Lecture 3 - Asset Revaluations and Impairment Testing

Question 1

PPE: Definition and recognition criteria

Answer 1

According to the IFRS conceptual framework, an asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.
However, even if an item satisfies the definition of an asset, it should be shown on the statement of financial position of a firm, only if
a) it is probable that future economic benefits will flow to the enterprise
and
b) the item has a cost or value that can be measured with reliability.

Question 2

Subsequent measure of PPE

Answer 2

According to IAS 16, items of PPE may be measured using either:
a) the cost model, where items are carried at cost less any accumulated depreciation and less any accumulated impairment losses or
b) the revaluation model, where items are carried at fair value at the date of revaluation (sufficiently regular intervals), less any subsequent accumulated depreciation and less any subsequent accumulated impairment losses.
Notes
1. If the revaluation model is used, it must be applied to entire classes of property, plant and equipment (i.e. it is not applied to individual assets within a particular class).
2.The revaluation model is not permitted under US GAAP and under the (converged with IFRS) Chinese GAAP.
3.The model is also applicable to intangible assets with finite useful lives – but used very very rarely.

Question 3

How is the revaluation model applied?

Answer 3

Revaluation shall be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the balance sheet date.
(IFRS 13: para 9):
This IFRS defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
•Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.
or
•Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.
or
•Level 3 inputs are unobservable inputs for the asset or liability.

Question 4

Increases and Decreases in the carrying amount

Answer 4

Whether an asset revaluation affects earnings depends on whether the revaluation initially increases or decreases an asset class’ carrying amount. 
-If a revaluation decreases the carrying amount of an asset class, the decrease is recognised as an expense in profit or loss. 
In the next periods if the asset class is revalued upwards at the previous value the increase is recognised in the profit and loss as well. 
Any increase beyond the previous decrease will not be recognised in the profit or loss! It will be recognised within other comprehensive income.

If a revaluation increases the value of an asset class, the increase in the carrying amount is recognised within other comprehensive income under the heading of revaluation surplus.
Any subsequent decrease in the asset’s value first decreases the revaluation surplus and then goes to the profit or loss as an expense.
NOTE: When a revaluation increase or decrease takes place, it is highly probable that a deferred tax liability may need to be recognised/adjusted!

Question 5

Why is this process for revaluation followed?

Answer 5

It is because of the Conservatism/Prudence principle.
Prudence is the inclusion of a degree of caution in the exercise of judgments needed in making the estimates required under conditions of uncertainty to avoid assets and/or income being overstated and prevent liabilities and/or expenses being understated (IFRS, Framework).
According to this, profits should be taken into the accounts when they are earned or realised whereas losses should be recognised as soon as the events giving rise to them take place.

Question 6

Impairment of Assets - IAS 36

Answer 6

According to IAS 36 (Impairment of Assets), an entity shall assess at the end of each reporting period whether there is any indication that an asset may be impaired.
Irrespective of this, goodwill and any intangible asset with indefinite useful life must be tested for impairment at the end of each reporting period (and whenever there is any indication that they may be impaired).
In assessing whether there is any indication that an asset may be impaired, an entity shall consider, external and internal sources of information.

Question 7

External indicators:

Answer 7

• a fall in the market value of the asset;
• material adverse changes in the regulatory environment; and
• material long-term increases in the market returns used for discounting.

Question 8

Internal indicators:

Answer 8

• material changes in operations and

* loss of key personnel.

Question 9

What will an entity do if it finds such indicators?

Answer 9

If any such indication exists, the entity shall estimate the recoverable amount (RA) of the asset.
(It estimates the RA for goodwill and intangible assets with indefinite useful lives anyway.)
RA is the higher of net selling price and value in use.
1) Net selling price -Disposal value less direct selling costs
2)Value in use- PV of future cash flows
An assets’ carrying value is reported at no more than RA.
i.e. impairment takes place: if carrying > recoverable amount

Question 10

Treatment of impairment of Assets

Answer 10

If an impairment test shows that the recoverable amount of an asset is lower than its net carrying amount, the asset value is written down to the lower value.
The asset write-down is expensed as an impairment loss in profit or loss.

Question 11

Impairment rationale

Answer 11

If impairment and the asset value were left unadjusted => overestimation of future economic benefits and current profit.
In case of subsequent increase of the recoverable amount a reversal of the impairment loss is permitted by IAS 36.
Under US GAAP and under the (converged with IFRS) Chinese GAAP once an impairment loss is recognised, it shall not be reversed in a subsequent period.
This also applies ONLY for goodwill under IFRS.

Question 12

Considering impairment of assets under US GAAP

Answer 12

Under US GAAP, measuring recoverability of the asset is separate from measuring the impairment loss and this is performed by following a two-step approach.
In the first step, entities are required to perform a recoverability test by comparing the expected undiscounted future cash flows to be derived from the asset with its carrying amount.
If the asset fails the recoverability test, the second step is triggered, under which the entity must record an impairment loss calculated as the excess of the asset’s carrying amount over its fair value.

Question 13

How are impairment losses calculated?

Answer 13

Under IFRS, an impairment loss is calculated as the excess of the asset’s carrying amount over its recoverable amount .
Under US GAAP, an impairment loss is calculated as the excess of the assets carrying amount over its fair value.

Question 14

Impairment of Goodwill

Answer 14

Goodwill acquired in a business combination shall, from the acquisition date, be allocated to each of the acquirer’s cash-generating units (CGUs), or groups of CGUs, 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.
A CGU to which goodwill has been allocated shall be tested for impairment annually, and whenever there is an indication that the unit may be impaired, by comparing the carrying amount of the unit, including the goodwill, with the recoverable amount of the unit.
If the carrying amount of the unit exceeds the recoverable amount of the unit, the entity shall recognise the impairment loss.
Impairment testing of goodwill in the US is different from that under IFRS

Question 15

Cash Generating Unit

Answer 15

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 internal management purposes; and
B. not be larger than an operating segment as defined by paragraph 5 of IFRS 8 Operating Segments before aggregation.

Question 16

Criteria used to check whether a CGU is impaired?

Answer 16

15% drop in revenue, based on a comparable consolidation scope
30% drop in EBITDA, based on a comparable consolidation scope

Question 17

Fair value less costs of disposal or value in use: common practices

Answer 17

The majority of companies employ only value in use calculations.
It is commonly based on a discounted cash flow analysis (of the free cash flows).
Some companies deviate from this practice: e.g. Italian firm Mediobanca states explicitly that it uses a dividend discount model.
Other companies employ value in use as the primary method of determining recoverable amount but apply fair value less costs to sell in relation to specific CGUs.

Question 18

Assumptions used while testing for impairment and related disclosures

Answer 18

If the unit’s (group of units’) recoverable amount is based on value in use, a company shall disclose a lot of information regarding the underlying assumptions that it considers. This includes the following:
1. each key assumption on which management has based its cash flow projections;
2. a description of management’s approach to determining the value(s) assigned to each key assumption (e.g. past experience or consistent with external sources of information);
3. the period over which management has projected cash flows based on financial budgets/forecasts approved by management;
4. the growth rate used to extrapolate cash flow projections beyond the period covered by the most recent budgets/forecasts;
5. the discount rate(s) applied to the cash flow projections.
These disclosures allow for identification of great variation in practice in terms of the assumptions that companies use.

Question 19

Discount rates and projected cash flows

Answer 19

An area which can cause debates and it is worth attention from the users’ point of view is the discount rates used relative to the projected cash flows.
According to IAS 36, whatever period of cash flow projections is used, it should not include any impacts of financing activities or tax.
Despite this, some companies state that cash flow projections are post tax (e.g. ThyssenKrupp, Pernod Ricard and Sodexo).
Other companies state that discount rates used are post tax (e.g. Siemens and Novozymes).
Other companies may even remain silent in this respect.
Obviously, if post tax cash flows are discounted using a pre tax rate there is potential for misleading results.

Question 20

More on the discount rates

Answer 20

Discount rates applied should reflect the time value of money and the risks specific to the asset for which the future cash flow estimates have not been adjusted (paragraph 55).
Although not required by the Standard, those firms that usually disclose specific information indicate that discount rates are determined either by reference to a weighted average cost of capital or using the capital asset pricing model only with specific CGU risk factors being taken into account.
Other firms may disclose factors external to the company (e.g. government bonds or peer company beta factors and leverage as well as other market borrowing rates).

Question 21

Sensitivity Analysis

Answer 21

If a reasonably possible change in a key assumption on which management has based its determination of the unit’s (group of units’) recoverable amount would cause the unit’s (group of units’) carrying amount to exceed its recoverable amount, relevant disclosures should be provided.
Following along these lines, it is common for firms discuss the possible impacts of changes in assumptions used (e.g. discount and growth rates).
Other firms may make reference to changes in cash flows or to changes in trading margins.
Nevertheless, most firms state that the changes in an assumption would not lead to any impairment or changes in an assumption are not reasonably possible.