Despite the accounting standards being very clear on a particular accounting treatment, preparers regularly ignore the clear instructions in the standard, resulting in their financial statements being potentially materially misstated.
Perhaps the most common situation where this occurs for Tier 1 and Tier 2 entities is testing for impairment and the application of NZ IAS 36 Impairment of Assets (or the equivalent standards for public benefit entities - PBE IPSAS 21 Impairment of Non-Cash-Generating Assets and PBE IPSAS 26 Impairment of Cash-Generating Assets). (Note, the requirements for PBE IPSAS 21 and PBE IPSAS 26 are similar to those of NZ IAS 36, and thus have not been separately addressed in this article.)
While estimating an asset’s recoverable amount requires a great degree of judgement and estimation, in a number of cases there are a set of very clear rules, which are commonly overlooked. These include:
- Not testing for impairment when the standard clearly requires it
- Not testing for impairment at the correct ‘unit of account’
- Not including the correct assets in the impairment test
- Basic errors in determining recoverable amount
- Basic errors in determining ‘value in use’
- Basic errors in determining ‘fair value less cost of disposal’.
This month we will discuss the first error, i.e. not testing for impairment when the standard clearly requires it. We will discuss the remaining errors in future editions of Accounting Alert.
Basic requirement of NZ IAS 36
The basic requirement of NZ IAS 36 is very simple. ‘An asset is impaired when its carrying amount exceeds its recoverable amount.’ NZ IAS 36, paragraph 8
Not testing for impairment, when the standard clearly requires it
There are five basic situations where NZ IAS 36 requires an asset to be tested for impairment:
- The asset is goodwill
- The asset is an intangible asset with an indefinite useful life
- The asset is an intangible asset not yet available for use
- There are external indicators that an impairment trigger has taken place
- There are internal indicators that an impairment trigger has taken place.
Testing goodwill for impairment
NZ IAS 36 clearly says: ‘Irrespective of whether there is any indication of impairment, an entity shall also test goodwill acquired in a business combination for impairment annually in accordance with paragraphs 80–99.’ NZ IAS 36, paragraph 10(b)
A common error is to assume that goodwill acquired during the current financial year is not subject to an impairment test. This is not true. All goodwill is subject to impairment testing, even if it arose as a result of a business combination during the current year.
Testing an intangible asset with an indefinite useful life for impairment
NZ IAS 36 also clearly says: ‘Irrespective of whether there is any indication of impairment, an entity shall also test an intangible asset with an indefinite useful life for impairment annually by comparing its carrying amount with its recoverable amount…’ NZ IAS 36, paragraph 10(a)
Therefore entities with intangible assets that they have determined to have indefinite useful lives, and are not amortising, must perform an impairment test on these brands, mastheads, licences, etc.
Testing an intangible asset not yet available for use
‘Irrespective of whether there is any indication of impairment, an entity shall also test an intangible asset not yet available for use for impairment annually by comparing its carrying amount with its recoverable amount…’ NZ IAS 36, paragraph 10(a)
Note that this requirement also applies to entities capitalising development costs under NZ IAS 38 Intangible Assets. It also raises the question of whether development of a mine is a tangible or intangible asset, remembering that at the point in time when an exploration and evaluation asset transfers to the development phase, it must be tested for impairment under NZ IFRS 6 Exploration for and Evaluation of Mineral Resources.
There are external indicators that an impairment trigger has taken place
At each reporting date (this includes the half-year if half-year financial statements are produced), an entity is required to assess whether there is any indication of impairment. This includes goodwill and indefinite life intangibles.
‘An asset is impaired when its carrying amount exceeds its recoverable amount. Paragraphs 12–14 describe some indications that an impairment loss may have occurred. If any of those indications is present, an entity is required to make a formal estimate of recoverable amount.’ NZ IAS 36, paragraph 8
‘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.’ NZ IAS 36, paragraph 9
External indicators of impairment
‘In assessing whether there is any indication that an asset may be impaired, an entity shall consider, as a minimum, the following indications:
External sources of information
a) there are observable indications that the asset’s value has declined during the period 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.
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.’
NZ IAS 36, paragraph 12(a) to (d)
The above non-exhaustive list raises a number of conditions where, if one of the events listed above has occurred, an impairment test must take place. This is in addition to the usual annual impairment testing of goodwill.
If your net assets are greater than your market capitalisation, you must test for impairment.
You can also see from NZ IAS 36, paragraph 12(b) requirements above, that an external indicator of impairment is ‘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.’ This requires you to perform impairment tests in advance of actually being impacted by new technology or new legislation, and arguably, impairment write-downs should occur at least a year in advance of operating losses.
There are internal indicators that an impairment trigger has taken place
NZ IAS 36, paragraph 12 goes on to list the following internal indicators of impairment:
Internal indicators of impairment
‘In assessing whether there is any indication that an asset may be impaired, an entity shall consider, as a minimum, the following indications:
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.
g) evidence is available from internal reporting that indicates that the economic performance of an asset is, or will be, worse than expected.’
NZ IAS 36, paragraph 12(e) to (g)
These requirements highlight the importance of tying internal budget information into impairment testing assessments and calculations. Failing to do so may result in errors occurring, for example, if you have no impairment write-downs but you have internal budgets showing that:
- The asset is not as profitable as budgeted
- The asset has cost more to construct than was budgeted, or
The asset has taken longer to construct or get into production than budgeted.
‘Evidence from internal reporting that indicates that an asset may be impaired includes the existence of:
Internal sources of information
a) cash flows for acquiring the asset, or subsequent cash needs for operating or maintaining it, that are significantly higher than those originally budgeted;
b) actual net cash flows or operating profit or loss flowing from the asset that are significantly worse than those budgeted;
c) a significant decline in budgeted net cash flows or operating profit, or a significant increase in budgeted loss, flowing from the asset; or
d) operating losses or net cash outflows for the asset, when current period amounts are aggregated with budgeted amounts for the future.’
NZ IAS 36, paragraph 14
Again, preparers must realise that impairment testing is required to consider planned future events such as disposals, reorganisations, etc. If there are plans to close a facility early, or to undertake a major refurbishment of that facility, an impairment test must be performed.
It must also be recognised that this list is not exhaustive.
‘The list in paragraph 12 is not exhaustive. An entity may identify other indications that an asset may be impaired and these would also require the entity to determine the asset’s recoverable amount or, in the case of goodwill, perform an impairment test in accordance with paragraphs 80–99.’ NZ IAS 36, paragraph 13
Next month
In next month’s Accounting Alert we will look at the common error of not testing for impairment at the correct ‘unit of account’.