15 July 2014
An impairment test measures whether a balance sheet item is worth the amount stated on the balance sheet. The balance sheet amount should be reduced if the impairment test indicates a lower value.
Impairment testing can be applied for both commercial (audit) accounts and tax accounts. Different countries, accounting standards and tax jurisdictions may have different rules on what is to be tested, when and how. Many countries have adopted IFRS (international financial reporting standards). For this reason, most of the discussion in this article refers to that set of accounting standards.
IFRS defines “Carrying Amount” as the amount at which an asset is recognized after deducting any accumulated depreciation (amortization) and accumulated impairment losses thereon. In short, it is the balance sheet amount of an asset or liability. IFRS states that indefinite life assets (long-term non-depreciating assets such as goodwill and certain branding assets) must be tested for impairment annually and also when there is an indication that the asset might be impaired. Indications include both Internal Indicators and External Indicators.
The list of External and Internal Indicators is extensive, but “Internal Indicators” generally refer to items under control of management such as an underperforming business unit. “External Indicators” include items outside the control of management such as changes in the economic environment. A number of years ago, I had a client in the steel industry. At the time, Chinese steel manufacturers were selling certain steel products at very sharp prices. The Chinese companies owned the entire value chain from mining to distribution and shipping. Given the large volumes, transport was only a small portion of the costs. These companies could therefore compete almost anywhere in the world. This economic pressure, change in industry dynamics and lack of ability for this company to adapt quickly to these changes lead to sweeping impairments along product line levels.
Definite life assets (long-term depreciated assets) may also need to be tested for impairment when there is an internal or external indication that these assets might be worth less than their Carrying Amount. I was asked a number of years ago to look at the value of a client’s inland barges. Utilization was less than 50% on some barges, suggesting that cash flow on those barges was underperforming. The barges were recorded as long-term depreciated assets and the underperforming barges were impaired.
Liabilities can also be impaired. I have a client who recorded provisions relating to a conditional earn-out from a previous acquisition. The acquired entity has recently been underperforming and it appeared that the earn-out might not be realized. The earn-out provision was ultimately impaired.
Now that we know what impairment testing is, let’s discuss how to do it. IFRS requires Carrying Amount to be compared to what IFRS calls “Recoverable Amount”, which is the higher of “Value in Use” and “Fair Value less Costs of Disposal”. Value in Use is the value that can be realized by the company that owns the asset or liability being tested and can include synergies, which are special conditions that cannot be realized by a hypothetical purchaser of the asset/liability outside of the company. The asset/liability might deliver major savings to a company by keeping it out of commission or grouping it with other assets/liabilities. Another example could be the application of the asset/liability to a company’s patented technologies. Fair value less costs of disposal refers to the price that could be received for an asset/liability, less selling costs, if the asset/liability is sold to a hypothetical purchaser at the impairment test date.
Certain rules apply to different accounting standards and tax jurisdictions. Some situations require pre-tax value measurements. Particularly in the case of tax impairments, fair value might not be adjusted for selling costs. A rule common in many cases is that the asset/liability should be tested in its current condition, for example, a dry-goods cargo vessel should not be retrofitted to transport oil.
In the case where a company has multiple business units (or cash generating units), impairment testing is usually carried out at business unit level. Testing at this level is required by IFRS, but also provides for a more accurate test and is anyhow good practice.
Value in Use and Fair Value less Costs of Disposal are often based on an income approach, though market approach is also possible. Asset (cost) approach is uncommon. Some practitioners view market approach as more in line with fair value, claiming that it minimizes unobservable valuation inputs (an IFRS and US GAAP requirement). However, the market implies valuation assumptions that would otherwise be directly estimated. In any event, it is good valuation practice to apply multiple approaches and to be able to explain the different results.
Once Recoverable Amount has been established, it must be compared to the Carrying Amount. If it is less than Carrying Amount, the asset/liability should be impaired. With definite-life assets and liabilities, Carrying Amount is fairly straight forward. It is the amount recorded on the balance sheet. However, with goodwill it is more complicated.
Goodwill can be found on the balance sheet, however this number should not be compared to Recoverable Amount. Goodwill cannot be separated from a company and sold individually, and does not have value in isolation. The value of goodwill cannot be measured directly. For this reason, we base goodwill impairment tests on company or business unit value.
Recoverable Amount in a goodwill impairment test is based on either “Enterprise Value” or “Equity Value”. Enterprise Value refers to the value of a company’s (or a business unit’s) operations. Equity Value is the value of a company’s (or a business unit’s) common equity. When basing Recoverable Amount on Enterprise Value, the result should be compared to invested capital. When the valuation basis is Equity Value, the result should be compared to common shareholders equity. If Enterprise Value is less than invested capital, or Equity Value less than common shareholders equity, goodwill should be impaired by the amount of this difference. This is the case in IFRS. In the case of US GAAP, if undiscounted cash flows are less than Carrying Amount, a complete purchase price allocation exercise must be carried out to recalculate goodwill, which is more complicated and time consuming than IFRS.
Impairment test reporting should include a plain language summary of all approaches and assumptions applied. The reader of the report should be able to replicate all calculations based on the information in the report. Commercial impairment tests are often reviewed by a company’s auditors, who involve valuation specialists in reviewing the impairment tests. These specialists can be expensive and their time is often divided over many projects. Review times can be lengthy. If the reporting is clear, this will minimize time and expense of the audit review.
With impairment testing, the devil is in the details. Common mistakes includes the calculation of Carrying Amount, discount rates and terminal value approaches. Simple mathematical errors are also common. Checks should be built into the valuation model. If an income approach value far exceeds the market approach value, there must be a defendable explanation. Take the time to prepare comprehensive impairment testing documentation. This will reduce time and expense with your company’s auditors and will simplify future impairment tests.
For further questions on impairment testing, contact Andrew Pike of AN Valuation Services at +31 70 221 0058 or firstname.lastname@example.org.