INTERMEDIATE ACCOUNTING IAS 36: IMPAIRMENT OF ASSETS

Some definitions Active market: Carrying value/amount? An active market is a market in which all the following conditions exist: (a) The items traded within the market are homogeneous; (b) Willing buyers and sellers can normally be found at any time; and (c) Prices are available to the public i.e. perfect flow of information. (d) Free entry and exit Carrying value/amount?

Definitions cont’d… A cash-generating unit (CGU) Corporate assets: 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. Corporate assets: are assets other than goodwill that contribute to the future cash flows of both the cash-generating unit under review and other cash-generating units.

CGU example 1 Example 1 A mining entity owns a private railway to support its mining activities. The railway is used to transport the ore mined and does not generate revenue the way passenger trains do. The private railway could be sold only for scrap value and it does not generate cash inflows that are largely independent of the cash inflows from the other assets of the mine.

CGU example 2 Example 2 A bus company provides services under contract with a municipality that requires minimum service on each of five separate routes. Assets devoted to each route and the cash flows from each route can be identified separately. One of the routes operates at a significant loss.

Definitions cont’d… Costs of disposal: Depreciable amount? are incremental costs directly attributable to the disposal of an asset or cash-generating unit, excluding finance costs and income tax expense. Depreciable amount? Depreciation/armotisation? Fair value? Impairment loss? Recoverable amount? Useful life? Value in use?

When is an asset impaired? An asset (be it tangible or intangible), is impaired when its carrying amount exceeds its recoverable amount. Par. 9: “An entity shall assess at the end of each reporting period whether there is any indication that an asset may be impaired. If any such indication exists, the entity shall estimate the recoverable amount of the asset”.

Example On 5 February 2014, PK Limited acquired plant at a cost of Sh. 600 million from SB Limited. The estimated productive capacity of the plant is 5 years. The company expects to generate the following cash flows from the use of the plant in the next 5 years: At the end of the 5 years, the asset will be disposed at Sh. 10 million only. Required: Compute the value in use (Assume a discount rate of 10 per cent per annum) If the fair value of the asset was Sh. 550 million and the estimated costs to dispose were Sh. 0.6 million, what would be the recoverable amount? Given an accumulated depreciation of Sh. 10 million, assess the value of impairment loss of the asset, if any.   Year 1 Year 2 Year 3 Year 4 Year 5 Sh. 'million' Cah inflows 200 198 178 140 80 Cash outflows 20 25 27 33 40 Value in use (discounted) = Total PV Sh. 524.19 million Fair value less costs to dispose = Sh. 544 million; Recoverable amount = Higher of: (Sh. 524.19 million and Sh. 544 million) = Sh. 544 million. Impairment loss exists = Sh. 590 million less Sh. 544 million = Sh. 46 million.       

Indicators of impairment External sources of information: (a) 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. (b) significant changes with an adverse effect on the entity 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 entity operates or in the market to which an asset is dedicated.

Indicators of impairment (c) market interest rates or other market rates of return on investments have increased during the period, and those increases are likely to affect the discount rate used in calculating an asset’s value in use and decrease the asset’s recoverable amount materially. (d) the carrying amount of the net assets of the entity is more than its market capitalisation.

Indicators of impairment Internal sources of information: (e) evidence is available of obsolescence or physical damage of an asset. (f) significant changes with an adverse effect on the entity have taken place during the period, or are expected to take place in the near future, in the extent to which, or manner in which, an asset is used or is expected to be used. These changes include: the asset becoming idle, plans to discontinue or restructure the operation to which an 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.

Indicators of impairment (g) evidence is available from internal reporting that indicates that the economic performance of an asset is, or will be, worse than expected.

Measuring recoverable amount IAS 36 defines recoverable amount as: the higher of an asset’s or cash-generating unit’s fair value less costs to sell and its value in use. If there is no reason to believe that an asset’s value in use materially exceeds its fair value less costs to sell, the asset’s fair value less costs to sell may be used as its recoverable amount (par. 21).

Fair value less costs to sell The best evidence of an asset’s fair value less costs to sell is: a price in a binding sale agreement in an arm’s length transaction, adjusted for incremental costs that would be directly attributable to the disposal of the asset (par. 25). Par 26: If there is no binding sale agreement but an asset is traded in an active market, fair value less costs to sell is the asset’s market price less the costs of disposal.

Costs to sell/dispose Costs of disposal, other than those that have been recognised as liabilities, are deducted in determining fair value less costs to sell. Examples of such costs are: legal costs, stamp duty and similar transaction taxes, costs of removing the asset, and direct incremental costs to bring an asset into condition for its sale.

Value in use The following elements shall be reflected in the calculation of an asset’s value in use: (a) an estimate of the future cash flows the entity expects to derive from the asset; (b) expectations about possible variations in the amount or timing of those future cash flows; (c) the time value of money, represented by the current market risk-free rate of interest; (d) the price for bearing the uncertainty inherent in the asset; and (e) other factors

Estimating future cash flows The following bases can be used to estimate the future cash flows: (a) base cash flow projections on reasonable and supportable assumptions that represent management’s best estimate, (b) base cash flow projections on the most recent financial budgets/forecasts approved by management, (c) estimate cash flow projections beyond the period covered by the most recent budgets/forecasts by extrapolating the projections based on the budgets/forecasts using a steady or declining growth rate for subsequent years.

Composition of estimates of future cash flows (a) projections of cash inflows from the continuing use of the asset; (b) projections of cash outflows that are necessarily incurred to generate the cash inflows from continuing use of the asset (including cash outflows to prepare the asset for use) and can be directly attributed, or allocated on a reasonable and consistent basis, to the asset; and (c) net cash flows, if any, to be received (or paid) for the disposal of the asset at the end of its useful life.

The discount rate The discount rate (rates) shall be a pre-tax rate (rates) that reflect(s) current market assessments of: (a) the time value of money; and (b) the risks specific to the asset for which the future cash flow estimates have not been adjusted. Discount rate (Ri) = Risk free rate (Rf) + Risk premium (Rp)

Allocation of Impairment loss for a cash-generating unit Any impairment loss calculated for a CGU should be allocated to reduce the carrying amount of the asset in the following order: First, to the specific asset in which there is an indication of impairment; Second, to reduce the carrying amount of any goodwill allocated to the cash-generating unit (group of units); and Then, to the other assets of the unit (group of units) pro-rata on the basis of the carrying amount of each asset in the unit (group of units).

Cont’d… These reductions in carrying amounts shall be treated as impairment losses on individual assets. In allocating an impairment loss, an entity shall not reduce the carrying amount of an asset below the highest of: Its fair value less costs to sell (if determinable); Its value in use (if determinable) and Zero.

Example 1 A cash-generating unit has the following net assets whose carrying value is Shs. 180 million: Shs ‘million’ Goodwill 30 Property 60 Plant and equipment 90 180 The recoverable amount has been determined and is Sh.135 million. Required: Allocate the impairment loss to the net assets of the entity.

Solution The allocation will be as follows: Goodwill Property Plant & Equip. Total Sh ‘million’ Carrying value 30 60 90 180 Impairment loss (30) (6) (9) (45) Carrying value after impairment - 54 81 135

Example 2 A cash generating unit has the following assets at their carrying amounts: The recoverable amount has been determined as Sh. 45 million Required: Allocate the impairment loss to the above assets of the entity. Shs. ‘millions’ Good will 10 Property 20 Plant and equipment 30 60 4/28/2017 MIS Notes

Example 3 An entity has two cash generating units, X and Y. There is no goodwill within the unit’s carrying values. The carrying values are X Sh. 10 million and Y Sh. 15 million. The entity has an office building that has not been included in the above values and can be allocated to the units on the basis of their carrying values. The office building has a carrying vlue of Sh. 5 million. The recoverable amounts are based on value-in-use of Sh. 9 million for X and Sh. 19 million for Y. Required: Determine whether the carrying values of X and Y are impaired. 4/28/2017 MIS Notes

Example 4 South Rift group of companies has a cash generating unit whose carrying amount is Shs. 380 million. An impairment review carried out shows that the recoverable amount is Shs. 260 million. The carrying amount is made up of the following assets: The intangible assets consist of some licenses to trade which can be transferred to other parties at a value of Shs. 50 million. Required: Show how the impairment loss will be allocated to the cash generating unit Asset Shs ‘million’ Goodwill 50 Other intangible assets 90 Buildings 160 Plant and equipment 80 380 4/28/2017 MIS Notes

Recognition and measurement of impairment loss If, and only if, the recoverable amount of an asset is less than its carrying amount, the carrying amount of the asset shall be reduced to its recoverable amount. That reduction is an impairment loss. An impairment loss shall be recognised immediately in profit or loss, unless the asset is carried at revalued amount in accordance with another Standard (for example, in accordance with the revaluation model in IAS 16). Any impairment loss of a revalued asset shall be treated as a revaluation decrease in accordance with that other Standard (par. 60).

Review Questions

Multiple choice questions (1) 1) If the fair value less costs to sell cannot be determined then: the carrying value of the asset is used the recoverable amount is the value in use the asset is not impaired the replacement cost is used 2) When calculating the estimates of future cashflows which of the following cashflows should not be included? Cashflows from disposal Cashflows from the sale of inventory produced by the asset Benefits from future restructuring Cash outflows on the maintenance of the asset

Multiple choice questions (2) 3) When deciding upon the discount rate to be used, which factors should not be taken into account? Risks which relate to the asset for which future cashflow estimates have been adjusted Cost of capital Corporate lending rates Risks specific to the asset which future cashflow estimates have not been adjusted 4) When allocating an impairment loss, such a loss should reduce the carrying amount of which asset first? Specific, impaired asset Property, plant and equipment Intangible asset Goodwill

Multiple choice questions (3) 5) A cash-generating unit is: the smallest group of assets that generates independent cash flows from continuing use any group of assets which forms part of the management reporting structure a reporting segment any group of assets that has independent cashflows