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The annual report of a company or a group of companies is meant to reveal the true and fair state of affairs as on the date of the balance sheet.
It has however traditionally been rather difficult to effortlessly know the realistic and fair values of the resources (assets) and burdens (liabilities) in the stated financial results. The accounting standards, therefore, now specify that such assets and liabilities need to be stated at their current values, using stipulated procedures for computation of obligatory charges, in the books of accounts. These charges are based on future cash flows and discounted at certain discount rates; the resulting diminution in the worth of the assets is the value of the impairment.
In reality, however, it is not always feasible for organisations, considering the complexity and multiple dimensions of the issue, to establish the numerous types of impairment that can occur. A careful study of such procedures and factors would enable a better understanding of the issues involved for all annual report users.
The International Accounting Standards Board (IASB) under IAS 36 defines impairment of an asset as occurring when its recoverable amount falls below its carrying amount in the books of accounts (Deloitte, 2010).
The carrying amount is defined as the amount stated in the balance sheet net of the accumulated impairment losses and accumulated depreciation; the recoverable amount is defined as the higher of the asset's fair value reduced by its selling costs and its value in use (Deloitte, 2010). The fair value relates to the value receivable from the asset sale in an arm's length contract, whereas the value in use is considered to be the discounted present value of future cash flows receivable from the use of the asset, as well as the value receivable at the end of its functional life (Deloitte, 2010).
It is pertinent to note here that the IAS 36 is largely applicable to assets that have long-term useful lives, and include (a) fixed assets like land and buildings, machinery and equipment, (b) investment property and assets, (c) goodwill and other intangible assets, (d) investments in related entities and (e) assets accounted at re-valued amounts. IAS 36 generally does not apply to current assets, current assets held for sale, and those for which other accounting standards apply (Deloitte, 2010). Appendix 1 details the assets excluded from the scope of IAS 36 (Pwc.com, 2010)
IAS 36.10 states that at each balance sheet, reviews of all assets need to be conducted to seek any warning regarding occurrence of impairment (Deloitte, 2010). . The sources that determine such impairment could be external or internal, as well as quantitative or qualitative. Some of the major external sources as indicators of impairment are (a) market value reductions, (b) unfavourable changes in technology or laws and negative economic or markets' performance, (c) changes in market interest rates and (d) company stock prices falling below book value (Deloitte, 2010). On the other hand the major internal sources of impairment include (a) natural wear and tear, obsolescence or damage to assets, (b) impairment arising from assets held for disposal or as components of a restructuring and (c) worse than expected business performance. A sign that an impairment has occurred can also call for reappraisal and adjustment of an asset's constructive life, depreciation technique or scrap value (Deloitte, 2010).
It is incumbent upon a company to compute the asset's recoverable value, wherever there is an indication that the particular asset may be impaired (Deloitte, 2010). Considering the complex relationships between the numerous factors in considering whether assets have suffered impairment, it is in fact practically difficult to define with certainty the extent of impairment, and more importantly, the consequential impact of such impairment on assets in other business verticals, division or functions.
The ongoing economic downturn is characterised by (a) huge write-offs and accounting write-downs, (b) persistence of turbulent market conditions, (c) continued infusion of liquidity by central banks worldwide into the capital markets and inter-bank market. Such a scenario does not lend confidence to future recovery; these conditions have affected and continue to affect all sectors, even beyond the financial services sectors (Pwc.com, 2010).
These write-downs and write-offs signify impairment of assets affecting industries and economies across the board. It, therefore, is imperative to consider all practical and feasible issues and conditions in following procedures and valuing the assets judiciously to reflect the post-impairment reality in as true and fair a manner as possible in the annual reports of companies. All external and internal sources determining the impairment need to be corroborated to arrive at the scope and extent of impairment of all the assets.
The telecommunications industry, for example, has to resolve complex issues in arriving at impairment valuations due to the inherent nature of business information that cuts across numerous end-user profiles, as well as the inter-operability of various network providers with differing technologies and geographies.
Certain specific problematic indicators of impairment in the telecom industry could relate to (a) unfavourable trends in performance norms like network utilisation charges, average revenue per user (ARPU), and the number, churn and cost of addition of subscribers, (b) network working and upkeep expenditure far in excess of initial budgets, (c) technology developments that render operating licences economically unviable, (d) new competition, and (e) the effect of changes in statutory laws and deregulations (Pwc.com, 2010).
The other important intangible assets in the telecom industry that could pose thorny problems include goodwill, telecom licences, custom built and developed software, customer relationships, trade names and trademarks purchased in a business group (Pwc.com, 2010). Rapid technological advances leading to obsolescence of earlier licences, delay in launching data services or the non-acceptance of such services in the market place can also lead to erroneous cash flows and impairment valuations (Pwc.com, 2010). Declining subscriber revenues due to reduced network utilisations or higher industry or competition financials should also necessitate impairment tests (Pwc.com, 2010).
An earlier scrutiny of annual reports found large levels of goodwill impairment in this industry, with almost one-third of the companies reporting an average Euro 4.0 billion impairment losses; in 2005, a single telecom major charged Euro 34.2 billion to the income statements. Identification of Cash Generating Units (CGUs) assumes special importance in this context (Pwc.com, 2010). This reflects the enormous complexities of impairment testing in goodwill valuations as well as allocation of goodwill to the purchaser's CGU of the business with which it will synergise.
An important factor in the complex impairment equation is the influence of the cost of capital on the short, medium and long term debts and / or refinancing of the organisation. Any swelling of risk premiums and credit spreads will increase cost of capital and make a large impact on future cash flow projections (Pwc.com, 2010).
There is a difference of opinion between Europeans and North Americans regarding the quantum of impairment losses to charge, totally or partially, upfront or in a staggered manner; the reluctance of European accountants in fully accepting the charge upfront will only delay the full impact of the impairment required to be absorbed in the economy (Castedello, 2009). The largely European companies that support the assimilation of a series of lesser charges are basically banking on the markets reverting to healthy pre-downturn days, whereas the North American companies tend to think of the single charge basis as more suitable to reflect the reality of current market instability (Castedello, 2009).
The pressure from regulators, like the SEC, in North America is largely responsible for companies to adopt more realistic impairment charges in their accounts, and it remains to be seen whether European regulators will follow suit (Castedello, 2009). KPMG's recent study in the US revealed that goodwill impairment for 2008, amounted to a colossal US $ 340 billion, approximately twice of that charged in 2007 (Castedello, 2009). The regulators' problem with valuation is first that it is an imprecise science, and second that it is becoming increasingly complex in the grey areas that need to be addressed to assign values to companies (Castedello, 2009). An example of such a situation could concern whether recompense of goodwill impairment related to an acquisition or a business forecast by self-generated goodwill recompenses could be felt to be unduly optimistic; accurate ascertainment of the extent of compensation or optimism can be problematic in both cases, (Castedello, 2009). The examples provided below exemplify the magnitude of the write-downs that have happened during this decade.
The Sprint Nextel Corporation wrote down approximately US $30 billion of the $36 billion purchase of Nextel and other entities, largely on account of the goodwill and premium paid for other intangible assets like premium for reputation and customers (Harrison, 2008). A write down of US $ 100 billion occurred subsequent to the US $ 124 billion America Online Inc. buyout of Time Warner Inc. in 2001; in Europe, Deutsche Telecom AG wrote down Euro 21.4 billion, (approximately US $ 32.5 billion) in 2002 for reduction in the value of its cellular phone assets, whereas Vivendi SA, wrote-down Eur.18.4 billion in the same year to reduce the value of its music, TV and entertainment units (Harrison, 2008).
In banking and financial services, organisations like the Lloyds Banking Group assess every year, at the balance sheet date, the likelihood of impairment of a financial asset or a group of such assets (Lloyds Group, 2010). The factors for determination of such impairment include (a) negligence in paying back of principal or interest, (b) the possibility of financial unsoundness of borrowers or groups of borrowers, (c) debt reduction or restructuring, (d) violation of loan terms and/or conditions and (e) starting of bankruptcy or other such proceedings (Lloyds Group, 2010).
Valuations of blocks of shares of publicly traded entities in thin or non-existent market conditions by financial institutions like hedge funds and pension funds pose peculiar problems, vis-à-vis IAS 36 and impairment valuations (Weretka, 2006). The sale of large blocks of shares cannot be executed, without further reduction of share prices, in thin markets characterised by insufficient liquidity apropos daily traded share volumes (Weretka, 2006). The use of traditional asset pricing models like the Capital Asset Pricing Model is considered inappropriate in such scenarios and business valuation experts, by and large, discount valuations with blockage factors of up to 15 percent (Weretka, 2006). The derivation of such business valuations and the subsequent estimation of impairment losses consequently become problematic; an asset pricing method, based on modelling the impact of prices of institutional traders can be used effectively in such a scenario (Weretka, 2006).
It appears, from the above analysis, that the determination of the many types of impairment losses, especially when there are a number of correlating and interdependent factors involved, is an exceedingly complex task. The recognition and valuation of impairment losses lends requires considered judgements and approximations by company and institutional managements. It is clear that most companies, and especially financial institutions, find, it difficult to strictly apply the requirements of IAS 36 in valuation and recognition of impairment losses.
APPENDIX 1 (Pwc.com, 2010)
EXCLUSION FROM SCOPE OF IAS 36
• Inventories (IAS 2)
• Assets arising from construction contracts (IAS 11)
• Assets arising from employee benefits (IAS 19)
• Deferred tax assets (IAS 12)
• Financial assets within the scope of IAS 39
• Investment property measured at fair value (IAS 40)
• Biological assets (IAS 41)
• Insurance contracts (IFRS 4)
• Non-current assets classified as held for sale (IFRS 5)