets - IAS 36 - Accounts

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Approaches to Present Value

IASB contrasts two approaches to estimating cash flows.

§ Traditional Approach

§ Expected Cash Flow

The Traditional Approach assumes that a single discount rate can incorporate all the expectations about the future cash flows and the appropriate risk premium.

The expected cash flow approach focuses more on the direct analysis of cash flows. It starts with cash flows that reflect the risk that management anticipate. Risk adjusted probability cash flow projections are not certain and, therefore, its not appropriate to use a risk free rate to discount such cash flows.

The standard thus highlights some of the problems and difficulties with the traditional approach that concentrates on encapsulating all of these variables into a single discount rate. ( this is because its not possible to use different discount rates for different risks and apply them to different ‘slices’ of cash flows).

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CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Hedging Instrument

Management may use hedging instruments, such as swaps and collars, to hedge cash flows. The cash flows prepared for the VIU calculation should reflect management’s best estimate of the future cash flows expected to be generated from the assets in the CGU. Management should use the contracted price for the relevant cash flows in its VIU calculation, unless the contract is already on the balance sheet at fair value.

Where the contract is on the balance sheet at fair value, it is accounted for under IAS 39. Where, the hedged cash flows are included in the VIU calculation at the spot price at the date of the impairment test. In addition, including the contracted prices of a contract already on the balance sheet at fair value would double- count the effects of the contract.

The principle to be applied is that working capital balances, including commodity contracts, recognised at fair value in accordance with IAS 39, are excluded from both the carrying amount of the CGU and the cash flows of the VIU calculation.

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CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Future Currency Cash Flows

Where future cash flows are expected to be denominated in a foreign currency, they should be estimated in that currency and then discounted at a rate appropriate for that currency.

This discount rate may be difficult to determine as its different to the rate used for the remainder of the present value calculation as its country and currency risk specific

The entity then translates the present value at the spot rate of exchange at the date of value in use calculation.

IAS 36 specifically prohibits use of the forward rate existing at the date of the impairment review. Forward differentials take into account interest rates and as the cash flows are to be discounted, the time value of money has already been taken into account.

It also does not permit the forecasting of future foreign cash flows and converting them at estimated sport exchange rate at future dates as such estimates cannot be reliably made.

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CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Future Restructuring

A key constraint concerning the assumptions in the cash flow forecasts relate to future restructuring or reorganization and capital investment.

In calculating value in use, future cash flows, should be estimated for assets and goodwill in their current condition. The future costs and benefits of a future restructuring should not be recognised in the cash flow forecasts, unless the entity is committed to the restructuring and related provisions have been made.

The costs and benefits of future expenditure that is intended to improve or enhance the assets or business should not be taken into account in the cash flow forecast.

In practice, Restriction on value in use should lead to entities using a fair value less costs to sell basis for the calculation of recoverable amount, as it will be higher. In cases where a restructuring is foreseen but not yet provided for, and it is reasonable to assume market participants would also restructure, fair value less costs to sell is likely to produce a higher amount.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Example :- An entity’s management has decided to redevelop its main offices to improve the environment in which its employees work and to provide better facilities to receive clients. The office building is subject to depreciation, but the land is not. The building and the land are carried at re-valued amounts.

The main office building will be demolished and replace by a new building. The re-valued carrying amount of the building is Rs.1 Crore. Management argue that the redevelopment’s plans increase the total value of the property. Management does not wish to recognise an impairment loss on the existing building in spite of its commitment to the property’s demolition and replacement.

The cash flow from a replacement asset cannot be considered when estimating future cash flows for an existing asset. The recoverable amount of the old building is zero. The cost of demolishing the old building is part of the costs of constructing the new building as it represents site preparation costs.

The impairment loss should be recognised first against the revaluation surplus for the asset. To the extent that the impairment exceeds the revaluation surplus for that building it should be recognised in the income statement.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Assets under Construction

Assets under construction also need to be considered when looking at the cash flows to include in a value in use calculation. Where the carrying amount of an asset does not yet include all the cash outflows that must be incurred before it is ready for use.

For example, a building under construction or a in complete development project, then IAS 36 give some specific guidance on what to include in the estimates of future cash flows; the future cash flows should include an estimate of the future cash flows expected to be incurred before the asset is ready for use or sale.

If the value in use cannot be determined for an individual asset under construction and the fair value less costs to sell of the asset is lower than the carrying amount then the CGU to which the asset belongs will need to be tested for impairment.

When calculating the value in use of the CGU to which the asset not yet ready for sale or use belongs an entity will need to determine at what stage of construction the asset will need to be included in the value in use calculation of the CGU

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CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Discount Rate

Projected future cash flows are discounted at a pre – tax rate that reflects both current market assessments of the time value of money and the risks specific to the asset for which the future cash flow estimates have not been adjusted. This means that an asset is regarded as impaired if its not expected to earn a current market related rate of return on its carrying value.

If an asset specific rate is not available directly from the market an entity should estimate and appropriate discount rate that reflects as far as possible market assessment of :

§ The time value of money to the end of the asset’s useful life.

§ The risks that the future cash flows will differ in amount or timing from estimates.

§ The price for bearing the risk inherent in the asset.

§ Other factors that market participants would reflect in the rate such as illiquidity.

The entity may take into account the following factors in determining this rate :

§ The WACC for the entity, determined using techniques such as the CAPM

§ The entity’s incremental borrowing rate

§ Other market borrowing rate

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CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

In the determining of discount rate Factors to consider might include :

§ Country Risk, for example the risk of political unrest

§ Currency Risk, for example the risk of devaluation

§ The nature of the asset being tested; intangible assets are higher risk.

§ Whether the cash flows are optimistic or stretch targets.

§ Price risk, Ex:- the risk that prices may be forced down by competitive pressures

Rate applicable to different business units within a group may vary to reflect any risk factors that are specific to those units. Trading activities and investments in different countries are likely to have different risks, for example, currency and political risk.

The rate should be appropriate to the country in which the CGU operates rather than the country in which the finance is sourced. In general, the more uncertain the cash flows are, the more risky the investment is, and the greater the risk adjustment is to increase the discount rate. The rate is independent of the entity’s capital structure and the way in which purchase of CGU was financed.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Discount Rate – Pre – tax Rate

IAS 36 requires the discount rate for value in use calculation to be calculated on a pre-tax basis. Thus a CGU’s pre-tax cash flows should be discounted at the pre-tax discount rate. When only the post tax discount rate is known, management should adjust the post-tax rate to estimate a pre-tax rate.

Example:- Entity A has calculated a WACC of 8% based on market assumptions. Management is aware that this is a post-tax rate and, therefore, wants to determine a pre-tax discount rate by grossing up the 8% by the statutory tax rate in entity A’s country, which is 35%. The result is 12.3% (8% / .65).

The 12.3% is only the correct pre-tax discount rate if the specific amount and timing of the future tax cash flows are reflected by this rate. So a grossed up discount rate works only is there is no deferred tax.

As soon as there is deferred tax an iterative calculation needs to be done that considers the fact that a carrying amount after impairment would trigger new deferred taxes and this would again change the carrying amount.

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CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Allocation of assets and liabilities to CGU’s

The way in which the carrying amount of a CGU is determined should be consistent with the determination of its recoverable amount. The carrying amount of a CGU is established by allocating assets and liabilities to individual CGUs. The carrying amount of a CGU consist of :

§ Assets that are directly and exclusively attributable to the CGU

§ An allocation of assets that are indirectly attributable on a reasonable and consistent basis to the CGU including

§ Corporate Assets

§ Capitalisation goodwill

§ Recognised liabilities, but only to the extent that the recoverable amount of the CGU cannot be determined without consideration of those liabilities.

The assets attributed to CGUs should be consistent with the cash flows that are identified for calculating recoverable amount. Liabilities that relate to financing the operating of CGUs are not allocated in determining the carrying amount. No distinction is made between external and intercompany financing.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Leased Assets

The standard does not specify how leased assets should be treated. Under the standard’s impairment review methodology, the approach would be as follows,

For Finance lease, the carrying value of a lease assets would be included in the carrying amount of the CGU; the lease liability and the lease payments would be excluded from the impairment calculation because they related to financing.

For Operating lease, no assets would be recognised in the carrying amount of the CGU; the lease payments would be treated as operating cash outflows in the calculation of value in use.

There may be circumstances when its not possible to determine recoverable amount without taking account of a recognised liability.

For example if the disposal of a CGU would require the buyer to take over a liability, the fair value less costs to sell is the price of the assets and the liability together, less costs of disposal. So that the comparison of recoverable amount and carrying amount are on a consistent basis, the liability should also be included in the carrying amount of the CGU.

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CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Goodwill

Goodwill acquired in a business combination represents future economic benefits arising from assets that are not capable of being individually identified and separately recognised. Goodwill does not generate cash flows independently from other assets or group of assets and so the recoverable amount of goodwill as an individual asset cannot be determined.

However, goodwill often contributes to the cash flows of individual of multiple CGUs. Therefore, goodwill acquired in a business combination must be allocated from the acquisition date to each of the acquirer’s CGUs or group of CGUs that are expected to benefit from the synergies of the business combination.

The allocation of the purchased goodwill is made independently of the allocation of the acquiree’s other assets and liabilities. Acquired assets or liabilities do not need to be allocated to the CGU. The allocation of goodwill is made based on the synergies expected to be derived from the combination.

The synergies are represented by those unrecognized assets of the acquired entity, such as market share, that are effectively transferred to the CGU, rather than by the recognised assets and liabilities that may or may not be transferred to it.

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CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

CGUs to which goodwill is allocated from the date of acquisition should be chosen using the following criteria :

§ the CGU should represent the lowest level within the entity at which management monitors goodwill for internal purposes; and

§ the CGU should not be larger than a reportable segment determined in accordance with IFRS 8 “Operating segments”

When an entity adopts IFRS 8 for the first time, it will need to consider its allocation of goodwill to CGUs. IFRS 8 requires goodwill to be allocated to operating segments; this may be a lower level than reporting segments under IAS 14.

The allocation goodwill should normally be completed before end of the financial year in which the combination takes place. However, the standard also states that if the initial allocation of goodwill cannot be completed within the year of acquisition, that initial allocation is completed before the end of the first financial year beginning after the acquisition date. Goodwill is tested once the location is completed within the time limit.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Example :- An acquisition takes place in Jan 2008. IAS 36 requires the goodwill arising on a business combination in the current year to be tested for impairment before the end of the current year, so the goodwill should be tested by the end of 2008. However, the entity has not completed its purchase accounting by the end of 2008. Therefore, it cannot allocate goodwill until the amount is known.

IFRS 3 allows an entity 12 months from the acquisition date to complete the purchase accounting. For this acquisition the entity must complete the purchase accounting by Jan 2009. At this time the goodwill number is known so the goodwill must be allocated to CGUs or groups of CGU by the end of the period end Dec 09.

Example :- A CGU was reviewed for impairment at 31st Dec 07 and recoverable amount was estimated 30 minr. Recoverable amount was based on the fair value less costs to sell. Goodwill of 6 MINR has previously allocated to the CGU and is not impaired at 31st Dec 07. In 2008 part of the CGU is disposed of form 20 minr net of disposed costs. The entity has to allocate the goodwill between the CGU ?

Assuming there no changes in the recoverable amount of the CGU up to the date of disposal and no other special effects of the disposal the allocation of the goodwill to the operation disposed of would be based on the ratio 2:1. Therefore, 4 minr of goodwill would be apportioned to the business disposed of.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

If an entity carries out a restructuring that changes the composition of one or more CGUs to which goodwill has previously been allocated, it should reallocate that goodwill amongst the units affects. The allocation will same as the way in the disposal of operations.

Individual assets comprising a CGU must be tested for impairment at different times from the CGU itself and CGU making up a group of CGU may be tested for impairment at different times from the group as a whole.

However, if individual assets are tested at the same time as the CGU is then tested afterwards. Similarly individual CGUs that are tested at the same time as a group to which they belong must be tested separately before the group is tested.

Groups need to keep details records of the composition of the aggregate amount of purchased goodwill to avoid having to carry out impairment test of all CGUs annually.

The record should explain to which parts of the group the goodwill relates and to which CGUs and groups of CGUs to which goodwill is allocated must be tested for impairment annually and whenever there is any indication it should be impaired.