IAS 36

International Accounting Standard IAS 36, Impairment of Assets, is the first accounting standard that deals comprehensively with the impact of a decline in value in assets1. IAS 36 became operative for annual financial statements covering periods beginning on or after 1 July 19992.

Prior to the publication of IAS 36, standards such as IAS 16, Property, Plant and Equipment, IAS 28, Accounting for Investments in Associates, and IAS 31, Financial Reporting of Interests in Joint Ventures, included principles for recognising impairment losses but no detailed guidance was given on how these losses should be measured.

Financial statements exhibit reliability when amounts are stated in a prudent manner3. The objective of IAS 36 is to prescribe the procedures applied by an enterprise to ensure that each asset is not overstated beyond the amount expected to be recovered through use or sale of the asset.

Impairment is assessed as at each balance sheet date on the basis of the best set of information available to the enterprise and, subject to the application of materiality, the accounting standard will apply even if management consider that any impairment loss existing as at balance sheet date is likely to reverse subsequently.

Coverage of the Standard
IAS 36 applies in general to all tangible and intangible non-financial assets, including:

• Property, plant and equipment, irrespective of whether carried at cost or revalued amount under IAS 16;
• Goodwill arising on an acquisition, accounted for under IAS 22;
• Investments in Subsidiaries, accounted for under IAS 27;
• Investments in Associates, accounted for under IAS 28;
• Interests in Joint Ventures, accounted for under IAS 31;
• Intangible assets, accounted for under IAS 38; and
• Investment property measured at cost, under IAS 40.

IAS 36 does not apply to the following assets covered under other accounting standards4:

• Inventories (IAS 2, Inventories, measured at the lower of cost and net realisable value);
• Assets arising from construction contracts (IAS 11 requires determination of recoverable amount albeit on an undiscounted basis);
• Deferred income tax assets (IAS 12 applies);
• Assets arising from employee benefits (IAS 19 specifies that an upper limit of such assets be determined on a discounted basis broadly compatible with IAS 36);
• Financial assets included in the scope of IAS 32;
• Investment property measured at fair value (IAS 40 applies); and
• Biological assets measured at fair value (once IAS 41 becomes effective).

The main issues addressed by IAS 36 are:

• What is impairment?
• When is an asset assessed for impairment?
• What is the basis for assessing asset impairment (individual assets or groups of assets)?
• How is an impairment loss measured and accounted for in the financial statements?
• In a subsequent period how is the reversal of an impairment loss measured and accounted for in the financial statements?
• What is required to be disclosed in the financial statements about asset impairment?
• What transitional provisions apply on initial application of the accounting standard?

What is ‘impairment’?
An asset is described as impaired – and an impairment loss is recognised – to the extent that the asset’s carrying amount exceeds its recoverable amount5.

Carrying amount (CA) is the amount at which an asset is recognised in the balance sheet after deducting any accumulated depreciation (amortisation) and accumulated impairment losses thereon.

Recoverable amount (RA) is the higher of an asset’s net selling price and its value in use.

Net selling price (NSP) 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.

Value in use (VIU) is the present value of estimated future cash flows expected to arise from the continuing use of an asset and from its disposal at the end of its useful life.

Three illustrations of the definition are shown in Figure 1.

Recognition – initial assessment as to whether an asset may be impaired
An assessment must be made at each balance sheet date as to whether there is any indication that an asset is impaired6. In many cases, this acts as the trigger point for applying the IAS. In the case of goodwill or other intangible asset with a useful life exceeding twenty years or an intangible asset that is not yet available for use, however, recoverable amount is determined under IAS 36 regardless of whether or not there exists an indicator of impairment7.

Information sourced both from within and external to the enterprise is taken into account in assessing whether an asset might be impaired. IAS 36 identifies the following8:

External sources of information

• Significant decline in market value.
• Adverse effect of change in law, technology, relevant market place(s) or in the economy.
• Increase in market interest rates or other market rates of return on investments.
• The reporting enterprise’s market capitalisation is below the carrying amount of its net assets.

Internal sources of information

• Evidence is available of obsolescence or physical damage of an asset;
• The asset is part of a restructuring, held for disposal or will be used differently; and
• The economic performance of an asset is, or will be, worse than expected – examples: actual results attributed to an asset are significantly less than budget; a significant increase in maintenance costs are expected in the next financial period.

Basis of assessment
IAS 36 requires each asset to be assessed for an indicator of impairment. When there is an indication that an asset may be impaired, RA is estimated for each asset6. In many cases however, it may not be possible to estimate RA of a stand-alone asset, for example when the asset does not generate cash inflows from continuing use that are largely independent of those from other assets9. In such a case, RA is estimated in respect of the cash-generating unit to which the asset belongs.

A cash-generating unit (CGU) is the smallest identifiable group of assets that generates cash inflows from continuing use that are largely independent of the cash inflows from other assets or groups of assets5.

The standard provides the following examples of a cash-generating unit:
A mining enterprise owns a private railway to support its mining activities. The private railway could be sold only for scrap value and the private railway does not generate cash inflows from continuing use that are largely independent of the cash inflows from the other assets of the mine.

It is not possible to estimate the recoverable amount of the private railway because the value in use of the private railway cannot be determined and it is probably different from scrap value. Therefore, the enterprise estimates the recoverable amount of the cash-generating unit to which the private railway belongs, that is, the mine as a whole.
A bus company provides services under contract with a municipality that requires minimum service on each of five separate routes. Assets devoted to each route and the cash flows from each route can be identified separately. One of the routes operates at a significant loss.

Because the enterprise does not have the option to curtail any one bus route, the lowest level of identifiable cash inflows from continuing use that are largely independent of the cash inflows from other assets or groups of assets is the cash inflows generated by the five routes together. The cash-generating unit for each route is the bus company as a whole.

How is an impairment loss measured and accounted for in the financial statements?
If there is an indication of impairment, the following steps are taken in relation to the asset or CGU:

• Determine net selling price;
• Determine value in use;
• Compute recoverable amount; and
• Compare with carrying amount and allocate impairment loss.

An impairment loss for a CGU is measured in much the same way as for an individual asset10. As discussed below, it may be necessary in the case of a CGU to have additional consideration for the impairment of goodwill and corporate assets.

Net selling price is the amount expected to be obtained from an arm’s length sale, less directly attributed disposal costs, and essentially reflects market price. Where a market price is not so readily available, a recent transaction for a similar asset may assist to support an estimate of NSP.

Value in use of an asset (or CGU) is estimated by:

1. Estimating the future cash inflows and outflows to be derived from continuing use of the asset (CGU) and from its ultimate disposal; and
2. Applying the appropriate discount rate to these future cash flows.

Cash flow projections are based on the most recent budgets or forecasts approved within the enterprise. A five-year horizon applies to specific budgets or forecasts of cash flows and, beyond that, an estimate of steady decline or growth rate is applied until the marginal discounted net cash flow is negligible. This growth rate generally should not exceed the long-term average growth rate reasonable within the enterprise’s industry and country of operation11.

Estimates of future cash flows include:

• Inflows derived from continuing use of the asset;
• Direct operating cash outflows and overheads that can be allocated on a reasonable and consistent basis; and
• Net cash flow expected on disposal12.

Estimates of future cash flow specifically do not include:

• The effect of a future restructuring to which the enterprise is not yet committed or future capital expenditure, whether planned or committed13; or
• Financing or income tax related cash flows14.

The discount rate applied should be a pre-tax rate reflective of the time value of money and the risks specific to the asset15. Again, judgement is required to estimate a rate that is, at least, not glaringly inappropriate. The following reference points may assist in supporting an appropriate rate:

• Weighted average cost of capital (or required rate of return) determined from using techniques such as the Capital Asset Pricing Model, or in applying Economic Value Added;
• Incremental borrowing rate specific to the enterprise;
• Other market borrowing rates, for example, comparable private sector enterprise bond yields.

The carrying amount of an individual asset is reduced to recoverable amount as a consequence of an impairment loss16. Except to the extent that it reverses a previous revaluation, the impairment loss is recognised as a current period expense in the income statement. If the asset is carried at revalued amount, for example under the allowed alternative treatment in IAS 16, Property, Plant and Equipment, an impairment loss is treated as a revaluation decrease under that other accounting standard17.

The depreciation or amortisation charge for the asset is adjusted 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 life18.

Allocation of impairment loss – additional requirements for CGU
An impairment loss is recognised across a CGU much in the same way as for an individual asset. It is necessary to consider how the loss is allocated amongst the individual assets in the CGU.

The IAS requires that the loss be allocated first to goodwill attributed to the CGU (see below) and then to the other assets pro-rata to the carrying amount of each asset. An individual asset’s CA should not be reduced below the highest of the asset’s NSP, VIU or zero19.

Example – recognition of an impairment loss
At the end of 20X0, Cholesterol Ltd (C) acquired 100% of Butterfat Ltd (B) for $200m. The fair value of the net identifiable assets of B was $160m and goodwill was $40m.

B processes dairy products primarily for export to the European Union (E). C uses straight-line depreciation and amortisation over a 20-year life for B’s assets. No residual value is anticipated.

In 20X2, E introduces import quotas significantly restricting imports of B's main product. As a result, and for the foreseeable future, B's production will be cut by 45%.

The adverse change in market place and regulatory conditions is an indicator of impairment that requires C to estimate the recoverable amount of the goodwill and net assets of B at the end of 20X2.

The cash-generating unit for the goodwill and the identifiable assets of B is its entire operation, since no independent cash inflows can be identified for its individual assets.

The net selling price of B’s cash-generating unit is not determinable therefore recoverable amount is value in use.

To determine the value in use of B’s cash-generating unit, C:

1. Prepares cash flow forecasts derived from the most recent financial budgets and forecasts for the next five years approved by management;
2. Estimates subsequent cash flows based on declining growth rates; and
3. Selects an appropriate discount rate, which represents a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the cash-generating unit.

The directors of C forecast the following net cash flows for B, inclusive of the effect of expected inflation:

Management’s forecast of the growth rate after the end of the next five years (note that this is less than the long term industry average) is +4.0% for 20X8 and -3.0% for 20X9 and cumulatively beyond.

The management believe that a discount rate of 15% represents the pre-tax cost that reflects current market assessments of the time value of money, the risks specific to B’s cash-generating unit, and the effect of expected inflation. See Figure 2 for calculations.

Subsequent reversal of an impairment loss
The accumulated impairment loss reported in last year’s balance sheet may reverse (at least in part) when there is a change in the estimates that gave rise initially to the impairment loss.

The process by which an impairment loss reverses mirrors the process by which the impairment loss was recognised initially. An assessment is made as to whether there are any indicators that an impairment loss recognised previously may no longer exist or may have decreased. The sources of information taken into consideration act in reverse to those that might have given rise to the impairment loss initially and would include20:

• Significant increase in market value.
• Favourable effect of change in law, technology, relevant market place(s) or in the economy.
• Decrease in market interest rates or other market rates of return on investments.
• The enterprise’s market capitalisation is now above the carrying amount of its net assets.
• Better than expected economic performance of an impaired asset.

An impairment loss reverses when, and only when, there is a change to the estimates on which the impairment was recognised initially, for example21:

• Changed basis for RA (from NSP to VIU or vice versa);
• Significant change in the amount and/or timing of estimated future cash flows or in the discount rate when RA was based on VIU; or
• Significant change in a component underlying NSP when RA was based on NSP.

IAS 36 specifies the following accounting treatment:

• In the case of an individual asset, an accumulated impairment loss reversal is capped to the lower of RA and CA (net of accumulated depreciation or amortisation) had no impairment been recognised in prior periods22.
• The impairment loss reversal is recognised as current period income in the income statement except to the extent that it reverses a previous revaluation decrease, in which case the impairment loss reversal would be credited to revaluation surplus23.
• The depreciation or amortisation charge on the asset’s revised depreciable amount is adjusted in future periods24.

Reversal of impairment loss – additional requirements for CGU
An impairment loss previously recognised for a CGU reverses in much the same way as for an individual asset. In addition, it is necessary to consider how the reversal is allocated amongst the individual assets in the CGU.

The IAS requires that the reversal be allocated first to assets other than goodwill, pro-rata to the carrying amount of each asset, capped at the lower of the individual asset’s RA (if determinable) and what would have been its CA had no impairment been recognised previously25.

Provision exists within IAS 36 for any residual impairment loss reversal to be allocated to goodwill but the criteria is such that this is expected to be very rare and, typically, only if the impairment of goodwill results specifically from the initial impairment event26. See Figure 3.

Financial statement disclosure
Both IAS 36 and the accounting standard that applies specifically to the impaired asset require financial statement disclosure about impairment. For example, IAS 16 requires a reconciliation of the opening and closing gross carrying amount of each class of property, plant and equipment, included in which are impairment losses recognised and reversed during the period. The disclosure requirements under IAS 36, summarised below, essentially fill any gaps that might exist in other standards.

For each class of asset, in addition to the requirements of other applicable accounting standards, when an asset (or CGU) is impaired, disclosure is required of the:

• Amount of impairment losses recognised and reversed for the period;
• Line item(s) in the income statement where those amounts are reported; and
• Amount of impairment losses recognised and reversed directly in equity for the period27.

When segment information is reported under IAS 14, disclosure is required of the amount of impairment losses recognised and reversed for each segment reported under the primary format28.

When material to the financial statements, disclosure is required of:

• The events and circumstances that led to the recognition or reversal of the impairment loss;
• The amount of the impairment loss recognised or reversed;
• The nature of the asset or a description of the CGU, as applicable, and the segment affected;
• Whether the recoverable amount is based on the value in use or the net selling price;
• The basis applied when recoverable amount is determined on net selling price; and
• The discount rate(s) applied when recoverable amount is determined on value in use29.

The IAS encourages, but does not require, disclosure about the key assumptions applied in determining recoverable amounts during the period (as at balance sheet date)30.

Transitional provision when IAS 36 is applied for the first time
IAS 36 is applied on a prospective basis only. The standard requires impairment losses and reversals of impairment losses, recognised on the adoption of IAS 36, to be reported in the income statement for the current period unless an asset is carried at revalued amount. An impairment loss (reversal of impairment loss) on a revalued asset is treated as a revaluation decrease (increase)31.

References

1. NB: Decline in value is a different concept to depreciation, the latter dealing with the inter- period allocation of cost.
2. IAS 36, Impairment of Assets, IASC, June 1998, para. 122.
3. Reliability is one of the four principal qualitative characteristics of a general purpose financial report. Refer to the Framework for the Preparation and Presentation of Financial Statements, IASC, para. 24 et seq.
4. IAS 36, para. 1.
5. Ibid., para. 5 for definitions.
6. Ibid., para. 8.
7. IAS 22, para. 56, and IAS 38, para. 99.
8. IAS 36, para. 9.
9. Ibid., para. 65 & 66.
10. Ibid., para. 15.
11. Ibid., para. 27.
12. Ibid., para. 32.
13. Ibid., para. 37.
14. Ibid., para. 43.
15. Ibid., para. 48.
16. Ibid., para. 58.
17. Ibid., para. 59.
18. Ibid., para. 62.
19. Ibid., para. 88 & 89.
20. Ibid., para. 95 & 96.
21. Ibid., para. 99 et seq.
22. Ibid., para. 102.
23. Ibid., para. 104.
24. Ibid., para. 106.
25. Ibid., para. 107 & 108.
26. Ibid., para. 109.
27. Ibid., para. 113.
28. Ibid., para. 116.
29. Ibid., para. 117 & 118.
30. Ibid., para. 119.
31. Ibid., para. 120.

Simon Riley is Deputy Director (Accounting), Hong Kong Society of Accountants