Following research by ESMA, the regulatory bodies are focusing on key aspects of IAS 36, says Graham Holt
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IAS 36, Impairment of Assets, describes the procedures that an entity should follow to ensure that it carries its assets at no more than their recoverable amount, which is effectively the higher of the amount to be realised through using or selling the asset. When the carrying amount of asset exceeds the recoverable amount, the asset is considered to be impaired and the entity recognises an impairment loss. Goodwill acquired in a business combination or intangible assets with indefinite useful lives have to be tested for impairment at least on an annual basis. The standard details the circumstances when an impairment loss should be reversed, although this is not possible for goodwill.
For the purposes of impairment testing, goodwill should be allocated to the cash-generating units (CGU) or groups of CGUs benefiting from goodwill. Such group of units should not be larger than an operating segment before aggregation. For any asset, an impairment test has to be carried out at each reporting date if there is any indicator of impairment. IAS 36 gives a list of common indicators of impairment such as increases in market interest rates, market capitalisation falling below net asset carrying value or the economic performance of an asset being worse than projected in internal budgets.
Detailed disclosures, including the circumstances that have led to impairment are required in relation to each CGU with significant amounts of goodwill and other intangible assets. These include the key assumptions on which management has based cashflow projections, a description of management's approach to determining the values of each key assumption, terminal growth rates and discount rates as well as sensitivity analysis where a reasonable change in a key assumption would lead to impairment.
Additionally, the International Accounting Standards Board (IASB) has recently published Recoverable Amount Disclosures for Non-Financial Assets (Amendments to IAS 36). These narrow amendments to IAS 36 detail the disclosure of information about the recoverable amount of impaired assets if that amount is based on fair value less costs of disposal. When developing IFRS 13, Fair Value Measurement, the IASB decided to change IAS 36 to require disclosures about the recoverable amount of impaired assets. The recent amendment limits the scope of those disclosures to the recoverable amount of impaired assets that is based on fair value less costs of disposal. The amendments are to be applied retrospectively for annual periods beginning on or after 1 January 2014 with earlier application permitted.
In January 2013,the European Securities and Markets Authority (ESMA) issued a report on the accounting practices relating to impairment testing of goodwill and other intangible assets. ESMA reviewed the nature of disclosures in the 2011 IFRS financial statements of a sample of 235 companies with material amounts of goodwill. Similarly, a recent research report by the Centre for Financial Analysis and Reporting Research (CeFARR) at the Cass Business School entitled Accounting for asset impairment: a test for IFRS compliance across Europe reviewed the compliance of European listed companies' as regards IAS 36. The authors, Hami Amiraslani, George E Iatridis and Peter F Pope, investigated the degree of compliance with IFRS by analysing impairment disclosures during 2010/11, relating to non-financial assets within a sample of over 4,000 listed companies from the European Union plus Norway and Switzerland.
The two reports make interesting reading and there is some consistency in their conclusions. The findings of the CeFARR research contextualise the ESMA report. CeFARR found that compliance with some impairment disclosure requirements varied quite considerably suggesting inconsistency in the application of IFRS. Compliance with impairment disclosure requirements that required greater managerial involvement was less rigorous than those requirements with low effort required. This leads to a tendency to use boilerplate description, which helps reduce the cost of compliance. There appears to be considerable variation across European countries in compliance with some impairment disclosure requirements.
CeFARR found that the quality of impairment reporting is better in companies whose jurisdiction has a strong regulatory and institutional infrastructure. They placed the UK and Ireland in this category. However, impairment disclosures seem to be of lower quality in jurisdictions where there is a weaker regulatory regime. They further conclude that companies operating in a strong regulatory and enforcement setting appear to recognise impairment losses on a timelier basis. These findings could have implications for future investment decisions in terms of lower risk in certain jurisdictions.
In the current economic and financial crisis, assets in many industries are likely to generate lower than expected cashflows with the result that their carrying amount is greater than their recoverable amount with the result that impairment losses are required. However, ESMA found that the material impairment losses of goodwill reported in 2011 were limited to a small number of companies, and these were mainly in the financial services and telecommunication industries. Overall impairment losses on goodwill in 2011 amounted to only 5percent of goodwill recognised in the 2010 IFRS financial statements.
An indication of impairment could be a fall in market capitalisation below the carrying value of equity. An equity/market capitalisation ratio above 100percent is one of the external sources of information indicating that assets may be impaired, and should be considered in assessing the realistic values of key assumptions used in impairment testing. ESMA reported that the average equity/market capitalisation ratio of its sample rose from 100percent at 2010 year-end to 145percent at 2011 year-end and further, that as at 31 December 2011, 43percent of the sample showed a market capitalisation below equity compared to 30percent in 2010. Of these entities, 47percent recognised impairment losses on goodwill in their 2011 IFRS financial statements.
ESMA feels that the increased equity/market capitalisation ratio and relatively limited impairment losses call into question whether the level of impairment in 2011 appropriately reflects the effects of the financial and economic crisis.
As CeFARR found, in many cases the disclosures relating to impairment were of a boilerplate nature and not entity-specific due to a failure to comply with the requirements of the standard and possibly IAS 36 not providing specific enough detail, especially as regards the nature of the sensitivity analysis.
As a result of the ESMA review, they have identified five problem areas:
1. Key assumptions of management
In the ESMA sample, only 60percent of the entities discussed the key assumptions used for cashflow forecasts other than the discount rate and growth rate used in the impairment testing and half of these entities did not provide the relevant entity-specific information.
2. Sensitivity analysis
ESMA has identified different practices with regard to disclosures on sensitivity analysis. Only half of the entities presented a sensitivity analysis where the book value of their net assets exceeded their market capitalisation. This is a surprisingly low figure considering that this is an indication of impairment.
3. Determination of recoverable amount
'Value in use' is used by most entities for goodwill impairment testing purposes and 60percent of entities used discounting to calculate 'fair value less costs to sell'. Thus a significant number of entities estimate the recoverable amount using discounted cashflows. IAS 36 requires different criteria for cashflows when using value in use or fair value less costs to sell to determine the recoverable amount. One would expect that third party information would prevail over entity based assumptions when determining 'fair value less costs to sell' in this way.
4. Determination of growth rates
IAS 36 states that for periods beyond those covered by the most recent budgets and forecasts, they should be based on extrapolations using a steady or declining growth rate unless an increasing rate can be justified. ESMA found that more than 15percent of issuers disclosed a long-term growth rate above 3percent which, given the current economic environment, is optimistic and probably unrealistic.
5. Disclosure of an average discount rate
ESMA found that 25percent of issuers in the sample disclosed an average discount rate, rather than a specific discount rate on each material cash-generating unit. The applied discount rate has a major impact on the calculation of value in use. Therefore separate discount rates should be disclosed and used which fit the risk profile of each CGU. The disclosure of a single average discount rate for all CGUs obscures relevant information.
As a result of the above, ESMA and the national regulatory authorities are focusing on certain key aspects of IAS 36. The key areas include the application by entities of the rules re impairment testing of goodwill and other intangible assets, the reasonableness of cashflow forecasts, the key assumptions used in the impairment test and the relevance and appropriateness of the sensitivity analysis provided.
ESMA expects issuers and their auditors to consider the findings of their review when preparing and auditing the IFRS financial statements. ESMA also expects national regulatory authorities to take appropriate enforcement actions where needed.
Graham Holt is associate dean and head of the accounting, finance and economics department at Manchester Metropolitan University Business School.