BE130 – Lecture 7 - Impairment of Assets PDF

Preview

Summary

BE130 – Current IssuesLecture 7 – Impairment of AssetsValuation of Assets Carrying amounts of some assets are measured:  Using either Cost model  Or Revaluation model But these models extensively use judgements:  Expected useful economic lives are estimates  Depreciation/amortisation expenses ar...

Description

BE130 – Current Issues Lecture 7 – Impairment of Assets Valuation of Assets Carrying amounts of some assets are measured:  Using either Cost model  Or Revaluation model But these models extensively use judgements:  Expected useful economic lives are estimates  Depreciation/amortisation expenses are subjective The important question is whether the carrying amounts of the assets overstate their “true” value? The main principle of IAS 36 An entity needs to ensure that assets are not carried at more than their recoverable amount.  Carrying amount à is the amount at which an asset is recognised less any accumulated depreciation / amortisation and accumulated impairment losses  Recoverable amount à Is the amount expected through the continuing use of the asset or through the disposal of the asset Depreciation expenses vs. Impairment loss Similar to depreciation expense, impairment loss is also a reduction in the asset value.  Depreciation expense is made in order to charge the cost of the asset over its useful economic life (based on the matching concept)  Impairment loss is recognised to bring down the carrying amount of the asset to its recoverable amount (based on the prudence concept) What assets should be tested?

When to undertake impairment test? Not necessarily at the end of each reporting period.  Finite life assets à only when there is an indication of impairment  Indefinite life assets à At the end of each reporting period:  Intangible assets with indefinite useful life  Intangible assets not yet available for use  Goodwill acquired in a business combination Or can test more often if there is an indication of impairment – any time during the period. Steps of Impairment Testing

External indicators of impairment  Significant decline in market value  Changes in the technological, market, economic or legal environment of the entity  Increases in interest rates or rates of return  Lower market capitalisation than equity book value  Significant adverse changes in the technological, legal environment or competitor actions Internal indicators of impairment  Evidence of obsolescence or physical damage  Discontinuance or disposal of assets or restructuring plans  Declining asset performance / expected to decline  Changed use within the entity  Economic performance of the asset (e.g. an internal reporting shows economic performance of an asset is worse than expected) How does the impairment test work?

Calculating FV less costs of disposal Costs of disposal:  Are those incremental costs that directly arise as a result of this disposal  Excludes finance costs and taxes If Fair Value less costs of disposal is greater than carrying amount, then it is not necessary to calculate the value in use. Calculating Value in Use? Value in use is the present value of the future cash flows expected to be derived from an asset or cash-generating unit à can use Discounted Cash Flow or similar models. Need to forecast cash flows and discount rates:  An estimate of the future cash flows expected  Expectations about possible variations  Discount rates (market rate or WACC)  Risks associated with the cash flow, liquidity in the markets Cash flows are expected to arise from:  Continuing use of the asset  Form disposal at the end of its useful life Recognition of impairment loss If recoverable amount of an asset < its carrying amount à  The asset is impaired  The asset’s carrying amount should be reduced to its recoverable amount. The reduction is an impairment loss (i.e. the amount by which the carrying amount exceeds the recoverable amount)  The impairment loss must be recognised as an expense (or reduction in the revaluation reverse).  It is also necessary to adjust depreciation for future periods Cash generating unit





Cash Generating Unit is a smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows of other asset /groups Cash generating unit is a collection of assets that generate a stream of cash flows. Normally it is:  A subsidiary that produces a distinct product  A unit based on internal management reports  A unit identified in the segmental reporting (e.g. a plant, oil rig, fixed & mobile network, newspaper, radio or TV station)

Assets to be allocated to cash generating units?  Cash generating unit includes carrying amounts  Of those individual assets that are directly attributable to this unit  And also those assets that can be allocated to it à these include goodwill and corporate assets  Corporate assets  Assets that contribute to the future cash flows of both this & other cash-generating units o Headquarters, common warehouse / logistic centres, R&D centres Cash generating unit WITHOUT goodwill When a cash-generating unit does not have goodwill:  Then impairment loss should be allocated to all individual assets of a pro-rata basis  The proportionate rate could be computed based on the carrying amounts of the individual assets An entity produces a product in a continuous process using three machines (ie the output of Machine A is the input for Machine B, the output of which is the input for Machine C. The output from Machine C is the entity’s only marketable product). After recognizing depreciation for the year ended 31 December 20X1 the carrying amount of Machines A, B and C are:

Carrying amount Item’s carrying amount in relation to the CGU’s carrying amount

Machine A 13,000

Machine B 29,250

Machine C 22,750

20%

45%

35%

The recoverable amount of the CGU is 55,000 Carrying amount

65,000 -

CGU 65,000

Recoverable amount Impairment loss

55,000 10,000

Impairment loss allocation

Machine A Machine B Machine C

Carrying amount before impairment 13,000 29,250 22,750

20% 45% 35%

Impairment loss

Carrying amount after impairment

2,000 4,500 3,500

11,000 24,750 19,250

Cash generating unit WITH goodwill Goodwill is inherent in a group of other assets  It is difficult to identify & measure cash flow from it, as goodwill cannot be separately identified.  Therefore, it should be allocated to a cash-generating unit or to groups of cash-generating units. The cash-generating unit should represent:  The lowest level within the entity at which goodwill is monitored for internal management purposes  Should not be larger than an operating segment Allocation of impairment loss on goodwill  If a cash generating unit’s recoverable amount is less than its carrying amount, then it is impaired  Impairment loss should be allocated:  First to goodwill, unless there is an asset that is clearly impaired  To other assets on a pro-rata basis, if it exceeds goodwill  For the rest of the assets, allocate first to the other intangibles and then to the tangible assets Allocation of impairment loss to NCI  If no goodwill is recognised for the NCI, then no impairment loss attributable to the NCI  Impairment loss allocation between the parent and the NCI depends on the goodwill calculation method à full or partial

Full goodwill method and impairment

Any impairment loss should be allocated between the parent and the NCI in the normal proportion that they share profit and loss The effect of the impairment loss recognition:  Total profit should be reduced  Parent’s share of goodwill should be reduced proportionally to its equity share  NCI’s share of goodwill should also be proportionately reduced Example:   

P acquires 60% shares of S and records goodwill with the carrying value of £500 (of which £140 attributable to NCI), using the full goodwill method. Carrying value of the S’s net identifiable assets were £600. At the end of the year P carries out an impairment review and determines that the recoverable amount of S to be £1000.

**What is the outcome of this impairment review? In this case, S should be considered as a CGU: Net identifiable assets: Goodwill Carrying Value of the CGU: Recoverable amount: Impairment loss

£600 £500 £1,100 (£1,000) £100

This impairment loss to be allocated between P and NCI:  P’s goodwill & profit to be reduced by £60 (60%x100)  NCI to be reduced by £40 (40%x100) in the financial statement **Find the New Goodwill for P and NCI after impairment. New Goodwill after impairment = £500 - £100 = £400 Allocated as follows: P = 360 – 60 (share of impairment loss) = £300 NCI = 140 – 40 (share of impairment loss) = £100

Partial goodwill and impairment

Partial goodwill à it is necessary to gross up the goodwill value for the purpose of impairment tests The objective is:  To include the unrecognised notional goodwill attributes to the NCI to the impairment review process  To determine impairment loss attributable to the patent and the NCI Example:   

P acquires 60% shares of S and records goodwill attributable to only P with the carrying value of £360, using the partial method. Carrying value of the S’s net identifiable assets were £600. At the end of the year P carries out an impairment review and determines that the recoverable amount of S to be £1000.

**What is the outcome of this impairment review? S is a CGU & need to “gross up” goodwill amount: Grossed up goodwill: £360 * (100/60) = £600 Net identifiable assets: Goodwill Carrying Value of the CGU: Recoverable amount: Impairment loss

£600 £600 £1,200 (£1,000) £200

Only P’s share of impairment loss be recorded: P’S goodwill & profit to be reduced by £120 (60% x 200)  Impairment loss will not impact the NCI

Reversal of an impairment loss

External or internal indicators may indicate that the conditions that caused impairment loss:  May not exist any more  May have decreased In such cases, can reverse impairment losses à the carrying amount of the asset shall be increased to its recoverable amount. However, the increase in the carrying value of the asset can only be up to what the depreciated historical cost would have been if the impairment had not occurred. Goodwill impairments cannot be reversed. Exercise: ABC plc bought a machine in 2010 for £500,000 and depreciated it on a straight-line basis over its useful life of 10 years. After 2 years the machine had a carried amount of 400,000. It was tested for impairment and its carried amount was reduced to 380,000. Three years later the directors of the company assessed that the machine has a value in use of 270,000 and have reasons to believe that the fair value of the machine is not higher than its value in use. **Calculate the value at which the machine should be recognized in the statement of financial position

2010 2011 2012 2013 2014

Carrying amount begin year 500,000 450,000 380,000 332,500 285,000

Depreciation

50,000 50,000 47,500 47,500 47,500

Carrying amount after depreciation 450,000 400,000 332,500 285,000 237,500

Impairment

20,000

Value in use 270,000 > 237,500 (so, reversal of impairment loss) It is not possible to include in the P&L a reversal of 32,500 because the assets cannot be recognized at a value higher than the carrying amount if the impairment had not occurred

2010 2011 2012 2013 2014

Carrying amount begin year 500,000 450,000 400,000 350,000 300,000

Depreciation 50,000 50,000 50,000 50,000 50,000

Reversal = 250,000 – 237,500 = 12,500 Academic research on goodwill impairment

Carrying amount after depreciation 450,000 400,000 350,000 300,000 250,000

  

Goodwill is not systematically consumed, therefore it does not systematically wear out So, there is no need for systematic amortisation But need to test goodwill annually for impairment  There may be non-recurring events (such as negative market conditions) that may reduce goodwill value  This may lead to volatile income statement and may produce unverifiable numbers  Therefore, academic research concentrates on this issue

Determinants of goodwill impairment  Whether goodwill impairments are predictable?  Goodwill write-offs would provide value relevant information, as they may imply changes in future expected cash flows  Possible determinants of goodwill impairment:  Deterioration in post-acquisition performance  Overpayment to acquired firm shareholders  Evidence shows that:  The amount and quality of current financial disclosures do not allow users of financial statements to effectively evaluate the appropriateness of management determinations regarding goodwill impairment  Impairment losses are not timely reported  Research shows that non-impairment may be motivated by agency problems that exist between shareholders and managers  For example, managers may delay impairment losses:  If their bonuses are related with earnings  If impairment losses affect firm leverage  If CEO tenure is high Managerial preference in goodwill impairment  Initial recognition and subsequent measurement of goodwill is based on FVA – however, no active market for IAs, so unverifiable  At the same time management has incentives to:  Inflate assets à possibly using higher goodwill balances  Inflate earnings à possibly recognising lower impairment losses  May manipulate impairment process Research shows that goodwill impairment losses are considerable lower than the previously computed amortisation costs, in spite of increase value of IAs. Managers make untimely goodwill write-offs  Goodwill write-offs lags economic reality,  Goodwill impairments lag deteriorating operating performance and stock returns  Managers only recognize impairment losses when it becomes evident Research concludes: managerial self-interests and earnings management motivate many goodwill impairment decisions (Li and Sloan, 2014)....