How To Manage Impairment Testing During Economic Uncertainty

On January 30, 2020, the World Health Organization declared COVID-19 a global health emergency. The negative economic impact of COVID-19 on many businesses has been rapid and severe. Numerous businesses have been directly impacted as a result of voluntary and mandated closures of physical offices and storefronts, as well as, significant declines in consumer activity.

As a result of these unprecedented economic times caused by the COVID-19 pandemic, impairment testing will be top of mind for many companies. This may result in situations where companies are completing impairment tests for the first time or where significant uncertainty and changing market conditions cause entities to re-evaluate their impairment testing models. In the following article, we provide a summary of items to consider when completing an impairment test under International Financial Reporting Standards (IFRS).

The impairment standard under IFRS is found in IAS 36 Impairment of Assets (IAS 36 or the Standard). IAS 36 is typically applicable to long-lived assets including goodwill, unless the long-lived assets are covered by another IFRS.

Long-lived assets with a finite useful life do not require an annual impairment test, however, at the end of every reporting period, a company must assess if there is any indication that an asset or cash-generating unit (CGU)^[1] may be impaired. For entities that have goodwill, intangible assets that are determined to have an indefinite life, or intangible assets not yet available for use, an impairment test is required at least annually, or when indicators of impairment exist.   

IAS 36 provides examples of internal and external indictors of impairment including, but not limited to: a decrease in economic performance; a change in the extent or manner in which the asset is being used or is expected to be used; evidence of obsolescence or physical damage to the asset; changes in market interest rates; significant adverse changes in the technological, market, economic or legal environment in which the entity operates; and, a market capitalization of the company lower than the carrying amount of net assets.

Indicators of impairment in a COVID-19 context may include decreases in revenue and profitability, deferral of projects and capital spending, and revisions to short and long-term business plans. If indicators of impairment are identified, companies should be prepared to complete an impairment assessment at their next reporting date instead of waiting until their fiscal year end. 

An impairment test is required to ensure that the carrying amount of an asset / CGU is not recorded at an amount higher than the entity can expect to recover either from using the asset / CGU or selling the asset / CGU. Under IAS 36, recoverable amount is defined as the higher of:

• Value in Use (VIU) – the present value of the future cash flows expected to be derived from an asset / CGU; and,
• Fair value less costs of disposal (FVLCD) – price that would be received to sell an asset / CGU or paid to transfer a liability in an orderly transaction between market participants at the measurement date, less the costs of disposal.

Value in Use

The VIU of an asset / CGU is determined through the application of a discounted cash flow model. This includes[1] (1) estimating the future cash inflows and outflows that are expected to be realized from the use or operation of the asset / CGU; and, (2) the application of an appropriate discount rate to the future cash flows. IAS 36 provides the following useful guidance regarding the calculation of the VIU:

1) Estimate the expected future cash inflows and outflows from the use or operation of the asset / CGU:

• Cash flow projections should be based on reasonable and supportable assumptions that represent management's best estimate, as at the measurement date, of the range of economic conditions that will exist over the remaining useful life of the asset / CGU. Greater weight is placed on external evidence;
• Cash flow projections should be based on the most recent financial budgets or forecasts as approved by management. However, as VIU cash flows are meant to reflect value of the asset/CGU in its current condition, forecast cash flows should exclude any future cash inflows or outflows expected from restructurings or from improving or enhancing the asset's performance;
• Cash flow forecasts should cover a maximum period of five years, unless a longer period can be justified;
• Beyond the period covered by the most recent budget / forecast, the cash flow forecast can include a terminal value which should be based on a maintainable level of cash flow capitalized by a perpetuity factor that reflects a steady or declining growth rate unless an increasing rate can be justified.

Cash flow projections in a COVID-19 environment should reflect the anticipated impact of COVID-19 based on information available at the reporting date. This may include the potential timing and impact of decreased demand for products / services, disruptions to workforce, and interruptions to the supply chain. The uncertainty regarding the timing and extent of the economic impact of the pandemic creates significant forecasting challenges for businesses determining their best estimate of future cash inflows and outflows expected to be realized from an asset or CGU.

In recognition of these forecasting challenges, IAS 36 allows for possible variations in the amount or timing of future cash flows to be reflected either as adjustments to the future cash flow or as an adjustment to the discount rate. In order to reflect variations in the amount or timing of future cash flows, businesses may consider developing several cash flow scenarios to which a probability-weighted likelihood of occurrence can be applied.    

2) Application of an appropriate discount rate:

The discount rate applied should be a pre-tax rate which reflects the current market assessment of the time value of money and the risks specific to the asset / CGU for which the future cash flow estimates have not been adjusted. Stated another way, the discount rate applied should reflect the return that investors would require if they were to choose an investment that would generate cash flows of amounts, timing and risk profile equivalent to those that the entity expects to derive from the asset[2].

In practice many entities use a weighted average cost of capital (WACC) to estimate the appropriate discount rate.  As the determination of a discount rate is a crucial part of the impairment test, specialist advice from a qualified chartered business valuator may be beneficial. Note, the WACC is an after-tax discount rate which must be adjusted to a pre-tax rate in order to comply with IAS 36.

Fair Value Less Costs of Disposal

As detailed above, FVLCD is defined as the price that would be received to sell an asset / CGU or paid to transfer a liability in an orderly transaction between market participants at the measurement date, less the costs of disposal. IAS 36 then directs users to rely on guidance detailed in IFRS 13 Fair Value Measurement (IFRS 13) in estimating the fair value of an asset/CGU.

IFRS 13 specifies that fair value is a market-based measurement, not an entity-specific measurement. Where possible, fair value should be determined based on an observable price of an identical or similar asset or liability.  Due to the challenging economic conditions resulting from COVID-19, the observable price of an asset may have declined significantly from previous reporting periods.   

However, it is understood that observable market prices or market information may not be available for all assets or CGUs. In these situations, a company can estimate fair value using another valuation technique that maximises the use of relevant observable inputs and minimises the use of unobservable inputs. Because fair value is a market-based measurement, the valuation technique applied should consider assumptions that market participants would use when pricing the asset or liability^[3].

Costs of disposal are incremental costs directly attributable to the disposal of an asset or CGU, such as legal costs and similar transaction fees, costs of removing the asset and direct incremental costs to bring an asset into condition for its sale (excluding finance costs and income tax expense).

Compare carrying amount to recoverable amount

Once the recoverable amount of the asset / CGU is determined, whether under FVLCD or VIU, the recoverable amount is compared to the carrying amount of the asset/CGU as per the financial statements at the measurement date. If the recoverable amount exceeds the carrying amount, then no impairment is required. However, if the recoverable amount under both the VIU and FVLCD is less than the carrying amount, then an impairment loss must be immediately recognized in profit or loss. If the recoverable amount determined under either the FVLCD or the VIU exceeds the carrying amount of the asset / CGU, no further analysis is necessary as the asset / CGU is not impaired.

Conclusion

Completion of asset impairment tests are a key component of the financial reporting process, especially during these unprecedented economic times. The impairment test can be complex and time consuming. It is important that the individuals preparing the impairment test have access to the skillset necessary to complete a thorough and supportable analysis. The preparation of an impairment test involves accounting estimates and is therefore frequently identified as a significant risk area in the audit of a company’s financial statements and is also subject to increased scrutiny from regulatory bodies. MNP’s business valuation team is experienced in the preparation of impairment tests and can assist in these matters.

To learn more about impairment testing, contact Brittany Dela Rosa, CPA, CA, CBV, Senior Manager, Valuations and Litigation Support, at 403.537.8415 and [email protected] or Amanda Salvatori, CPA, CA, CBV, Partner, Valuation and Litigation Support, at 416.596.1711 and [email protected].

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[1] A cash-generating unit is defined in IAS 36 as “the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets.”  Assets are tested for impairment at the individual asset level unless that asset does not generate cash inflows that are largely independent of the cash inflows from other assets (or groups thereof). In practice, many assets will need to be grouped into CGUs for impairment testing.  For the purposes of this article the term asset and CGU are used interchangeably.