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Indicators of impairment
Extract from FRS102: Section 27.7 – 27.8
27.7 An entity shall assess at each reporting date 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. If there is no indication of impairment, it is not necessary to estimate the recoverable amount.
27.8 If it is not possible to estimate the recoverable amount of the individual asset, an entity shall estimate the recoverable amount of the cash-generating unit to which the asset belongs. This may be the case because measuring recoverable amount requires forecasting cash flows, and sometimes individual assets do not generate cash flows by themselves. An asset’s cash-generating unit is the smallest identifiable group of assets that includes the asset and generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets.
OmniPro comment
FRS 102 defines a cash generating unit as ‘the smallest identifiable group of assets that generate cash inflows that are largely independent of the cash inflows from other assets or groups of assets’.
It is vital that an entity goes down to as low a level as possible when determining a CGU. The higher the level of aggregation the more likely an unprofitable asset will be masked.
The identification of CGU’s will require judgement and Section 27 does not provide detailed guidance in determining a CGU. However under the hierarchy mentioned in Section 10- Accounting Policies, Estimates and Errors, users may refer to IFRS. Under IAS 36.69 (standard dealing with Impairments), in identifying whether cash inflows from an asset are largely independent of the cash inflows from other assets, entities are advised to consider various factors including:
- How management monitors the entity’s operations (such as product lines, businesses, individual locations, districts or regional area’s); or
- How management makes decisions about continuing or disposing of the entity’s assets and operations.
While monitoring by management may help identify CGU’s, it does not override the requirement that the identification of CGU’s is based on largely independent cash inflows.
Example 1: Lowest available CGU
Company A is a manufacturing plant that produces construction specifically designed plywood. The company has significant fixed assets. At year end there was a significant decline in the construction market which indicated that an impairment was required on the property, plant and equipment. In assessing the level at which an impairment review could be carried out, it would be very hard to determine it for the fixed assets themselves as they do not have largely independent cash flows, therefore in this case the cash flows of the manufacturing plant as a whole would be used in the value in use calculation.
Example 2: Lowest available CGU
A group operates a chain of supermarkets, management review the activity of each supermarket individually and all cash flows for each supermarket are independent of each other. In this case the cash flows from each supermarket would be seen as one cash generating unit and an impairment review carried out on this basis. It would not be appropriate to include all supermarkets in the one CGU as it would be carried out at too high a level and therefore mask any impairment write offs in some supermarket which were not as profitable.
IAS 36 also stresses the significance of an active market for the output of the asset in identifying a CGU. It is irrelevant if the entity uses the output in its own products. An active market is defined by FRS 102 as one in which all of the items traded are homogeneous, where willing buyers and sellers can normally be found at any time and which has prices that are available to the public.
Indicators of impairment
Extract from FRS102: Section 27.9 – 27.10
27.9 In assessing whether there is any indication that an asset may be impaired, an entity shall consider, as a minimum, the following indications:
External sources of information
a) During the period, an asset’s market value has declined significantly more than would be expected as a result of the passage of time or normal use.
b) Significant changes with an adverse effect on the entity have taken place during the period, or will take place in the near future, in the technological, market, economic or legal environment in which the entity operates or in the market to which an asset is dedicated.
c) Market interest rates or other market rates of return on investments have increased during the period, and those increases are likely to affect materially the discount rate used in calculating an asset’s value in use and decrease the asset’s fair value less costs to sell.
d) The carrying amount of the net assets of the entity is more than the estimated fair value of the entity as a whole (such an estimate may have been made, for example, in relation to the potential sale of part or all of the entity).
Internal sources of information
e) Evidence is available of obsolescence or physical damage of an asset.
f) Significant changes with an adverse effect on the entity have taken place during the period, or are expected to take place in the near future, in the extent to which, or manner in which, an asset is used or is expected to be used. These changes 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.
g) Evidence is available from internal reporting that indicates that the economic performance of an asset is, or will be, worse than expected. In this context economic performance includes operating results and cash flows.
27.10 If there is an indication that an asset may be impaired, this may indicate that the entity should review the remaining useful life, the depreciation (amortisation) method or the residual value for the asset and adjust it in accordance with the section of this FRS applicable to the asset (e.g. Section 17 Property, Plant and Equipment and Section 18 Intangible Assets other than Goodwill), even if no impairment loss is recognised for the asset.
OmniPro comment
It is clear from the above guidance that an impairment review is only required where indicators of impairment exist. There is no specific requirement for an annual impairment review to be performed in the below cases (this was required under old GAAP):
- Goodwill and intangible assets with an estimated useful life of more than 20 years;
- Property, plant and equipment of more than 50 years and on which no depreciation is charged on the grounds of immateriality.
- Review of goodwill for impairment after the first year of acquisition.
Section 27 does not require an entity to carry out post impairment monitoring whereas under old GAAP subsequent monitoring of cash flows was explicitly required for 5 years after the impairment was booked where the recoverable amount was based on value in use, with re-performance of the original impairment calculation if actual cash flows are significantly less than forecast.
See below application of some of the above indicators:
a) Example 3: A decline in the asset’s market value
Company A purchased a specialised piece of property, plant of equipment for CU300,000 during the year. At the end of year 1, the supplier dropped its price for that type of equipment to CU200,000. In this case, this would indicate a possible impairment. As a result an impairment may be required. This drop in price does not automatically mean an impairment loss as it is likely the value in use of the asset when taken together with a CGU for the Company will be higher so therefore no impairment may be required. If a residual value is estimated for the plant, then this would have to be updated as stated in Section 17.
If we assume that the piece of property is now abandoned and no longer in use within the CGU, then the fair value of that asset itself would be used to determine the amount of the impairment loss. The value in use for the CGU cannot be used as the asset is no longer providing any economic benefit, therefore its recoverable amount is the fair value less cost to sell.
Similarly assume Company A has an office block which it uses. Due to a significant reduction in property prices, there are indications that this asset is stated above its carrying amount. In this case, this would be an indicator of an impairment, however, this does not necessarily mean a write down is required as it is part of a CGU (that being the overall factory etc.) which when taken as one CGU shows significant headroom between the carrying value and the value in use. Therefore the slump in the property price is irrelevant.
b) Example 4: Significant adverse changes that have taken/will take place in the market
Company A is a pharmaceutical company that had an exclusive patent in which it sold its products. This patent expires and will not be renewed at the end of the year which will result in new entrants coming in and charging lower prices. At the end of that year the completion of the patent is an indicator of impairment as the future cash flows of the entity will be significantly reduced due to the entrant of new competitors and the impact of reduced selling prices.
c) Example 5: Change in assets use
Company A, produced a product; Product B. Due to changes in technology and the market, Product B sales are expected to decrease significantly. However, product B can be used in another product produced by Company A and this product will continue to make a profit using this product. The change in use of Product B, is an indicator of impairment and an impairment review will need to be carried out to review cash flows on the product as a result of the change in use.
d) Example 6: Introduction of new competitor
Company A has been the market leader for a product for a number of years. During the year a new competitor entered the market and has produced a similar product but is superior to Company A’s product. Even with the competitors introduction, sales have continued to increase.
In this case the introduction of the superior product is an indicator of impairment so management should carry out an impairment review. The existence of sales continuing to increase is not enough to negate the need to carry out an impairment review.
e) Example 7: Impairment indicators – decision to close
Company A made a decision at the year end to close its factory with immediate effect. In this case this is an indicator of impairment and an impairment review will be required. Given that the Company will no longer trade after the year end, there is no value in use, therefore the fair value less cost to sell should be used in order to determine the impairment to be booked on any property, plant and equipment, inventory etc.
If we assume that a decision was announced that it would cease in one years time from that date. Then in assessing whether an impairment existed, the value in use calculations could be used. If these value in use calculations showed no impairment requirement no write down is necessary. However, the depreciation to be charged of the assets in the following year would need to be updated so as to write them off in that year.
f) Example 8: Performance of an asset is worse than expected
Company A has performed detailed budgets and cash flows for a factory which is determined to be one CGU. During the year the actual performance significantly deviated from the budgeted numbers. This significant deviation is an indicator of impairment. Note the opposite is also true i.e. where the Company made significant profits in the past and now they are forecasting losses.
g) Example 9: Investment in subsidiary
Company A holds a 100% investment in Company B (cost CU500,000). At the year end Company B’s performance was far less than expected and a significant loss was incurred. As a result Company B’s net assets was CU400,000. The significant loss made by Company B is an impairment indicator. As it is likely that it would be difficult to determine the fair value less cost to see in an active market, the value in use model should be utilised to determine with an impairment is required. In this particular case, it may be appropriate to impair the investment down to the net asset amount of CU400,000 assuming Company B itself has completed an impairment review on its end.
Interest rates
Section 27.9(c) makes it clear that movements in interest rates is an indicator of impairment. Movement in interest rates could imply that assets are judged to be impaired if they are no longer expected to earn a market rate of return, even though they may generate the same cash flows. However, that said an upward movement in rates may not give rise to an impairment as it does not materially affect the rate of return expected from that asset.
An entity would not be required to do a formal impairment review of asset’s recoverable amount if the discount rate used in the value in use calculation is unlikely to be affected by an increase in market rates. This is relevant where an asset has a long term life.
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