Correct reporting of impairments is undoubtedly difficult. We look at some of the reasons for this and summarise findings from the FRC’s recent review.
Impairments under IAS 36 (Impairment of Assets) are a key focus of the FRC and can be a challenging area for management, involving significant estimation and judgement.
The inputs and assumptions management uses in its impairment models are often so complex that they lead to errors in judgement, calculation and disclosure.
What do the standards say?
IAS 36 is prescriptive in its assessment of whether an asset is impaired or not. If the carrying amount of an asset is higher than its recoverable amount, that asset is classed as impaired. The recoverable amount is determined as the higher of the fair value less costs to sell, and its value in use (VIU). These are defined as:
- Fair value less costs to sell: the price that would be received on sale of an asset or paid to transfer a liability in a transaction between market participants, at the measurement date, less costs directly related to the disposal of the asset
- VIU: the present value of the future cash flows expected to be derived from an asset or cash-generating unit.
This assessment is applicable to all assets on the statement of financial position, other than those covered by their own standards (eg, deferred tax assets in the scope of IAS 12, or financial assets in the scope of IFRS 9). So, its impact on companies can be wide-ranging, especially those that have undergone business combinations in the past and may therefore hold material goodwill and other intangible assets.
When should an impairment assessment be considered?
For assets held on the statement of financial position which are carried with an indefinite useful life (ie, not amortised), an impairment assessment must be carried out every year – whether impairment indicators exist or not (see below).
For other assets, an assessment is required if there’s an indication that they may be impaired. IAS 36.12 asks management to look at two distinct (but not exhaustive) sources of information when considering impairment indicators:
External sources:
- Declines in market value
- Negative changes in technology, markets, economy or laws
- Significant increases in interest rates
- When net assets of the company are higher than its own market capitalisation.
Internal sources:
- Obsolescence or physical damage of the asset(s)
- If the asset is currently or planned to be idle, changed as part of a restructuring or held for disposal
- When the asset has a worse economic performance than budgeted
- For investments in subsidiaries, joint ventures or associates, when the carrying amount is higher than that of the investee’s assets, or a dividend exceeds the total comprehensive income of the investee.
Calculating impairments: the complexities
Calculations of impairments through impairment models can be some of the most complex pieces of financial data the company puts together annually. The discounted cash flow (DCF) model is the most used to calculate the VIU. It should typically cover five years, with an explanation if that period differs.
The use of internal and external, historic and future-looking data, above what a company would usually prepare in its going concern analysis, means significant estimates and judgements must be made about the company’s future outlook.
This might include expected trends in sales demand, cost fluctuations and potential changes in the industry in which it operates, against a backdrop of current economic instability caused by world events (eg the potential impact of ongoing wars in the Middle East on global economies).
Common pitfalls in impairment assessments
Regulatory and thematic reviews continue to highlight problems in the preparation of impairment assessment calculations. Key issues include:
- Calculation of unrealistic recoverable amounts and a lack of sensitivity analysis: optimistic future assumptions which do not appropriately consider both past performance and sensitivities on key suppositions, leading to overstatement of the future potential values of the asset(s).
- Inappropriate identification of cash generating units (CGUs): the majority of assets tested for impairment are done at a CGU level, as opposed to an individual asset level. This is often because the respective asset is not generating its own, independent cash flows. The CGU is defined as the smallest identifiable group of assets that generates cash inflows largely independent of those from other assets or groups of assets. This lowest level of cash flows from a group of assets is often not adequately considered, leading to inflated cash flows and valuations for the assets being tested. Management should be conscious of the levels of cash flows reported internally, as this often indicates the lowest level.
- Consistency of information: projections should be consistent with other management-prepared financial information (such as internal budgets and forecasts), as well as with information prepared for the audit in relation to going concern (ISA 570).
- Material enhancements of assets: when completing an impairment analysis using the VIU method, the recoverable amount should not be based on forecasts which incorporate large-scale upgrades to the assets but, instead, on their current future potential outputs.
- Calculation of terminal values: the last period being terminally valued must represent a constant state of affairs, being careful not to include any one-off income amounts that could overvalue future cash flows.
- Discount rates: the valuation of future cash flows can be highly sensitive to the discount rate applied. Care should be taken to apply a rate for each CGU which takes account of business, country or climate-specific risk. The weighted average cost of capital (WACC) should be taken only as a starting position for the calculation of the discount rate, not a proxy. Beginning with the WACC, management must take guidance from IAS 36 (A15–A31) as to the adjustments required.
- Allocation of impairment: when an impairment loss is recognised, it must be allocated to reduce the carrying amount of the assets of the CGU in a prescribed order. First, relating to any goodwill, and then to other assets on the CGU.
Disclosure requirements for impairments
IAS 36 (paragraphs 126–134), together with IAS 1 (Presentation of Financial Statements), explains disclosure requirements for impairment considerations in detail.
For assets in which an impairment is recognised, or an impairment from previous periods is reversed, details must be included for each class of asset. This can be done as part of the other information disclosed for the class of asset, for example within the year-on-year reconciliations provided in the property, plant and equipment notes required by IAS 16.
IAS 36 also asks for sufficient detail for each CGU, so that readers of the financial statements can understand the estimates used to measure recoverable amounts. These include but are not limited to: each key assumption in the cash flow projections; any sensitivity to risks and uncertainty; and the discount rate applied to management’s projections. As mentioned below, this is a key area of focus of the FRC for listed businesses, based on failures noted from their annual Corporate Reporting financial reviews.
For any entity within the scope of IFRS 8 (operating segments), being those entities which have either debt or equity instruments traded in a public market or in the process of filing its financial statements with a securities commission or other regulatory organisation for the purposes of trading, the impairment losses and reversals must also be disclosed at the reportable segment level.
What are the shortcomings exposed by disclosure reviews?
A recent review of corporate reporting by the FRC has continued to highlight weaknesses in impairment disclosures. In 2023/2024 this was the most common area of cases opened with companies (12% of all cases related to impairment for the second consecutive year).
Some of the most notable disclosure omissions continue to relate to:
- Companies not providing enough relevant information for significant judgements and key assumptions when estimating the recoverable amount of assets and cash-generating units
- Companies not explaining the sensitivity to changes in key assumptions, where possible changes could cause impairment of goodwill or significant further adjustments to already-impaired assets.
At a granular level, specific findings also relate to:
- Inconsistency between assumptions used in disclosures relating to impairment and those in other sections of the financial statements, such as the viability statement
- Climate change: lack of disclosure about potential uncertainties and/or sensitivities relating to the impact of climate change on projections
- Period of assessment: where a period other than the expected five years was used, this was sometimes not adequately explained or justified
- Impairment method: unclear disclosures about how goodwill had been allocated to CGUs, and a lack of explanation for changes in methodology implemented period on period. Discrepancies between the allocation of assets in impairment disclosures, compared to those made in line with segmental information.
The FRC’s 2023/2024 review of corporate reporting can be found here.
For further guidance on impairments, please contact Alex Adie or Nick Joel.
