Time of change: blog

The importance of impairment testing

Adrian Galis
Director, Corporate finance
16 December, 2008

The economic crisis that started in the US in 2007 had reached around the world by autumn of 2008. It is forecast that there will be more reductions in world trade volumes and private investment in 2009. From the perspective of a listed company with audited financial statements, a critical step out of this crisis is to restore investor confidence. An important factor here is the accurate reflection of data in financial statements. We should bear in mind that in hard times, most market participants expect losses from impairment.

The objective of IAS 36, Paragraph 1, is “to prescribe the procedures that an entity applies to ensure that its assets are carried at no more than their recoverable amount. An asset is carried at more than its recoverable amount if its carrying amount exceeds the amount to be recovered through use or sale of the asset. If this is the case, the asset is described as impaired and the standard requires the entity to recognise an impairment loss.”

Let’s define a few terms before continuing to the testing procedure:

• Fair value less cost to sell (“FV”) is defined as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.
• The value in use (“VU”) is the discounted value of future cash flows expected to be derived from an asset.
• An asset’s carrying amount is the amount at which an asset is recognised after deducting any accumulated depreciation and accumulated impairment losses.

So the procedure to test for impairment should look like this:

1. Identify the asset to be tested.
2. Estimate the asset’s FV and/or its VU. If the first one to be estimated is greater than the asset’s carrying amount, then the other value does not have to be estimated. However, if the first estimate is less than the carrying amount, then the other value needs to be estimated.
3. If either FV or VU are greater than the asset’s carrying amount, then there is no impairment.
4. If both FV and VU are less than the asset’s carrying amount, then the impairment is calculated as the carrying amount less FV or VU (whichever is higher).
5. The asset is written down to its new value.

Given the economic turmoil, it is important that companies start thinking early about impairment, since many will be affected. Starting early is especially important for companies that have never been through this process. The extra time will be useful for understanding the key value drivers and setting up procedures properly.