– Siddhant Kandoi
Ind-AS 36 was introduced as the Indian Accounting Standards equivalent for IAS 36 (IFRS), covering Impairment of Assets. Under the erstwhile Indian GAAP, very few companies in India carried out impairment testing; but with the introduction of Ind AS, it becomes much more relevant and widespread. In this article, we summarise the applicability, requirements and methodologies used in applying Ind AS 36, with a practical approach to impairment assessment and testing.
APPLICABILITY OF IND AS 36, IMPAIRMENT OF ASSETS
This standard must be applied in accounting for the impairment of all assets, unless they are specifically excluded from its scope. Assets to which IND AS 36 is commonly applied are:
- Investment in Subsidiaries, Joint Ventures and Associates,
- Plant, property and Equipment,
- Intangible Assets including Goodwill
To assess impairment of assets or intangible assets, a CGU approach is used i.e. recoverable amount is assessed for each cash-generating unit (CGU) and compared with the carrying amount of the CGU, then drilled down to asset level.
INDICATORS OF IMPAIRMENT AS PER IND AS 36
In assessing whether there is any indication that an asset may be impaired, an entity shall consider the:
- Internal indicators such as obsolescence or physical damage of an asset, under-performance of an asset compared to expectations, reassessing the useful life of an asset as finite rather than indefinite, etc.
- External Indicators such as changes in regulations, adverse effects in the technological, economic or legal environment, increase in market interest rates, etc.
The following must be done annually whether or not there are indications of impairment:
- Impairment testing of intangible assets with an indefinite useful lives and intangible assets not yet available for use
- Impairment testing of goodwill and/or intangible assets acquired in a business combination
To arrive at the impairment loss, the following steps need to be followed:
- Estimating Recoverable Amount (RA)
- Comparing Recoverable Amount (RA) and Carrying Amount (CA)
- Recognising Impairment Loss
Estimating Recoverable Amount
Recoverable amount is the higher of the following for a CGU or asset:
- Fair value less costs of disposal (FVLCOD)
- Value in use (VIU)
It is not always necessary to determine both an asset’s FVLCOD and VIU. If either of these amounts exceeds the asset’s carrying amount, the asset is not impaired.
Fair Value less Costs of Disposal (FVLCOD)
- Fair Value is the amount obtainable from the sale of an asset or CGU in an arm’s length transaction between knowledgeable, willing parties.
- Fair value estimate takes market participants’ perception of the price of an asset into account. FVLCOD would consider future developments only if they are publicly known, supportable and are considered by other market participants as well.
- Examples of costs of disposal 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
Value in use is the present value of the future cash flows expected to be derived from an asset or cash-generating unit. VIU is usually estimated by using the Discounted Cash Flow (DCF) method, in the following steps:
- Estimating the future cash inflows and outflows derived from continuing use of the asset
- Estimating the terminal period cash flows or cash flows from its ultimate disposal, as applicable
- Applying the appropriate discount rate to those future cash flows
These steps are explained further below.
Step 1: Forecast Cash Flows
Cash flows are prepared based on reasonable and supportable assumptions that represent management’s best estimate, most recent financial budgets/forecasts approved by management. Projections should cover a maximum of 5 years unless a longer period can be justified.
Future cash flows will be operating cash flows only based on current status of the business and will not include:
- Improvement or enhancement of performance
- A future restructuring to which an entity is not yet committed
VIU should reflect the present value of future cash flows. In practice, present values are computed either by a ‘traditional’ or ‘expected’ cash flow approach.
Under a ‘traditional cash flow approach’, a single set of estimated cash flows and a single discount rate are used.
Under an ‘expected cash flow approach’, all expectations about possible cash flows are used instead of the single most likely cash flow. Discount rates must therefore also be varied to reflect the risk within each set of possible cash flows.
Step 2: Terminal Cash flows
Terminal Value can be calculated either by Gordon Growth model or Exit Multiple method, in case of ongoing businesses.
In the Gordon Growth model, the terminal value is calculated by capitalizing the final year’s cash flows at a rate that is derived as the difference between the discount rate applicable to the business and the terminal growth rate.
In the Exit Multiple method, the terminal value is calculated by applying a market multiple to the company’s final year EBITDA or EBIT, to arrive at enterprise value at the end of the cash flow period. The chosen market multiple is usually an average of recent exit multiples for listed companies or private transactions.
Whether Gordon Growth model or Exit Multiple method is used, the resent must be presented in present value terms.
Step 3: Applying the appropriate discount rate to future cash flows
As per Ind AS 36, the discount rate shall be a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the asset for which the future cash flow estimates have not been adjusted. However, in practice the Capital Asset Pricing model (CAPM) is used, which takes the post-tax discount rate into account. In such as situation, the cash flows should be post-tax cash flows as well, to ensure consistency.
The CAPM method requires multiple inputs from market data, of which the key ones are:
- Risk Free rate derived from government bond yields
- Beta which calculates the volatility of a specific industry
- Equity market risk premium is the risk premium of the stock market
- Specific risk premium is the risk premium specific to the company and its cash flows
- Cost of debt of the company and the tax rate it is subject to
- Industry gearing ratios i.e. the capital structure of companies in the same sector
Comparing Recoverable Amount and Carrying Amount
Subsequent to estimation of the asset’s recoverable amount, the next step is to compare the same to the carrying amount. Where the carrying amount exceeds the recoverable amount, the entity will record an impairment loss.
Goodwill and Corporate Assets relating to a Cash generating unit (CGU) would be allocated to it while calculating carrying amount.
Recognising Impairment Loss, if any
An impairment loss shall be recognised immediately in the P&L account, unless the asset is carried at revalued amount in accordance with another standard.
The impairment loss shall be allocated to reduce the carrying amount of the assets of the unit (group of units) in the following order:
- first, 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).
The carrying amount of an asset will never be reduced below the higher of its individual recoverable amount and zero.
CROSS CHECKS AND SENSITIVITY OF IMPAIRMENT RESULTS
Recoverable amount is usually calculated using a VIU approach. This means that the result is based on a DCF method which uses the CGU or company cash flows, but does not factor in market multiples or movements therein. It is therefore necessary to cross-check recoverable amounts against market multiples.
This is done by calculating the implied multiple (RA/EBITDA or RA/PAT) and comparing it to the trading multiples of listed companies and/or transaction multiples of private companies in the same sector. Significant divergence, if any, from market multiples, should be justifiable – if it is not justifiable then a review of cash flows or discount rates is usually necessary.
Similarly, recoverable amount calculations should also be tested for sensitivity to key inputs such as revenue growth, EBITDA margins, discount rate and terminal growth rates applied. This is done to assess whether a small change in any input could potentially trigger an impairment in an unimpaired asset – if so, it is usually recommended that an impairment be recognized out of conservatism.
Impairment testing, especially for the first time, can be a complicated and daunting task. Auditors would require a detailed impairment memo that explains that impairment testing process applied by the company. As such, most companies find it helpful to outsource the building of cash flows as well as execution of impairment testing to valuation professionals who have deeper experience in this area.