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This post is series of post which I have started on the potential impacts of COVID-19 on Financial Reporting. If you haven't yet read the first article then please click on below link to study,
COVID-19 & FINANCIAL REPORTING
In today's post, we shall look following
-Basis of IAS 36 Impairment of Assets
-Whether organisations have to revalue assets amidst COVID-19 based on the guidance of IAS-36
-Challenges which companies are facing to compile the figures based on IAS 36.
1) Basis of IAS 36 Impairment of Assets (The detailed standard issued by IASB consists of 48 pages. Here i shall try to give a short & concise summary of the main points. let me know if you want to have full IASB issued copy of the standard, i shall endeavor to forward you that).
The main objective of the standard is to make sure that assets are not recorded at more value than fair value less cost of disposal or value in use. If assets are recorded at higher amount than fair value or value in use then the asset is called impaired and impairment shall be recorded.
Refer to para 2 of the standard, it shall not be applied to below assets:-
(a) inventories (see IAS 2 Inventories);
(b) contract assets and assets arising from costs to obtain or fulfil a contract that are recognised in accordance with IFRS 15 Revenue from Contracts with Customers;
(c) deferred tax assets (see IAS 12 Income Taxes);
(d) assets arising from employee benefits (see IAS 19 Employee Benefits);
(e) financial assets that are within the scope of IFRS 9 Financial Instruments;
(f) investment property that is measured at fair value (see IAS 40 Investment Property);
(g) biological assets related to agricultural activity within the scope of IAS 41 Agriculture that are measured at fair value less costs to sell;
(h) contracts within the scope of IFRS 17 Insurance Contracts that are assets; and
(i) non‑current assets (or disposal groups) classified as held for sale in accordance with IFRS 5 Non‑current Assets Held for Sale and Discontinued Operations.
-Land & Building
-Property, plant and equipment
-Investment property at amortised cost
-Intangibles including goodwill
-Assets at revalued amounts as per IAS 16 and IAS 38
Paragraph 6 of the IAS define the impairment loss in below words:-
An impairment loss is the amount by which the carrying amount of an asset or a cash‑generating unit exceeds its recoverable amount.
a) Fair value less cost to sell. This value is calculated according to IFRS 13 Fair Value Measurement.
b) Value in Use: This is the present value of future cash flow from a particular asset
Below diagram shall help to understand this.
If fair value less cost of disposal isn't available, then recoverable amount is the value in use.
For assets to be disposed off, recoverable amount is the fair value less cost of disposal.
Cost of disposal includes only the incremental costs of disposal. It doesn't include normal overhead on the asset.
IAS explains the timing of test for the impairment of assets. To cope this, assets are divided into two categories; first those which have to be tested for impairment annually and second those which has to be tested only when there is indication of impairment.
Assets to be tested annually includes:-
b) Intangible asset not yet held for use
c) Goodwill
All other assets shall tested only if there is indication of impairment. Paragraph 9 to 16 of the IAS explains multiple indicators of internal and external sources which organisations can consider for the potential trigger points of impairment. Below is the diagram for two different types of impairments and which asset they cover.
Once it is determined that particular asset or cash generating unit shall be impaired, it may affect remaining useful life of asset (in some cases) and future depreciation amounts. Impairment amount shall be debited to P&L and reduce the assets value. In case, impairment is related to a revalued asset in which case it shall decrease the revaluation surplus through other comprehensive income.
Impairment is usually tested for the individual assets. in case it is not possible to determine the impairment of individual asset then it shall be determined for a cash generating unit. Cash Generating Unit is the smallest group of assets that generate cash inflows that are largely independent of from cash inflows of other assets or group of assets.
Goodwill in book resulted from a business combinations shall be tested for impairment annually.
To test for impairment, goodwill has to be allocated to each of the acquirer cash generating units, or group of cash generating units expected to benefit from the synergies from the combination, irrespective of whether other assets and liabilities of the acquiree are assigned to those group of asset or not. Impairment test of the cash generating units to whom goodwill has been allocated shall be performed at least annually by comparing the carrying amount of CGU including goodwill with its recoverable amount.
If carrying amount is higher than the recoverable amount of goodwill allocated CGU then impairment shall be recorder. To record impairment, first goodwill amount which is allocated to that CGU shall be reduced. Once all goodwill allocated to that CGU has been reduced than the carrying amount of other assets of the CGU shall reduced on pro rate basis.
Paragraph 110 to 125 sets out the requirements for the reversal of impairment loss.
In the same way as impairment indicators are evaluated for impairment, these shall also be tested for reversal of impairment. IAS describes multiple indicators of the reversal of impairment.
Reversal can not be done due to unwinding of discount. Discount rate is used to calculate the Present Value of future cash flows. With the passage of time, discount factor will be higher and even the cash flow estimated are same as of actual but amount will be higher now due to higher discount factor. IAS prohibits such reversal.
IAS 38 Intangible Assets prohibits the recognition of internally generated goodwill so IAS 36 does not allow for the reversal of impairment for goodwill.
Whether COVID-19 is One of Indicators of Impairment as per IAS 36?
Paragraph 8-16 states when the recoverable amount of the assets shall be determined.
As i indicated already above; intangibles with indefinite useful life, intangible not available for sale and goodwill shall be tested for impairment annually irrespective of any indication of impairment so COVID-19 is not actually having any impact on the trigger point of these assets although it has affected the calculation of impairment which we see in the next part of this post.
Other assets shall be tested for impairment only when there are indicators of impairment. Paragraph 12 of IAS 36 narrates the major internal and external sources of impairment which are the trigger points for companies to test impairment of asset. Instead of narrating all those sources here, i'm narrating below points which i think COVID-19 has triggered already. Bullet reference number are kept same as narrated in IAS for the ease of reference.
Internal Sources:- Organisations already established budgets and forecasts are changing due to change in demand and production of goods. Less inflows of revenue, committed/fixed outflows (expenses), less sources of funding from market and already established terms of long supplier contracts are posing serious liquidity issues to multiple organisations so there are plan of discontinue or restructure many operations. Any one of these internal elements is enough to call for impairment testing of related asset.
External Sources:- These is less demand of goods and concurrently less demand of equipment which ultimately has reduced the market value of many assets. Economy has jump into recession and in many cases its not too far when volatile capital markets shall crash for some companies and their Net assets carrying value shall be standing higher than their total market capitalization.
Para 13 of the standard narrates that elements mentioned in para 12 are not only trigger points for impairment testing. An entity may identify other indicators that an asset may be impaired and these would require the entity to determine the assets recoverable amount, or in case of goodwill, perform an impairment test in accordance with paragraphs 80-99.
Challenges which entities are facing to compile the figures based on IAS 36
It is clear now that trigger point for impairment of assets has occurred and so the organisations who have to issue their financials soon shall need to perform an impairment test. The challenge which organisations are facing today is of accurate future forecasts and budgets. COVID-19 is posing an unprecedented macro-economic scenario where at this stage nobody can confirm on concrete terms what will be graph of economy? shall it start rising sooner or later? and whether we have reached the lowest point on the graph?
Major bunch of IAS 36 is made up of how an entity can calculate the impairment amount. It consists of para no. 18 to 57. Let me compile major issues which entities shall face now to calculate the recoverable amount of their assets as per IAS para no. 18 to 57.
COVID-19 is posing a challenge to all above three elements of the calculation, particularly it is more critical to get an estimate of future cash flows.
Uncertainty around forecasts of
demand and production, outdated and less detailed financial forecasts, the inability
of management to forecast the timing of such flows are major issues which
entities are facing today to explicitly conduct an impairment test.
At one hand, where companies have to conduct such impairment test, they also have to take ample care while conducting such exercise as in coming years it might get hard for some of the assets to reverse their impairment i.e. IAS 36 prohibits the reversal of impairment for goodwill. For other assets' impairment reversal, organisation has to explain in writing the fundamentals of assumption which were assumed wrongly to justify reversal in coming years.
Issues are critical for the organisations whose accounting or fiscal year is near to end while other companies have enough time to wait, see and make a more reliable and accurate impairment test.
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