Investigating the significance of impairment for Lloyds

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The assignment on impairment of assets consists of three parts: first is an evaluation of the extent to which IAS 36 complies with the Framework's qualitative characteristics of relevance and reliability; the basic procedure of and allocation of impairment, and its effect on the income statement and balance sheet, in the second part; and a report (where the names of parties involved are created simply to follow the format of a report) based on Lloyds Banking Group PLC, prepared for a client who is considering of investing in shares of the Group.

Part 1

"Impairment, as a procedure, is an essential element in the International Accounting Standards Board's (IASB) strategy of moving financial reporting from the historical cost to a fair value basis" [1] , and moving from prudence to realism in financial reporting. [2] Tangible and intangible fixed assets need to be ensured that they are not carried at a figure greater than their recoverable amount. [3] Recoverable amount is the higher of net selling price and value in use, as defined by IAS 36. [4] This essay will give brief explanations of indications of impairment and the qualitative characteristics of relevance and reliability, followed by an evaluation of the extent to which the required treatment of impairment satisfies the characteristics of relevance and reliability.

According to IAS 36, an impairment test is required when indications of impairment exist, which may arise from:

"Internal sources:

Obsolescence or physical damage of a fixed asset.

A significant reorganisation of business operations.

The loss of key employees.

Internal reports that indicate that the economic performance of an asset is, or will be, worse than expected.

External sources:

A significant fall in the asset's market value.

An adverse change in the company's competitive or regulatory environment.

A significant increase in market interest rates.

A key employer in the locality where a company carries on business closes down.

The carrying amount of the entity exceeds market capitalisation." [5] 

The characteristics of relevance and reliability have become increasingly significant as standard-setting bodies seem intent to replace historical cost system with that of a fair value. [6] According to Ernst & Young (2005), reliability is a necessary pre-condition for relevance, whereby if users of financial statements consider information to be unreliable; it will definitely not be considered relevant. "Information in financial statements is relevant when it influences the economic decision of users." [7] When an information performs a predictive role or a confirmatory role it is said to be relevant. [8] A reliable information is one which is free from material error and bias. [9] This definition gives rise to the four subsidiary qualities of reliability: faithful representation, substance over form, neutrality, and prudence.

"The basic requirement of IAS 36 is that recoverable amount is determined for the cash generating unit (CGU) to which the asset belongs unless either:

The asset's fair value (FV) is higher than its carrying amount; or

The asset's value in use (VIU) can be estimated to be close to its FV and its FV can be determined." [10] 

The asset's own carrying value could be based on its FV if the CGU to which the asset belongs has been impaired.

Informations needed for the treatment of impairment are CGU, cash flow estimates, a discount rate, VIU, and recoverable amount. The first issue that needs to be assessed is the determination of CGUs. These are groups of assets which produce an identifiable stream of cash flows. [11] An example of relevance here is a boutique chain which has a number of outlets across a country. Each boutique is a CGU provided that cash inflows are monitored and those costs are allocated. The assessment of impairment is unlikely to be material if it is based on an individual asset. There is a tendency of a material impairment review when groupings of boutiques are affected by the same economic factors. External users of financial statements might consider the information to be reliable possibly because the relevant common factors are taken into account for identifying the relevant CGUs for the purpose of an impairment review. Therefore, in this sense, IAS 36 satisfies the qualitative characteristics of relevance and reliability.

Another issue that will be assessed is the determination of cash flow estimates with an appropriate discount rate to arrive at VIU. Ernst & Young (2005) argued that the determination of cash flow estimates and discount rate are not without complex issues, and often there is no agreed methodology to follow. According to Edwards (2006), there are two elements of estimating cash flows: first, up-to-date budgets and plans for a period not exceeding five years, and second, cash flows thereafter based on the assumptions of steady or declining growth rates, with the rate not exceeding the long-term average of a country in which a firm operates. The extent to which IAS 36 satisfies the characteristics of relevance and reliability is on the assumptions concerning growth rates so as to ensure realistic, perhaps prudent, forecasts are made. [12] These cash flows are then discounted to present values with an appropriate discount rate. Ernst & Young (2005) recommended that the rate is to be obtained from market rates, which should be implicit in current market transactions for similar assets or weighted average cost of capital (WACC). VIU can be relied upon by users to an extent where the cash flow estimates and discount rate are reasonably relevant and reliable. The problem with estimating cash flows is that they are forecasted over a long horizon. This is likely to increase risk of uncertainties, and hence unreliability. The identification of a discount rate is likely to be extremely difficult, and it is not practical to discount the estimated cash flows to present values with a chosen rate since such a rate may have been selected long before the impairment review. The market situations, which could affect the identification of discount rate, may not be the same. When such estimates are not reliable, they are considered to be irrelevant.

In conclusion, the extent to which IAS 36 satisfies the qualitative characteristics of relevance and reliability depends upon the information needed for an impairment review. Theoretically, IAS 36 may seem to be a straightforward standard, but not in practice. This could be due to the difficulty to obtain information, for example discount rate. More empirical studies may be needed so as to provide a concrete guidance to entities in forecasting and obtaining relevant information for impairment.

Part 2

Assumption: the revised balance sheet value for special-purpose freehold property is zero because the investigation revealed that the property could not continue be used by Retford plc and could be sold for £30 million. Hence, the revised net current assets value is increased by £30 million.

Part 3

To: Amerdale Eastend

From: EVA Consultants

Re: Report on Impairment


The purpose of this report is to provide a brief introduction of impairment, followed by an analysis of the significance of impairment for the financial progress and position of Lloyds Banking Group. Impairment is defined as "a reduction in the recoverable amount of a fixed asset or goodwill below its carrying value." [13] The acquisition of HBOS led to the prudent valuation of HBOS's commercial property related assets, and hence an increase in total impairments to £13.4 billion. [14] Approximately three quarters of impairment in the first half year related to assets which are expected to be included in the Government Asset Protection Scheme. [15] This report consists of three parts:

Allocation of impairment and its impact on the financial statements.

The causes of impairment.

Management's assessment for the position and prospects of Lloyds Banking Group based on the significance of impairment.

This report will focus only on the three divisions of retail, wholesale, and wealth and international, mainly because material amounts of impairment are allocated to these divisions (see Appendix 1).

Allocation of impairment and its impact on the financial statements

As mentioned earlier, the total impairments for the half year to June 2009 is £13.4 billion. This shows an increase in impairment losses from £10,885 million to £13, 399 million. [16] The allocated amount to the three divisions can be seen on Appendix 1.

The effect of the impairment reviews on income statement is to reduce profit before tax for the period (Appendix 1). Since impairment will reduce the recoverable values of assets, the total net assets will be reduced by the respective amounts.

The causes of impairment


In Retail, as a result of a lower house prices on mortgage impairment charge, there is an increase in impairment losses by 60 per cent to £2, 192 million. [17] The tendency of increased consumer arrears and insolvencies, the uncertain UK economic condition, and the rising unemployment level have also contributed to the increase in impairment losses. [18] Consequently, Lloyds Banking Group is expecting a moderate increase in impairment losses in the second half of 2009. [19] However, this may not be likely to happen in 2010 as it is expected that there will be a stability in house prices, and hence a fall in impairment charge in 2010. [20] 


The significant increase of impairment losses from £8,663 million to £9,738 million is due to the lower prices of commercial property and a reduction in the levels of corporate cash flows as a result of the poor economic environment. [21] Approximately 80 per cent of the impairment charge for the half year to 2009 consists of assets to be included in the Government Asset Protection Scheme because HBOS legacy assets are more sensitive to respond to the economic condition. [22] The impairment charge is expected to fall in the second half of the year and a further reduction in 2010.

Wealth and International

In general, impairment losses have increased by £1, 401 million to £1, 469 million. [23] In Wealth, the increased in impairment losses to £26 million is the result of the economic climate, particularly entities traded in Spain. [24] In International, impairment losses increased by £1, 380 million to £1, 443 million. [25] The severe declines in the Irish and Australian Commercial real estate portfolios have caused significant deterioration in impaired assets. [26] 

Despite the outlook of the Irish economy, the Group is expecting a fall in the impairment charge in the second half of the year, followed by a further reduction in 2010. [27] About 85 per cent of the first half year impairment charge is related to assets which will be included in the Government Asset Protection Scheme. [28] 

Management's assessment for the position and prospects of the Lloyds Banking Group based on the significance of impairment

Although there has been a significant increase of impairment losses in the first half year, the management team expects the economy will be stabilised and hence the performance and position of the Lloyds Banking Group may improve in the second half, and with progressive reductions thereafter. [29] For example, in Retail, the prospect of improved performance is likely to be due to a continued low interest rates and improving house prices. [30] 


In conclusion, based on the analysis of the position and prospects of the Group, it is advisable for the client to invest shares in the Group.