(Second of two parts)
In last week’s article, we discussed how to determine the timing of assessment for any impairment for non-financial assets, as well as the indicators of impairment. This article will cover how to measure and estimate the recoverable amount of an asset, how to determine the recognition and reversal of impairment, and provide detailed disclosure on assumptions used to fully understand an impairment assessment especially in these uncertain times.
An asset is impaired when an entity is not able to recover its carrying value (i.e., the amount shown on the entity’s balance sheet) either by using it or selling it. The recoverable amount is the higher of the asset’s (or group of assets’) fair value less costs of disposal (FVLCD) and value in use (VIU).
VIU involves estimating the future cash inflows and outflows that will be derived from the use of the asset and from its ultimate disposal and discounting the cash flows at an appropriate rate. The calculation of an asset’s VIU incorporates an estimate of expected future cash flows, and expectations about possible variations of such cash flows. The forecasted cash flows should reflect management’s best estimate at the end of the reporting period of the economic conditions that will exist over the remaining useful life of the asset. This means entities should consider both short-term effects and long-term effects on assets with longer useful life, such as capital assets and goodwill.
Due to the evolving COVID-19 situation, there are significant challenges to preparing the forecast or budgets for future cash flows. In these circumstances, an expected cash-flows approach based on probability-weighted scenarios may be more appropriate than the traditional single best estimate when estimating VIU. In coming up with scenarios, entities should consider the length and severity of the pandemic, government measures, availability of proper intervention (i.e., vaccine), distribution and supply chains, revenue growth and collections, capital, changes in regulations, and changes in customer behaviors, among others.
Cash flows are discounted at an appropriate rate, which is a pre-tax discount rate that reflects current market assessments of the time value of money and asset-specific risks for which future cash flow estimates have not been adjusted. The discount rate should likewise consider the price for bearing the uncertainty inherent in the asset, and other factors, such as illiquidity, that market participants would reflect in pricing the future cash flows the entity expects to derive from the asset. It is therefore highly important to exercise careful judgement when determining the discount rate to be applied.
RECOGNITION AND REVERSAL OF IMPAIRMENT
An impairment loss is recognized to the extent the carrying amount exceeds its recoverable amount. In subsequent periods, external and internal sources of information (such as significant favorable changes in the market conditions, the asset’s value, use and performance) may indicate that an impairment loss recognized for an asset, other than goodwill, may no longer exist or may have decreased. In this case, previous impairment losses may be reversed. Note, however, that an impairment reversal cannot be recognized merely from the passage of time or improvement in general market conditions. When an impairment reversal is recognized for assets other than goodwill, the adjusted carrying amount of the asset may not exceed the carrying amount of the asset that would have been determined had no impairment loss been previously recognized.
PAS 36 specifically prohibits the reversal of impairment losses for goodwill. If impairment on goodwill was determined and recognized in the interim period, it cannot be reversed in the subsequent interim periods or at year-end.
Disclosure is particularly crucial in these times. Due to sensitivity, it is critical for an entity to provide detailed disclosures on the assumptions used, the evidence these are based on, and the impact of a change in key assumptions. Disclosures include, among others, the valuation methodology used and the approach in determining the appropriate assumptions and key assumptions used in cash flow projections aside from long-term growth rate and discount rate; the values of the key assumptions and the probability weights of multiple scenarios when using an expected outcome approach; and inputs used in determining the discount rate and the source thereof. This makes it also important to go beyond minimum disclosure requirements to help users better understand the impairment assessment.
With the COVID-19 situation, impairment assessment will be a complex and difficult undertaking. Hence, it is imperative for management to be judicious, more prudent and to employ careful judgment in making assumptions, especially when forecasting cash flows and determining the discount rate to be used.
It must be noted that cash flow forecasts may now be substantially — if not completely — different from pre-pandemic or existing budgets. Moreover, historical and comparative data may no longer be relevant and helpful in making such forecasts. Assumptions must be updated and should be drawn from and be reflective of the current pandemic circumstances.
This naturally requires a more cautious outlook for the future. As previously mentioned, the impact of COVID-19 may no longer be reflected in a single set of cash flows due to the high degree of uncertainty involved; there may be a need to develop multiple scenarios and apply probabilities to each scenario to arrive at the expected cash flows. In evaluating these scenarios, those with a downward impact on cash flows and on the value of the asset should be given more weight to reflect the market view of risk and uncertainty.
On the other hand, determining the discount rate is equally challenging given the current market volatility, and that most relevant parameters and inputs to determine discount rates have become unpredictable. Values and assumptions which were accepted, used and applied in the past and in previous impairment assessments and testing may no longer be reasonable or appropriate.
For instance, beta and cost of equity may have increased significantly due to capital market volatility; risk-free rates are reaching lows; and debt liquidity issues are severely affecting the cost of debt for many companies. That said, the risk-adjusted discount rates to be used should be calculated with serious considerations for the current market and economic conditions, the value of comparable reporting entities or assets that is available and evident in the market, and the risks of the asset or cash-generating unit to be valued.
The pandemic continues to evolve and until such time that a proper and permanent intervention is identified, there remains significant uncertainty about our future, our economy and business viability. Until then, the recoverability of most entities’ assets remains the focus and they will need to continuously reassess, recalibrate and be transparent about their assumptions and outlook for the future of their business. Disclosure is key — if not paramount — to understanding all these under the current situation.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinions expressed above are those of the author and do not necessarily represent the views of SGV & Co.
Meynard A. Bonoen is an Assurance Partner of SGV & Co.