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Philippe Förster and Olivier Scherer of PwC France consider some of the key issues in calculating the impairment of non-financial assets in tough economic conditions

This article was first published in the April 2012 International edition of Accounting and Business magazine

Concerns over the impairment of sovereign debt, sharp cuts in economic growth forecasts, highly volatile market conditions, lack of financing and the effect of government austerity measures raise many questions about the recoverability and valuation of assets.

The poor economic conditions increase the likelihood that asset-carrying amounts are greater than the expected cashflows from the assets. As a result, impairment charges may well be required. Because IAS 36, Impairment of Assets, is one of the more complicated standards, getting the accounting and disclosures right can be a challenge.

Is the economic crisis an impairment indicator?

An economic downturn is not in itself always a trigger event for impairment testing. However, the economic phenomena that make up the crisis may well be indicators for many entities. Almost all will be affected by one or more of the economic factors, even those entities that are expecting to survive the downturn or take advantage of the crisis.

The following impairment indicators might be particularly relevant in the current economic climate:

  • 2011 financial year actual figures are significantly lower than the original 2011 budget;
  • cashflow is significantly lower than earlier forecasts;
  • there have been material decreases in mid-term or long-term growth rates compared with previous estimates;
  • there has been a significant or prolonged decrease in the entity’s stock price;
  • market capitalisation is less than the book value of net assets;
  • there has been a change in the business model, a restructuring, discontinued operations, etc;
  • there has been an increase in the entity’s cost of capital;
  • market interest rates or other market rates of return have changed;
  • there are fluctuations in the foreign exchange rates or commodity prices that impact the entity’s cashflows;
  • investment projects have been deferred.

This list is by no means comprehensive. The indicators given above and in IAS 36 are examples only.

Are the assumptions underlying the business plans relevant?

The assumptions used in the business plan should be reasonable and supportable. In the current uncertainty:

  • Management assumptions should be consistent with market evidence, such as independent macroeconomic forecasts, and the analysis of industry commentators, analysts, brokers and other third-party experts. Greater weight should be given to any external evidence that is available.
  • Any differences between the business plan’s underlying assumptions and market evidence should be analysed and understood. Management may find it helpful to explain these differences in disclosures or other material accompanying the financial statements.
  • Management should analyse any differences between FVLCTS (fair value less costs to sell) and VIU (value in use) and ensure that they are supportable.

Integrating country risk in the calculation of the weighted average cost of capital

During the past months, sovereign yields have increased dramatically in several European countries. Some entities (in Spain and Italy, for example) can now raise debt at yields lower than their own government. At the same time, German yields have dropped to all-time lows. Bond and stock markets are highly volatile, and strong swings can be triggered by political or economical events.

The traditional approach, which uses the sovereign bond yield as a risk-free rate, can therefore no longer be used for all countries, and using spot rates seems more than ever inappropriate. There are no easy, one-size-fits-all solutions. Depending on the entity’s exposure to the economy of a given country, the impact of country risk on company value can be very different.

Various possible solutions to that issue might be considered. One is to use the German bond rates as the risk-free rate, considered by the market as reflecting the lowest country-risk level. However, as German spot rates are currently exceptionally low, probably because investors are moving their capital away from riskier investments, the use of longer-term historical averages and forward rates is recommended.

It might be necessary to add a country-risk premium on top of this base rate, depending on where the entity is active and its exposure to country risk. This premium could be derived from corporate bond spreads or, in the absence of a liquid corporate bond market, country CDS (credit default swaps) spreads (compared to Germany). Given the current environment, these spreads should be analysed carefully.

Given the level of judgment involved and the possibility of there being more than one acceptable way to determine the discount rate, companies could consider disclosing the methodology and the inputs to arrive at the discount rate used when a possible change in such inputs could result in a significant change in the recoverable amount.

Disclosures of particular interest to financial analysts and regulators this year

Financial analysts and regulators are focusing on getting detailed and current information in this period of market turbulence. IAS 36, IAS 1, Presentation of Financial Statements, and IAS 10, Events After the Balance Sheet Date, all prescribe relevant disclosures. In addition, there are often specific regulatory requirements that should be incorporated in the financial statements to the extent they provide meaningful information to the readers of those statements and reflect management’s views and judgments when assessing recoverable amounts.

The critical disclosures often looked for by analysts and regulators in the past years relate to sensitivity analyses (that is, key assumptions that have a significant risk of causing a material adjustment to the carrying amount of assets, including goodwill). These key assumptions should not be restricted to discount rates or growth rates; they might also include expected profit margins and other highly sensitive assumptions that may have a significant impact on future cashflows.

Some regulators are also expecting preparers to ‘stretch’ the assumptions to reflect what the impact of one particular government decision would be on the recoverable amount of a cash-generating unit (CGU) – for example, an increase in tax rates.

Other disclosures where there is heightened risk of impairment include:

  • a description of the asset/CGU being tested;
  • the amount by which the recoverable amount exceeds the carrying value;
  • the values assigned to the key assumptions used in the sensitivity analysis;
  • the amount by which the key assumptions would have to change for the recoverable amount to equal the carrying amount. For example, an entity might disclose that a 1% increase in the pre-tax discount rate would cut its recoverable amount to the same as its carrying amount;
  • the aggregate carrying amount of goodwill allocated to the CGUs and the aggregate carrying amount of intangible assets with indefinite useful lives allocated to the CGUs.

Philippe Förster is manager, IFRS technical department and Olivier Scherer is IFRS technical leader, PwC France

Last updated: 3 Apr 2014