Section 22 – Impairment of Assets

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Section 22-Impairment of Assets

Section 22 provides detailed guidance on the indicators of impairment, how impairment reviews should be performed and the circumstances in which they should be reversed.

Objective and scope
Extract from FRS 105 – Section 22.1

22.1      An impairment loss occurs when the carrying amount of an asset exceeds its recoverable amount. This section shall be applied in                          accounting for the impairment of all assets (including goodwill), other than the following, for which other sections of this FRS establish                    impairment requirements:

      (a)   assets arising from construction contracts (see  Section 18   Revenue);

      (b)   financial assets within the scope of Section 9 Financial Instruments; and

      (c)   inventories (see Section 10 Inventories).

OmniPro comment

Section 22 requires that no asset within its remit should be stated at an amount above its recoverable amount. The items above are excluded as these have specific rules under their own standard. In summary a list of the main assets coming within the remit of Section 22:

Note impairment of investments in associates, joint ventures, subsidiaries in the entity financial statements is dealt with under Section 9 of FRS 105.

Impairment of assets
Extract from FRS 105 – Section 22.2 – 22.5
General principles

22.2      If, and only if, the recoverable amount of an asset is less than its carrying amount, the micro-entity shall reduce the carrying amount of                  the asset to its recoverable amount.

22.3      If it is not possible to estimate the recoverable amount of the individual asset, a micro- entity shall estimate the recoverable amount of the              cash-generating unit to which the asset belongs. This may be the case because measuring the recoverable amount requires forecasting                cash flows, and sometimes individual assets do not generate cash flows by themselves. An impairment loss for a cash-generating unit                    shall be recognised and measured in accordance with the relevant requirements of Section 27 Impairment of Assets of FRS 102. 

22.4      A micro-entity that has goodwill acquired in a business combination shall apply the additional impairment requirements applicable to                        goodwill in paragraphs 27.24 to 27.27 of FRS 102.

22.5      A micro-entity shall recognise an impairment loss immediately in profit or loss.

OmniPro comment

See diagrammatic representation of the analysis to be performed when assessing if an impairment is present.

*Note the carrying value can be the value of the individual assets where cash flows can be identified from the asset or it can be a carrying value of a cash generating unit where cash flows cannot be identified as specific to an asset. The starting point is an individual asset, then one should move to a CGU. As can be seen from the above, it may not always be necessary to calculate the FVLCS and the value in use. If one of the measures give a value which is greater than the carrying value this indicates no impairment is required so there is no need for further work to be performed to assess the other measure.

Recoverable amount is defined in Appendix I of FRS 105 as ‘the higher of an asset’s (or cash generating unit’s) fair value less costs to sell and its value in use.

Fair value less cost to sell is defined as ‘the amount obtainable from the sale of an asset or CGU 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.

As can be seen from the above, it may not always be necessary to calculate both.

Where an impairment loss is calculated on a CGU FRS 105 requires an entity to review the guidance in Section 27 of FRS 102 in deciding how this should be allocated. This has been look at further below

Cash Generating Unit 

FRS 105 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 vitally essential 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 22 does not provide detailed guidance in determining a CGU. However it is useful to refer to IFRS in this regard. Under IAS 36.69 (standard dealing with Impairments under IFRS), 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:

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 105 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 22.6-22.8

Indicators of impairment

22.6      A micro-entity shall assess at each reporting date whether there is any indication that an asset may be impaired. If any such indication                    exists, the micro-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.  

22.7      In assessing whether there is any indication that an asset may be impaired, a micro- 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 micro-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 micro-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 micro-entity is more than the estimated fair value of the micro-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 micro- 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 micro-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.

     (f)   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.

22.8      If there is an indication that an asset may be impaired, this may indicate that the micro- 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 (eg Section 12 Property, Plant and Equipment and Investment Property and Section 13 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/FRSSE):

Section 22 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:

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 12.

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.

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.

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.

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.

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.

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.

Interest rates

Section 22.7(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.

Measuring recoverable amount
Extract from FRS102: Section 22.9 – 22.11

22.9      The recoverable amount of an asset is the higher of its fair value less costs to sell and its value in use.

22.10     It is not always necessary to determine both an asset’s fair value less costs to sell and its value in use. If either of these amounts                             exceeds the asset’s carrying amount, the asset is not impaired and it is not necessary to estimate the other amount. 

22.11     If there is no reason to believe that an asset’s value in use materially exceeds its fair value less costs to sell, the asset’s fair value less                    costs to sell may be used as its recoverable amount. This will often be the case for an asset that is held for disposal. 

OmniPro comment

As detailed in the introduction above, where one method shows the recoverable amount is in excess of the carrying amount, then the second method does not have to be completed e.g. if fair value less cost to sell indicates the recoverable amount is greater than carrying amount, then the entity does not have to calculate the value in use.

If the value in use calculation indicates an impairment but the fair value less cost to sell method does not (or vice versa), then no impairment should be booked even where the entity has no intention of selling the asset.

Example 10: Value in use differs from fair value less costs to sell

Company A operates a factory and manufacturers products. The value in use calculation indicates an impairment of the fixed assets. The fair value of the fixed assets alone are well above the carrying amount. The company has no intention of disposing of the asset. In this particular case no impairment should be booked as the fair value is higher than the carrying amount. The intentions of management should be ignored as the company could if it wishes sell these valuable assets at any time.

Fair value less costs to sell
Extract from FRS102: Section 22.12 – 22.13

22.12     Fair value less costs to sell is the amount obtainable from the sale of an asset in an arm’s length transaction between knowledgeable,                     willing parties, less the costs of disposal. The best evidence of the fair value less costs to sell of an asset is a price in a binding sale                        agreement in an arm’s length transaction or a market price in an active market. 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 a micro-entity could obtain, at                   the reporting date, 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, a micro-entity considers the outcome of recent transactions for similar assets within the              same industry.

22.13     When determining an asset’s fair value less costs to sell, consideration shall be given to any restrictions imposed on that asset. Costs to                 sell shall also include the cost of obtaining relaxation of a restriction where necessary in order to enable the asset to be sold. If a                             restriction would also apply to any potential purchaser of an asset, the fair value of the asset may be lower than that of an asset whose                  use is not restricted. 

OmniPro comment

An active market is defined in Appendix I of FRS 105 as ‘a market in which all the following conditions exist:

     (a)   The items traded in the market are homogenous;

     (b)   Willing buyers and sellers can normally be found at any time; and

     (c)   Prices are available to the public’.

It is clear from the above that if there is a binding sales agreement in an arm’s length transaction or an active market then the price must be used. However, there are very few active markets for tangible and intangible fixed assets or trade CGU’s.

Example 11: Fair value less costs to sell

Company A owns a packaging machine. It’s NBV at year end was CU20,000. Its remaining useful life at that time was 10 years. The price that would be obtained in an active market for the machine is CU16,000 and would incur costs on disposal of CU1,000. At the year end due to a decrease in demand for the Company’s product, the machine is rarely used. The Company estimates that the value in use is well below the fair value less cost to sell. In this example, as the fair value less cost to sell is highest, an amount of CU5,000 would be posted at year end. The journal to post is:

 

CU

CU

Dr Impairment of Fixed Asset in P&L

(NBV of CU20,000 – (CU16,000-CU1,000))

5,000

 

Cr Accumulated Depreciation

 

5,000

Where an active market does not exist, then the fair value can be based on recent transactions of identical nature. Where this is not possible valuation techniques should be used. One such example is a discounted cash flow model. Such a model should incorporate assumptions that market participants would use in estimating the asset’s fair value. The model should utilise the maximum use of market inputs, and rely as little as possible on entity determined inputs. A valuation technique would be expected to arrive at a reliable estimate of fair value:

Therefore the model should utilise the models that are used by investors in assessing the fair value e.g. hotel generally sell on a multiple of EBITA however discounted cash flows are usually used for manufacturing companies. The assumptions in whatever model should be based on the assumptions other market participants would use and should not be based on management’s uncorroborated views or information not known by the market.

Where an active market does not exist but a valuation model is used, the advantage of using this model above the value in use model is that that model can incorporate any future capital expenditures any third party investor would incur to enhance the cash flows or restructuring that would be carried out. Under the value in use model any future capital which enhances the level of performance above current performance cannot be included in the cash flows.

In reality it is not always easy to determine fair value so it is likely that entities will default to the value in use model.

When using market data, careful selection is required and bias should not come into play, it should look at multiples on a number of transactions and not just the one which gives the right answer for the entity particularly where multiples are used.

Discount rate for fair value less cost to sell

The discount rate to use is the post tax discount rate and the cash flow should be post-tax. The post tax rate should be easier to obtain than a pre-tax rate.

When comparing the fair value of cash flows with the carrying amount it is important to compare like with like i.e. if cash flows include working capital then the carrying amount should include this also. Likewise, the cash flows should incorporate current tax but exclude deferred tax assets.

Value in use
Extract from FRS102: Section 22.14 – 22.18

22.14  Value in use is the present value of the future cash flows expected to be derived from an asset. This present value calculation involves                   the following steps:

     (a)  estimating the future cash inflows and outflows to be derived from the continuing use of the asset and from its ultimate disposal; and

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

22.15  In measuring value in use, estimates of future cash flows shall include:

     (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, expected to be received (or paid) for the disposal of the asset at the end of its useful life in an arm’s length                            transaction between knowledgeable, willing parties.

The micro-entity may wish to use any recent financial budgets or forecasts to estimate the cash flows, if available, and extrapolate the projections using a steady or declining growth rate for subsequent years, unless an increasing rate can be justified.

22.16  Estimates of future cash flows shall not include:

     (a)  (a) cash inflows or outflows from financing activities;    or

      (b)  income tax receipts or payments.

22.17  Future cash flows shall be estimated for the asset in its current condition. Estimates of future cash flows shall not include estimated future               cash inflows or outflows that are expected to arise from:

     (a)  a future restructuring to which a micro-entity is not yet committed; or

     (b)  improving or enhancing the asset’s performance.

22.18 The discount rate(s) used in the present value calculation shall be a pre-tax rate(s) that reflect(s) current market assessments of:

     (a)  the time value of money; and

     (b)  the risks specific to the asset for which the future cash flow estimates have not been adjusted.

The discount rate(s) used to measure an asset’s value in use shall not reflect risks for which the future cash flow estimates have been adjusted, to avoid double-counting.

OmniPro comment

As can be seen from the sections above, there are detailed rules as to what can or cannot be included in the cash flows under the value in use model.

Value in use can be determined on an asset basis or where there is no independent cash flows from that asset, the smallest CGU which incorporates this asset. Value in use calculations at the level of CGU will be required where the fair value less cost to sell cannot be determined or where this is below the carrying amount and:

Section 22.17 makes it clear that future cash flows should only be estimated in its current condition. It cannot incorporate any future reconstructions not committed nor can it include cash outflows for purchasing fixed assets which enhance the cash flow generation possibilities for the entity. Therefore in reality, the only capital expenditure that should be incorporated into the model is the cost of maintaining the current fixed assets at their current condition and any replacement expenditure on the assets making up a larger asset that requires replacement at various intervals and is depreciated over a shorter life than the main asset. In addition, it should incorporate normal repairs and maintenance costs for maintaining the assets.

Where an entity is committed to future reconstructions which will result in cost savings these may be included in the future cash flows.

Example 12: Determining cash flow to include

Company A is a manufacturing company providing special plywood to the construction industry. During the year there was a large slump in the construction market which was an indicator of impairment. The company has prepared the estimated cash flow and has included the below in the cash flow. Determine which ones will be allowed to be included as part of the value in use calculation.

          Solution: Neither the costs of the reconstruction or the cost savings can be incorporated into estimated future cash flows as the entity was           not demonstrately committed to it i.e. it was not provided for in the year end financial statements.

         Solution: Section 22.17 does not allow planned future capital expenditure which enhances the cash flow potential to be incorporated into              the cash flow. Neither does it allow the future additional cash inflows from the proposed expenditure.

         Solution: Given that this is a component that is separately depreciated from the main production line and it does not enhance the                          performance of the line above the performance at the date of the value in use calculation, this should be included in the estimated cash                  outflows. Note the cash flows should incorporate these based on the life of that component so if these parts had to be changed every five               years, it would have to be included in the cash flow every five years.

         Solution: When determining whether this cash flow is appropriate, one would have to look at the industry in which the company operates.              Given that the market has slumped it would be very unusual for a 10% growth rate to be assumed. On this basis it is likely that these growth          rates would need to actually show a reduction for at least the first few years as opposed to an increase. The 10% growth rate for 10 years              also seems to be too long a period. IAS 36 would state that a growth rate should not be incorporated for more than 5 years and as stated in          Section 22 from then on a steady rate or declining growth rate should be used. Therefore these growth rates would have to be reduced and          usually after 5 years decreasing or no further growth should be assumed. However each circumstance would need to be assessed                        individually based on the industry in which the entity operates.

          Solution: Although this is an allowable cash flow usually the repairs and maintenance cost included in the cash flow should some way                   equate to the yearly depreciation charge.

          Solution: This is incorrect as the company should compare like with like. In this instance the company should take the net assets relating to            the CGU so that they are comparing like with like.

          Solution: This is incorrect as a pre-tax discount rate should be used.

          Solution: The entity must incorporate the effects of inflation into its cash flows under the standard. Therefore, the expected future inflation              needs to be incorporated.

          Solution: The inclusion of tax cash flows is not allowed under Section 22.

         Solution: The terminal value amount must exclude all abnormal or exceptional items included in the last forecasted periods cash flows as              this incorrectly inflates the terminal value amount.

          Solution: This is incorrect as the cash flows should incorporate the earnings before interest, tax, amortisation and depreciation as                         financing activities should be excluded together with any non-cash costs.

The interest income and expense should therefore have also been excluded in the above example.

Estimate the future pre-tax cash flows 

Section 22.15 above provides guidance on the cash flows to be included and specifically states that it can use budgets or forecasts to estimate the cash flows and that an entity may extrapolate the projections based on the budgets or forecasts using a steady or declining growth. Section 22 does not specify how long the projections and budgets can be used before extrapolation must occur. IAS 36 specifically states that this should be used for a maximum of 5 years, for the period before which a steady or declining growth rate could be assumed. It would not be unreasonable to apply this in Section 22. The five year rule is based on the theory that indicates that above-average growth rates will only be achievable in the short term, because such above average growth will lead to competitors entering the market which will lead to a reduction in the growth rate for the economy as a whole.

Inflation should be incorporated in the cash flows and therefore the discount rate used should exclude the effect of inflation or vice versa.

Usually it is appropriate to incorporate the earnings before interest, tax, amortisation and depreciation in the cash flows as financing activities should be excluded and the other items are non-cash items.

Foreign cash flows

Section 22 does not consider how foreign currency cash flows should be translated in the cash flows. Where the cash flows are in a currency which is not the entities functional currency, guidance may be obtained under the hierarchy stated in Section 2 and it would be good to refer to IAS 36. IAS 36 states that foreign currency cash flows should first be determined in the foreign currency they are generated in and then discounted at a discount rate appropriate to that currency. The entity can then translate the present value calculated in the foreign currency using the spot exchange rate at the date of the value in use calculation.

Steps in calculating VIU

The steps in calculating the value in use are:

Step 1: divide the entity into CGU’s where an asset does not have independent cash flows

Step 2: estimate the future pre-tax cash flows of the CGU under review

Step 3: identify an appropriate discount rate and discount the future cash flows

Step 4: compare the carrying value with the value in use and recognise the impairment loss where applicable.

Value in use – discount rate

As per Section 22.18 the discount rate used should be the pre-tax discount rate that reflects the current market assessments of the time value of money; and the risk specific to the asset for which the future cash flow estimates have not been adjusted.

In essence the discount rate to be applied should be an estimate of the rate that the market would expect on an equally risky investment. The discount rate specific for the asset or CGU will take account of the period over which the asset or CGU is expected to generate cash inflows and it may not be sensitive to short term rates.

In most cases the asset specific rate will not be available from the market and therefore estimates will be required. In practice many entities will use the weighted average cost of capital (WACC) as a starting point to estimate the appropriate discount rate and it is a commonly known methodology. Where WACC is used some of the issues which must be considered are:

The determination of an appropriate discount rate is a difficult process and will require judgment. Usually sensitivity analysis should also be determined to see the effect a change in discount rate would have. Usually a WACC rate is used and where this shows sufficient head room, then this may suffice. However, where this shows an impairment the pre-tax rate must be used. Other rates that should be looked at is the entity’s incremental borrowing rate or other borrowing rates.

See the example below which shows the difficulty in determining a pre-tax WACC rate.

Example 13: WACC

Company A has calculated a WACC of 5% based on market assumptions. This is the post-tax rate and they require the pre-tax rate for the value in use calculation as it is probable that an impairment exists. The tax rate is 10%. Therefore assuming there is no timing difference the pre-tax WACC is 5.555% (5%/(1-.1)). However as it is likely that there will be large timing differences, then a more detailed method will be required to determine the pre-tax WACC.

The most appropriate WACC model to use is the CAPM model (capital asset pricing model). The formula for to calculate the CAPM is:

Rs= Rf +B(Rm-Rf)

Where:

Rs= return on security we are interested in (expected return on capital assets or return required)

Rm= the expected return from the market as a whole (ISEQ shows return for all quoted companies in Ireland

Rf – return available on risk free securities (government bonds etc.)

B= beta factor. Market as a whole produces a given return, the beta factor for an individual share measures the volatility of the return on that share to the market as a whole. Market as a whole has a beta factor of 1. Risk free securities have a beta of 0. This factor is the ratio of the return on that share to the markets overall return e.g. return on share is 29% & return on market as a whole was 15%, then beta factor for shares is 29/15=1.93. Beta factor is a measure of the systematic risk of the capital asset. If shares in ABC plc tend to vary twice as much as returns from the market as a whole, so that if market returns (i.e. ISEQ) increase by 3% returns on ABC plc would be expected to increase by 6% and vice versa. Hence beta factor for ABC is 2

Rm-Rf is the risk premium looked for in return for investing in securities other than risk free securities. From above we can see that the minimum return must at least be the risk free rate.

Value in use – terminal value

In relation to non-current assets, a large component of value attributable to an asset or CGU arises from its terminal value, which is the net present value of all of the forecast free cash flows that are expected to be generated by the asset or CGU after the explicit forecast period.

When the asset is to be sold at the end of its useful life the disposal proceeds and costs should be based on current prices and costs for similar assets, adjusted where necessary for price level changes if the entity has chosen to include this factor in its forecasts and selection of a discount rate.

CGU’s and certain assets have indefinite lives and therefore the amount to be included in the terminal value is usually the amounts in the last forecast period that is presented. It is essential that the terminal year cash flows reflect maintainable cash flows as otherwise any material one off or abnormal cash flows that are forecast for the terminal year will inappropriately increase or decrease the valuation. The maintainable cash flows expected to be generated by the asset or CGU is then capitalised by a perpetuity fact based on either:

The formula to calculate the terminal value is as follows:

CF * (1+g)/(r-g)

Where CF= maintainable cash flows

g = terminal value growth rate (where applicable)

r = discount rate

For example, Company A prepared a cash flow for impairment testing purposes based on budgets for years 1 to 5. The assumed discount rate is 10% and the terminal value growth rate is 1%. The projected cash flow including discounting is as per below.

Recognising and measuring an impairment loss in the case of a cash generating unit.

Section 22.3 refers an entity to Section 27.21 to 27.27 of FRS 102 where there is a cash generating unit exists and an impairment loss is required and where goodwill is recognised as part of a business combination. Note business combination under FRS 105 can only be combinations of trade assets and liabilities as opposed to acquisitions of shares as FRS 105 does not allow consolidated financial statements to be prepared. See below the guidance where such circumstances arise.

Section 27.21 of FRS 102 states ‘An impairment loss shall be recognised for a cash-generating unit if, and only if, the recoverable amount of the unit is less than the carrying amount of the unit. The impairment loss shall be allocated to reduce the carrying amount of the assets of the unit in the following order:

(a)        first, to reduce the carrying amount of any goodwill allocated to the cash-           generating unit; and

(b)      then, to the other assets of the unit pro rata on the basis of the carrying amount of each asset in the cash-generating unit.

However, an entity shall not reduce the carrying amount of any asset in the cash-generating unit below the highest of (Section 27.22 of FRS 102):

(a)        its fair value less costs to sell (if determinable);

(b)        its value in use (if determinable); and

(c)      zero.

Any excess amount of the impairment loss that cannot be allocated to an asset because of the restriction in paragraph 27.22 shall be allocated to the other assets of the unit pro rata on the basis of the carrying amount of those other assets (Section 27.23 of FRS 102).

Goodwill, by itself, cannot be sold. Nor does it generate cash flows to an entity that are independent of the cash flows of other assets. As a consequence, the fair value of goodwill cannot be measured directly. Therefore, the fair value of goodwill must be derived from measurement of the fair value of the cash-generating unit(s) of which the goodwill is a part (Section 27.24 of FRS 102). 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 that are expected to benefit from the synergies of the combination, irrespective of whether other assets or liabilities of the acquiree are assigned to those units (Section 27.25 of FRS 102).

Example 14: Impairment loss for a CGU with goodwill

In year 1 Company A acquired trade assets and liabilities of Company B for CU100,000. On acquisition 3 CGU’s were identified called CGU 1, CGU 2 and CGU 3. The fair value of the assets acquired was CU60,000 and goodwill of CU40,000 was recognised on acquisition and set against each CGU.  The goodwill was allocated to each CGU based on the synergies expected to be achieved which ultimately was allocated 1/3rd to each CGU.

In year 2, due to a change in the market trends the demand for the product produced by CGU 1 reduced significantly. The value in use calculations indicate a recoverable amount of CU9,000. At that date the carrying amount of the goodwill and identifiable assets were CU10,000 and CU20,000 (split between asset A&B of CU12,000 and CU8,000) respectively. Therefore, the total impairment to be booked is CU21,000 (CU10,000+CU20,000-CU9,000 recoverable amount).

The calculation of the allocation of the impairment loss of CGU 1 is carried out as follows:

 

Carrying value

Impairment

Carrying amount after impairment

Goodwill

CU10,000

(CU10,000)*

CUnil

Asset A

CU12,000

(CU6,600)**

CU5,400

Asset B

CU8,000

(CU4,400)***

CU3,600

Total

 

 

 

*impairment set against goodwill first and remaining amount set against all other assets on a pro-rata basis.

**impairment allocated pro-rata to identifiable assets e.g. asset A= (CU21,000-CU10,000 allocated to goodwill) * (CU12,000/(CU12,000+CU8,000)) = CU6,600.

***impairment allocated pro-rata to identifiable assets e.g. asset A= (CU21,000-CU10,000 allocated to goodwill) * (CU8,000/(CU12,000+CU8,000)) = CU4,400.

See below the illustration of the restriction mentioned in Section 27.22 and 27.23 of FRS 102 and its applicability to FRS 105.

Example 15: Restriction of reduction of assets as a result of an impairment

In year 1 Company A acquired the trade assets and liabilities of Company B for CU100,000. On acquisition one CGU was only identified. The fair value of the assets acquired was CU60,000 split between three machines (Machine A: CU10,000, Machine B: CU30,000 and Machine C: CU20,000) and goodwill of CU40,000 was recognised. In year 2, due to a change in the market trends the demand for the product produced by the CGU reduced significantly. Therefore an impairment review was necessary. The value in use of the CGU at that time was estimated at CU25,000. The carrying value of Machine A, B & C was CU7,000, CU25,000 and CU16,000 respectively. The carrying value of goodwill at that time is CU20,000. The fair value less cost to sell of machine C was CU6,000. The fair value of the other machines cannot be determined. See below how the impairment loss of CU43,000 (CU7,000+CU25,000+CU16,000+20,000-CU25,000 recoverable amount) should be allocated.

 

Carrying value

Impairment

Carrying amount after impairment

Goodwill

CU20,000

(CU20,000)*

CUnil

Machine A

CU7,000

(CU1,000)**

CU6,000

Machine B

CU25,000

(CU13,414)***

CU11,586

Machine C

CU16,000

(CU8,586)****

CU7,414

Total

 

CU43,000

  

*impairment set against goodwill first and remaining amount set against all other assets on a pro-rata basis.

**Note 1: impairment allocated pro-rata to identifiable assets e.g. asset A= (CU43,000-CU20,000 allocated to goodwill) * (CU7,000/(CU7,000+CU25,000+CU16,000)) = CU3,354. However as the fair less cost to sell is CU6,000 it cannot be written down below CU6,000. Therefore the adjustment is limited to CU1,000 (CU7,000-CU6,000). The remaining CU2,354 (CU3,354-CU1,000 booked) has to be allocated between the remaining assets.

***Note 2: impairment allocated pro-rata to identifiable assets e.g. asset A= (CU43,000-CU20,000 allocated to goodwill) * (CU25,000/(CU7,000+CU25,000+CU16,000)) = CU11,979. However the CU2,354 in note 1 above has to be allocated to machine B as follows: = CU2,354 * (CU25,000/(CU25,000+ CU16,000))= CU1,435. Therefore total impairment to be booked against Machine B is CU1,435+CU11,979= CU13,414.

***Note 3: impairment allocated pro-rata to identifiable assets e.g. asset A= (CU43,000-CU20,000 allocated to goodwill) * (CU16,000/(CU7,000+CU25,000+CU16,000)) = CU7,667. However the CU2,354 in note 1 above has to be allocated to machine B as follows: = CU2,354 * (CU16,000/(CU25,000+ CU16,000))= CU919. Therefore total impairment to be booked against Machine B is CU919+CU7,667 = CU8,586.

Note we have called the assets machine A, B & C here but any of these could easily have been other assets. The treatment would not change.

Allocation of corporate assets

Section 22 does not deal with allocating carrying value of corporate assets e.g. office building for all CGU’s., however this is likely to be allocated on the basis of the carrying value of each CGU. It can also be determined on the basis of turnover or employee numbers. If the fair value less cost to sell of this building on its own is above its carrying amount it would not need to be included in the value in use calculation and therefore would not need to be included in the carrying amount when comparing it to the value in use.

Integrated entity

Section 27.27 makes it clear that where goodwill cannot be allocated on a non-arbitrary basis where it has been integrated with existing operations then the goodwill of the acquired entity should be added with the existing asset when comparing to the recoverable amount in order to assess if an impairment has occurred. For example Company A acquired the trade assets and liabilities of Company B in the year. Company A already had a similar business to Company B and in year 2 Company B’s trade assets and liabilities was subsumed into this business. For the purposes of impairment the goodwill recognised on the acquisition of the trade asset and liabilities of Company B will be added to the carrying value when carrying out an impairment review for that part of the business.

Reversal of an impairment loss
Extract from FRS102: Section 22.14 – 22.1

22.19     An impairment loss recognised for goodwill shall not be reversed in a subsequent period 1.

22.20     For all assets other than goodwill, if and only if the reasons for the impairment loss have ceased to apply, an impairment loss shall be                     reversed in a subsequent period. A micro- entity shall assess at each reporting date whether there is any indication that an impairment                   loss recognised in prior periods may no longer exist or may have decreased. Indications that an impairment loss may have decreased or               may no longer exist are generally the opposite of those set out in paragraph 22.7. If any such indication exists, the micro-entity shall                       determine whether all or part of the prior impairment loss should be reversed.

Reversal where recoverable amount was estimated for an individual impaired asset

22.21     When the prior impairment loss was based on the recoverable amount of the individual impaired asset, the following requirements apply:

     (a)   The micro-entity shall estimate the recoverable amount of the asset at the current reporting date.

     (b)   If the estimated recoverable amount of the asset exceeds its carrying amount, the micro-entity shall increase the carrying amount to                       recoverable amount, subject to the limitation described in paragraph (c) below. That increase is a reversal of an impairment loss. The                    micro-entity shall recognise the reversal immediately in profit or loss.

     (c)   The reversal of an impairment loss shall not increase the carrying amount of the asset above the carrying amount that would have been                 determined (net of amortisation or depreciation) had no impairment loss been recognised for the asset in prior years.

     (d)   After a reversal of an impairment loss is recognised, the micro-entity shall adjust the depreciation (amortisation) charge for the asset in                 future periods to allocate the asset’s revised carrying amount, less its residual value (if any), on a systematic basis over its remaining                     useful life.

OmniPro comment

The section above makes it clear that an impairment loss should only be reversed when the circumstance that caused the reversal has reversed. All impairments can be reversed with the exception of impairments on goodwill. Once a goodwill impairment has been recognised it cannot be reversed.

Depreciation is charged on the revised carrying amount over its useful life. Likewise when an impairment is first booked the impaired amount is depreciated over the remaining useful life.

When making a reversal of an impairment an asset cannot be increased above what it would have been carried at had no impairment occurred in the first instance.

See below for illustration of the above points.

Example 16: Reversal of impairment on an individual asset

Company A purchased a specialist machine in year 1 for CU100,000. It is depreciated over 10 years and has a nil residual value. At the end of year 3 an impairment of CU20,000 was identified due to a slump in the market for the products the machine produced (i.e. the NBV at that time was CU70,000 (CU100,000/10yrs*7yrs) and the recoverable amount was CU50,000). Following a review at the end of year 6, there was evidence to show that the impairment had reversed and the value in use at that time was now CU70,000.

Carrying Value at the End of Year 6 Prior to Reversal (CU50,000/7yrs*4yrs remaining)

CU28,571

Recoverable Amount

CU70,000

Possible Impairment Reversal   

CU41,429

However as per Section 21.21(c) the carrying amount cannot be increased above that what it would have been had no impairment been recognised.

Carrying value at the end of year 6 if no                        CU40,000(CU100,000/10yrs*4yrs impairment remaining)   

Therefore the maximum amount that the carrying amount can be increased to is CU40,000

The amount of the impairment to be reversed is:

Notional Carrying Amount if No Impairment was Booked

CU40,000

Carrying Amount Prior to Reversal

CU28,571

Amount of the Impairment to be Reversed

CU11,429

The journal to be posted would be to:

 

CU

CU

Dr Fixed Assets

11,429

 

Cr Impairment in the P&L

 

11,429

Depreciation of CU10,000 (CU40,000/4yrs remaining life) will be charged per annum going forward. Depending on materiality this may be classed as an exceptional item.

Example 17: Reversal of impairment on a cash generating unit

Company A acquired the trade asset and liabilities of Company B for CU100,000. One CGU was identified. The fair value of the assets acquired was CU80,000 and the goodwill recognised on acquisition was CU20,000. The goodwill and identifiable assets are depreciated over 10 years and have a nil residual value. At the end of year 3 an impairment of CU20,000 was identified due to a slump in the market in which the CGU operates (i.e. the NBV of the goodwill at that time was CU14,000 (CU20,000/10yrs*7yrs) and of the identifiable assets was CU56,000 (CU80,000/10yrs*7yrs) and the recoverable amount was CU50,000). Post the impairment the carrying amount of goodwill was Nil and the carrying amount of the identifiable assets was CU50,000.

Following a review at the end of year 6, there was evidence to show that the impairment had reversed and the value in use at that time was now CU50,000.

The carrying value at the end of year 6 was as follows:

 

CU

Identifiable assets = CU50,000/7yrs remaining life at date of impairment*4yrs remaining at the end of year 6)

28,871

Goodwill (nil as was fully written off at end of year 3)

Nil              

Total carrying amount at end of year 6

28,571

Value in use at that date           

50,000

Difference to be considered for reversal

21,429

 

  

So the total amount considered for reversal is CU21,429

The carrying value at the end of year 6 if no impairment was booked is:

 

CU

Identifiable assets = CU80,000/10yrs*4yrs remaining life at date of reversal of impairment) =

32,000

Goodwill (CU20,000/10yrs*4yrs)

8,000  

Total carrying amount at end of year 6

40,000

Therefore the max of the impairment reversal of CU21,429 noted above that can be utilised is CU11,429 (CU40,000-CU28,571) as the carrying amount cannot be stated above what it would have been stated if no impairment had been booked.

Total Impairment Reversal Allowable

CU11,429

Allocated First to Goodwill Notionally as Goodwill impairment Cannot be Reversed

(CU8,000)

Remaining Amount to be reversed to Identifiable Assets

CU3,429

Therefore the actual journal to be posted for the impairment reversal is:

 

CU

CU

Dr Fixed Assets/Identifiable Assets

3,429

 

Cr Impairment – Profit and Loss

 

3,429

Being journal to increase carrying amount of fixed assets to CU32,000 being the amount it would have been stated at had an impairment not occurred.

Transition exemptions

Section 28 provides no exemptions on the transition to FRS 105.

Principal transition adjustments

    1)  Reversal of prior year goodwill impairments since the date of transition (applicable to entities transitioning from old GAAP/FRSSE)

Reversal of an impairment for goodwill will not be allowed under Section 22 however, under old GAAP/FRSSE the reversal of a previous impairment was allowed under certain circumstances. Therefore, where a reversal of an impairment on goodwill was recognised under old GAAP/FRSSE since the date of transition to FRS 105, a transition adjustment will be required. Where it occurred pre transition and the exemption not to restate prior business combinations is claimed then it cannot be reversed.

Example 18: Reversal of prior year goodwill impairments reversal since the date of transition (applicable to entities transitioning from old GAAP/FRSSE)

Company A reversed a previous impairment booked on goodwill on 2 January 2015 as allowed under old GAAP/FRSSE. The date of transition is 1 January 2015. The amount of the goodwill impairment reversed was CU100,000.  This reinstated goodwill was amortised over its remaining useful life of 5 years under old GAAP/FRSSE. Under FRS 105 this reversal is not permitted. The adjustments required on transition are:

Year ended 31 December 2015

 

CU

CU

Dr Reversal of Goodwill Impairment in P&L

100,000

 

Cr Goodwill      

 

100,000

Being journal to reverse the previous reversal of the goodwill impairment

 

CU

CU

Dr Goodwill

20,000

 

Cr Amortisation of Goodwill in P&L (CU100,000/5yrs)

 

20,000

Being journal to reverse amortisation charged under old GAAP on reinstated goodwill as no longer exists under FRS 105.

Journals required for the year ended 31 December 2016 assuming the above journals are carried forward:

 

CU

CU

Dr Goodwill

20,000

 

Cr Amortisation of Goodwill in P&L

(CU100,000/5yrs)

 

20,000

Being journal to reverse amortisation charged under old GAAP/FRSSE on reinstated goodwill as no longer exists under FRS 105.

    2) Impairment set against intangible assets first and then against all other assets on a pro rata basis under old GAAP

Under Section 27.21 of FRS 102 which is where Section 22.3 refers to; if a CGU is impaired the impairment will be first set against goodwill and then set against other assets on a pro-rata basis.  In contrast under FRS 11 of old GAAP/FRSSE the impairment loss was set against goodwill first, then intangibles and then finally against other assets on a pro-rata basis. Section 28.9 makes it clear that assets which were derecognised under old GAAP cannot be re-recognised on adoption to FRS 105, hence any impairments where intangibles are reduced to nil cannot be reinstated on adoption to FRS 105. Therefore where a prior year impairment review has been performed on a CGU and where the CGU contained intangibles and the impairment did not result in the write off of all the assets in the CGU, a transition adjustment may be required where the intangible was not written off in full. It may be particularly relevant for impairments since the date of transition i.e. in the comparative year. An example has not been included as in the majority of the cases the CGU will have been written down.

    3) Other differences where accounting adjustments are unlikely to occur on transition are (applicable to entities transitioning from old                          GAAP/FRSSE):

 

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