One of the underlying principles in financial reporting is that assets should not be carried in the balance sheet (statement of financial position) in excess of recoverable amount.
Essentially this means considering whether the carrying value of assets are materially different than what the reporting entity could realistically receive for those assets.
Standards were introduced in this area to stop companies from deliberately overstating their assets or failing to make provisions against assets when it is evident that the value of the asset(s) in question are not 0*worth as much in real terms as what the balance sheet is suggesting.
FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland and FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime makes it mandatory for reporting entities to undertake an assessment of the assets carried in the balance sheet at each reporting date and consider whether the carrying amounts of those assets (i.e. the value stated in the balance sheet) exceeds the value they would realistically realise those assets for.
In the example above, the financial controller is incorrect in his assumption that just because the company has not received correspondence until the next financial year it does not have to make any provision against the bad debt. Clearly, if the financial controller makes no provision against the bad debt (sometimes referred to as an ‘allowance against receivables’) then trade debtors will be overstated, increasing the value of assets and hence increasing the overall balance sheet value which would be misleading to the users of the financial statements.
Paragraph 27.1 of FRS 102 says that an impairment loss occurs when the carrying amount of an asset exceeds its recoverable amount. In the example of Cahill above, the carrying value of trade debtors are higher than recoverable amount because the company does not expect to recover the debt from its customer due to it going into liquidation. Not only that, reporting entities need to take care of ‘overlapping’ sections in FRS 102 because Section 32 Events after the End of the Reporting Period would deem the bankruptcy of a customer so soon after the balance sheet date to be an adjusting event and hence would require the carrying amount of trade debtors to be adjusted at the year-end because the letter from the liquidator so soon after the year-end is indicative that the debtor will not be recoverable.
Impairment of inventories
Many AAT students, members and Licensed Accountants are familiar with the phrase ‘lower of cost and net realisable value’. Indeed, many AAT assessment papers use this concept when examining inventories standards (such as IAS 2 Inventories). It is worth pointing out that FRS 102 does not use the term ‘lower of cost and net realisable value’; instead FRS 102 uses the term ‘lower of cost and estimated selling price less costs to complete and sell’. There is no change to the overall concept, just a change to the wording of net realisable value.
An entity must make an assessment at each reporting date as to whether inventories are impaired. The entity does this by comparing the carrying value of each item of inventory with its selling price less costs to complete and sell.
Reversal of inventory impairments
It is possible that an entity recognises an impairment loss in respect of its inventory in one accounting period (which will be recognised in profit or loss), but then the circumstances which caused the inventory to be impaired no longer exist; or there may be clear evidence of an increase in selling price less costs to complete and sell because of a change in the market’s circumstances. Where these situations apply, the entity can reverse the previously recognised impairment loss, but the reversal in profit or loss must only be limited to the original amount of the impairment loss. This will enable the carrying amount to be at the lower of the cost and the revised selling price less costs to complete and sell.
Impairment of assets other than inventory
As mentioned above, when an asset’s carrying amount in the balance sheet is higher than its recoverable amount then an impairment loss must be recognised. The impairment loss is recognised immediately in profit or loss, unless the asset is being measured under the revaluation model.
In the example above, if the building had not been subjected to the revaluation model, then the entire £300,000 would be taken to profit or loss.
Indicators that an asset is impaired
At the outset it is important to note that if there is no evidence that an asset is impaired, then there is no need to estimate a recoverable amount.
Where there are indicators that an asset is impaired and there is a need to estimate recoverable amount, but estimating recoverable amount is not possible, then the entity estimates the recoverable amount of the cash-generating unit to which the asset belongs. A ‘cash-generating unit’ is defined in the Glossary as the smallest identifiable group of assets that generates cash inflows which are largely independent of the cash inflows from other assets or groups of assets. Therefore, a group of machinery in a manufacturing plant could be classed as a cash-generating unit.
When an entity assesses whether an asset is impaired, it considers two types of sources of information:
– external sources; and
– internal sources.
External sources of information
External sources of information which may be available to determine whether an asset is impaired may be as follows:
1. During the period, an asset’s market value has declined significantly more than would be expected as a result of the passage of time or normal use.
2. Significant changes that have an adverse effect on the entity have occurred during the period (or will occur in the near future) in the technological, market, economic or legal environment in which the entity operates (or in the market to which the asset is dedicated).
3. Market interest rates or other market rates of return on investments have increased during the period which are likely to materially affect the discount rate the entity uses in calculating an asset’s value in use and decrease the asset’s fair value less costs to sell.
4. The carrying amount of the net assets of the entity is more than the estimated fair value of the entity as a whole (this estimate might have been arrived at because the directors are planning to sell the company).
Internal sources of information
Internal sources of information which may be available to determine whether an asset is impaired may be as follows:
1. Evidence is available of obsolescence or physical damage of an asset.
2. Significant changes that have an adverse effect on the entity have taken place during the period (or may take place) which will adversely affect the way an asset is used. This could include the asset becoming idle, plans to discontinue or restructure the operation to which the asset belongs, plans to dispose of an asset before the previously expected date and reassessing the useful life of an asset as finite rather than indefinite.
3. Evidence is available from internal reporting that indicates that the economic performance of an asset is, or will be, worse than expected.
The recoverable amount of an asset is the higher of its fair value less costs to sell and its value in use.
It may not be necessary to calculate both an asset’s fair value less costs to sell and its value in use because if either of these two amounts exceeds the asset’s carrying amount in the balance sheet then the asset is not impaired and hence it will not be necessary to calculate the other amount.
Fair value less costs to sell
Fair value less costs to sell is essentially the amount that could be obtained from the sale of an asset in an arm’s length transaction between knowledgeable and willing parties less the associated costs of disposal. Arriving at a fair value will usually be fairly straightforward because the fair value will be the price that could be fetched in the open market and in some cases there may be a binding agreement that indicates fair value, or an active market in which the asset is frequently traded in which to obtain a fair value. A real-life scenario in obtaining fair value is when it comes to selling a car privately; sellers will look to the market to determine what price could realistically be fetched for the car.
Value in use
Value in use is the most complicated value to arrive at because it involves estimating future cash flows which are expected to be derived from the asset and discounting those cash flows to present value. The calculations of value in use are complex in nature and are outlined in paragraphs 27.15 to 27.20A of FRS 102, but can be illustrated using the following example:
Example – Value in use calculations
North Ltd (North) manufactures chemicals for use in domestic cleaning products and has four brands which are manufactured by a separate manufacturing division. Each manufacturing division is classed as a cash-generating unit for the purposes of impairment testing. North acquired brand X through the acquisition of a small company several years ago and at the year-end the value of goodwill attributable to this brand was £140,000. Demand for brand X has significantly declined over the last few years, but demand for the other three brands has increased.
The directors have undertaken an exercise relating to the expected cash inflows and outflows of brand X using forecasts and the analysis is shown below:
The company’s accountants have placed a value on the goodwill attached to brand X using the ‘whole company approach’ and this value was £83,000. The external accountants have also undertaken a further exercise to calculate value in use, using an assumed interest rate of 5% and this has resulted in the following:
Value in use of £93,656 exceeds the whole company approach valuation of £83,000 and hence value in use becomes recoverable amount.
An impairment loss has arisen on the goodwill valuation amounting to £46,344 (£140,000 less £93,656) and this impairment loss is to be recognised in profit or loss as an operating expense within the amortisation charge.
Impairment losses in a cash-generating unit
A cash-generating unit does not have to be, say, a branch or a subsidiary of a reporting entity. Indeed, a group of assets can also constitute a cash-generating unit (such as a group of machinery).
In respect of a cash-generating unit, an impairment loss is recognised if, and only if, the recoverable amount of the unit is less than the carrying amount of the unit. Where this is the case, there is a certain order in which the impairment loss has to be recognised:
– first, to reduce the carrying amount of any goodwill allocated to the cash-generating unit; and
– then, to the other assets of the unit pro rata on the basis of the carrying amount of each asset in the cash-generating unit.
Care must be taken when dealing with an impairment loss in a cash-generating unit because the carrying amount of any asset cannot be reduced below the highest of:
– its fair value less costs to sell (if determinable);
– its value in use (if determinable); and
Example – Allocating an impairment loss in a cash-generating unit
A manufacturing company has a group of assets which it classes as a cash-generating unit. Financial statement extracts for the year-ended 31 December 2016 are as follows:
Property, plant and equipment 200,000
The cash-generating unit has suffered an impairment loss of £150,000 due to adverse press reports concerning its products. The external accountancy firm has calculated fair value less costs to sell and value in use of goodwill. They have established that the fair value less costs to sell amount is £60,000 and the value in use is £50,000. The directors do not consider it practicable to arrive at a figure for fair value less costs to sell or value in use for its property, plant and equipment.
The impairment loss of £150,000 will first be allocated to goodwill with the remainder being applied to the property, plant and equipment. However, neither the goodwill nor any asset in the cash-generating unit can be reduced below the higher of:
(a) fair value less costs to sell (if determinable);
(b) value in use (if determinable); and
As fair value less costs to sell is higher than value in use, goodwill is to be carried at £60,000, so of the £150,000 impairment, £70,000 (£130,000 less £60,000) will be allocated to goodwill and the remainder of £80,000 will be charged against property, plant and equipment. Financial statement extracts will then be:
Property, plant and equipment 120,000
This article has considered some of the most notable aspects of Section 27 Impairment of Assets. However, there are other more complex considerations dealt within in Section 27 (such as reversals of impairment losses on assets other than goodwill) which may be considered in a future article. The disclosure requirements in respect of impairment are in FRS 102 at paragraphs 27.32to 27.33A.
The next article in the series examines how to deal with a transition to FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime when the micro-entity has assets that are carried at revaluation or at fair value.
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Steve Collings is the audit and technical partner at Leavitt Walmsley Associates Ltd.