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This work seeks to address the question of the extent to which it is feasible for companies to determine many types of impairment losses especially when there are numerous variable factors involved. It also seeks to address the issue of the applicability of IAS 36 by companies operating in thin or non-existent market conditions.
The issue (impairment of assets) referred to here is treated by IAS 36. This standard was approved by the IASC board in April 2008 and became effective 2 months later (IASC, 2002). All statements that were produced on or after July 1 1999 needed to apply the standard. The standard warrants that the recoverable amount of an asset (excluding inventories, deferred tax assets, assets related to construction contracts, financial assets, and assets from employee benefits) be estimated if there is an indication of any impairments (IASC, 2002). An asset is impaired when its carrying value is less than the amount that could be recovered from using or selling the asset. The standard therefore sets out to provide a set of procedures that could be employed by companies to ensure that assets are not overvalued or recorded at values higher than their recoverable value. If an asset has lost its value, it is said to be impaired and therefore the company needs to recognise this loss of asset value by registering an impairment loss in the accounts. In certain cases, assets may appreciate in value thus the standard also has provisions to deal with such cases.
The task of determining whether or not an asset is impaired lies with determine its recoverable value at the balance sheet date. The recoverable value indicates the highest of the assets net selling price and its value in use. It thus represents the maximum benefit that can be earned from holding the asset. Conceptually, the calculation of impairment losses on assets might seem very easy or straight forward as it warrants only that the net recoverable value from the asset be obtained.
In practice however the determination of impairment losses is a rather onerous task as will be discussed below. Hoogendoorn (2006) noted that in the implementation of IFRSs and IASs, the five most difficult issues in practice are financial instruments (IAS 32, IAS 39), Pensions (IAS 19), Purchase Accounting (IFRS 3, IAS 38), Impairment Testing (IAS 36), Disclosures (materiality). The difficulty with Impairment Testing mainly arises from the subjectivity involved in the calculation of the recoverable amount.
The first factor that makes this task complicated is the fact that each company in practice holds several assets. The standard applies to Properties, plants and Equipment, Goodwill, Investments in subsidiaries and Intangible assets such as brand names, Research & development etc.
Property, Plant and equipment include items such as motor vehicles, office equipment, computers, furniture, land, machinery etc. These items are also subject to continuous depreciation. Due to the fact that there a company holds so many assets, the preliminary process of identifying an asset which may be impaired becomes difficult. The standard prescribes that at each balance sheet date, the company must assess whether any asset may be impaired and if it is the case, estimate their recoverable value. This allows for a lot of subjectivity in the determination of which assets should be tested for impairment. The amount of impairment loss will therefore depend on the individual accountant's judgement. The standard further provides specific external sources of information that may indicate the likelihood of an asset's impairment. The standard states:
External sources of information
- During the period, an assets has decline significantly more than would be expected as a result of the passage of time or normal use
- Significant changes with an adverse effect on the enterprise have taken place during the period, or will take place in the near future, in the technological, market, economic or legal environment in which the enterprise operates or in the market to which an asset is dedicated''
IASB, 2002 IAS 36-13
As Alexander et al, 2007 noted, both indicators suggest a fall in the recoverable amount relating to the net selling price and the Value-in-use. Ambiguity lies in the fact that a lower recoverable amount must not arise from any of these indicators because the recoverable amount is the higher of fair value less cost to sell and value-in-use (Alexander et al, 2007). The fourth indicator states
- ''d) the carrying amount of the net assets of the reporting entity is more than its market capitalisation''
IASB, 2002 IAS 36-13
This merely indicates that there is a problem with the recorded value of assets. It may indicate that assets are impaired but it does not give any indication of which assets are impaired. In a corporation with many assets worth billions of pounds, this indicator will not offer any help in situating of impaired assets.
The indicators from the internal sources of information seem more useful but they prescribe extreme situations such as technological obsolescence, physical damage, discontinued operations, restructuring and asset disposals which are not commonplace in every organisation.
An organisation such as TESCO PLC which has not been through significant asset restructuring, which has been successful amidst the difficult operating conditions and a recession, which operates in over 13 countries and which holds assets-'Property, Plants and Equipments' worth over 23.152 Billion Pounds as at Dec 2009 will find the indicators useless in its task to identify impaired assets.
Corporations with a huge pool of assets to test for impairment must therefore employ the principle of materiality in the determination of what assets to test for impairment. This makes the whole process more subjective as it wholly depends on the accountant's judgement.
Alexander et al. 2007 noted that the 39 paragraph making up the 'Measuring the recoverable amount' procedures prescribed by the standard are cumbersome and thus worrisome to apply in practice.
The standard prescribes that the recoverable amount constitutes either of Fair value less cost to sell and Value-in-use. The implication is that if either of them is higher than the assets carrying amount then the asset is not impaired. The underlying assumption is that Fair value less cost to sell is equal to value-in-use. Many researchers will argue that this assumption is flawed.
The major question however is 'what is the fair value of an asset?' The standard proposes that the price offered in a binding sale agreement in an arm's length transaction with knowledgeable parties or the market selling price of the assets in an active market. IAS 36 also proposes that the outcomes of recent transaction of similar assets should be considered. The problem with this is that no two assets (property, plant and equipment) are similar. The use of comparatives may be misleading. Not all assets have an active market. The fact that an asset is not bought at a particular price does not mean that the asset is overpriced. Determining the fair value of some assets can therefore be very problematic.
When this cannot be determined, the standard warrants that the value-in-use should be computed. The computation of value-in-use requires two steps:
- Estimating the future cash inflows and outflows should be obtained from the continuing use of the asset and also from its ultimate disposal
- Using the appropriate discount rate to these future cash flows.
IASB, 2002 IAS 36-18
The estimation procedure involves a lot of subjectivity. The accountant needs to estimate how much will be generated from the asset each year and how much will be spent on the asset each year until the asset is sold or disposed of. Major assumptions will include projected tax rates, projected output levels, projected levels of inflation, estimated useful life of the asset etc. The task is further complicated when the company has so many assets to compute future cash flows for.
A situation arises when the assets cannot be directly linked to cash flows. A company such as Tesco has a fleet of delivery trucks. The company does not charge customers for deliveries so it is difficult to estimate cash inflows from the fleet of trucks. Trucks may need repairs, replacement etc. in the future but it is uncertain when, what type of repairs and how much such repairs will cost. A projection of future inflows and outflows from a fleet of deliver trucks may therefore be meaningless. The standard emphasis that a five year cut-off point should be used in estimating future cash flows. This is arbitrary and will lead to significant undervaluation of long term assets such as land, heavy equipment, machinery and buildings
The second step involves the application of an 'appropriate' discount rate to the net future cash flows. The IASB describes an 'appropriate' discount rate as;
...a pre-tax rate (or rates) that reflect(s) current market assessments of the time value of money and the risks specific to the asset. The discount rate should not reflect risks for which future cash flow estimates have been adjusted.
Risk is a relative term and the expected reward for risk will vary from one investor to the other. It is difficult to know exactly what level of risk to attach to each asset. The most common measure is the return investors will expect if they invested in an asset that will generate cash flows identical to the expected future cash flow to be generated from the asset in question. In reference to the above example of the Fleet of trucks owned by TESCO PLC, it will be impossible to find an asset that generates identical cash flows as the fleet of trucks, with the same risk profile as the fleet. The principle of identifying a suitable discount rate is sound but will not be feasible in practice. The tendency is for accountants to use a justifiable estimate.
The value-in-use very much depends on the discount rate applied. A small change in the discount rate from say 11% to 12% might result in an asset being impaired. A change in discount rate thus significantly changes value-in-use.
Discount rates are derived from the risk premium and a risk free rate. The risk free rate adjusts for current interest rates and current rates of inflation. In unstable economic conditions, the risk free rate will continue to fluctuate. For example, the rate of inflation in the UK rose to 3.5% far above the desired level of 2%. Interest rates fluctuate as a matter of monetary policy. It may be difficult to estimate or project future interest and inflation rates to use in discounting cash flows. The computation of value-in-use is therefore very subjective and may not be feasible in certain organisations.
In an attempt to salvage the difficulty of estimating recoverable values for certain assets, the standard proposes the use of 'cash generating units' when the recoverable amount cannot be estimated for an individual asset. It states;
...if it is not possible to estimate the recoverable amount of the individual asset, an enterprise should determine the recoverable amount of the cash generating unit to which the asset belongs( the asset cash generating unit).
IASB, 2002 IAS 36-26
Financial institutions applying IAS 36 in thin trading and non-existent markets do face a difficulty. Although, IAS 36 does not apply to financial assets that are covered by IAS 39 (financial instruments; recognition and measure), it does apply to financial assets not covered IAS 39. Without a ready market for the assets from which the recoverable amount can be obtained, it is difficult to know whether such assets are impaired or otherwise. The values of such assets greatly fluctuate depending on current market conditions. This therefore makes it difficult to estimate future cash flows that can be generated from holding the assets.
Overall, the principle on which the standard is based is robust and by itself promotes better, fair and transparent reporting. It is however difficult to apply in practice. It is recommended that the board continues research on the issue and find ways to make the standard more applicable to every corporation.
References & Bibliography
Alexander, D., Britton, A. and Jorissen, A. (2007) International Financial Reporting and Analysis, 3rd edition, Thomson Learning
Technical summary IAS 36- Impairment of Assets, IASC foundation Education
International Accounting standards 2002 International Accounting standards Board
Hoogendoorn, M (2006) International Accounting and IFRS Implementation in Europe and Beyond- Experiences with first time adoption in Europe, Accounting in Europe, Vol 3, pp 23-26
European Commision (2001) Examination of the conformity between IAS 1 to IAS 41 and the European Accounting Directives .
PriceWaterHouseCoopers (2009) Making Sense of the Complex World; IAS 36 Impairment of Assets. A discussion paper on the impact on the telecoms industry