Introduction
In the complex landscape of financial reporting, ensuring that assets are properly valued remains one of the most challenging aspects for organizations worldwide. International Accounting Standard 36 (IAS 36) - Impairment of Assets provides the framework for addressing this challenge, requiring entities to ensure that their assets are carried at no more than their recoverable amount. Yet despite its critical importance, many organizations struggle with implementing effective impairment testing procedures.
The consequences of inadequate impairment testing can be severe, ranging from material misstatements in financial statements to erosion of investor confidence and regulatory scrutiny. In recent years, impairment charges have become increasingly significant, particularly in industries experiencing rapid technological change, market volatility, or economic downturns. The COVID-19 pandemic further highlighted the importance of robust impairment testing as organizations faced unprecedented disruptions to their operations and cash flows.
This article aims to provide a comprehensive guide to navigating IAS 36, offering practical insights into implementing effective impairment testing procedures. We will explore the fundamental concepts of IAS 36, examine the step-by-step process for conducting impairment tests, and share best practices derived from real-world applications. Whether you are a financial executive, auditor, or accounting professional, this guide will equip you with the knowledge and tools needed to ensure compliance with IAS 36 while enhancing the quality of financial reporting in your organization.
Understanding IAS 36
Scope and Objectives
IAS 36 applies to a wide range of assets, including property, plant and equipment, intangible assets, goodwill, right-of-use assets, and investments in subsidiaries, associates, and joint ventures (in separate financial statements). However, it specifically excludes certain assets such as inventories, deferred tax assets, and financial assets within the scope of IFRS 9, which are covered by other standards with their own impairment requirements.
The primary objective of IAS 36 is to ensure that assets are carried at no more than their recoverable amount. This is achieved by requiring entities to:
- Assess at each reporting date whether there are indications that an asset may be impaired
- Estimate the recoverable amount of an asset when impairment indicators exist
- Recognize an impairment loss when the carrying amount exceeds the recoverable amount
- Reverse previously recognized impairment losses when appropriate (except for goodwill)
- Provide specific disclosures related to impairment testing and recognized impairment losses
Special Requirements for Certain Assets
IAS 36 establishes more stringent requirements for certain assets, regardless of whether impairment indicators exist:
- Goodwill acquired in a business combination must be tested for impairment annually
- Intangible assets with indefinite useful lives must be tested for impairment annually
- Intangible assets not yet available for use must be tested for impairment annually
Key Definitions
Understanding the key definitions in IAS 36 is essential for proper application of the standard:
| Term | Definition | Practical Implications |
|---|---|---|
| Carrying Amount | The amount at which an asset is recognized in the statement of financial position | Includes acquisition cost less accumulated depreciation/amortization and any previous impairment losses |
| Recoverable Amount | The higher of an asset's fair value less costs of disposal and its value in use | Requires estimation of both values to determine which is higher |
| Fair Value Less Costs of Disposal | The amount obtainable from selling an asset in an orderly transaction, less the costs of disposal | Based on market participant assumptions, not entity-specific factors |
| Value in Use | The present value of estimated future cash flows expected from continuing use of an asset and from its disposal at the end of its useful life | Entity-specific value based on management's best estimates of future cash flows |
| Cash-Generating Unit (CGU) | The smallest identifiable group of assets that generates cash inflows largely independent of other assets or groups of assets | Critical for testing assets that don't generate independent cash flows |
| Corporate Assets | Assets that contribute to future cash flows of multiple CGUs | Requires special allocation approaches for impairment testing |
These definitions form the foundation for the impairment testing process and are crucial for ensuring consistent application of IAS 36 across different types of assets and business contexts.
Impairment Indicators
IAS 36 provides a non-exhaustive list of indicators that an asset may be impaired. These indicators are categorized as external and internal sources of information:
External Indicators
- Significant decline in market value beyond normal depreciation
- Significant adverse changes in the technological, market, economic, or legal environment
- Increases in market interest rates likely to affect discount rate and decrease recoverable amount
- Carrying amount of net assets exceeding market capitalization
Internal Indicators
- Evidence of obsolescence or physical damage
- Significant adverse changes in how an asset is used or expected to be used
- Internal reporting indicating that economic performance is or will be worse than expected
- For investments in subsidiaries, associates, or joint ventures, evidence that the investment may not be recoverable
Figure 1: Financial team analyzing potential impairment indicators during quarterly review
The presence of one or more impairment indicators triggers the requirement to perform an impairment test by estimating the recoverable amount of the affected asset or CGU. However, it's important to note that the absence of these indicators does not eliminate the need for annual impairment testing for goodwill and intangible assets with indefinite useful lives.
Important Consideration
Impairment indicators should be assessed at each reporting date as part of the financial close process. Organizations should establish a systematic approach for monitoring and documenting potential indicators, particularly for significant assets or CGUs. This assessment should involve input from various departments, including operations, sales, and strategic planning, to ensure all relevant information is considered.
Impairment Testing Process
The impairment testing process under IAS 36 follows a structured approach that ensures assets are properly valued in financial statements. This process can be broken down into several key steps:
Identify Assets for Testing
Determine which assets require impairment testing based on indicators or annual testing requirements.
Determine Testing Level
Assess whether the asset generates independent cash flows or should be tested as part of a CGU.
Calculate Carrying Amount
Determine the carrying amount of the asset or CGU being tested.
Estimate Recoverable Amount
Calculate the higher of fair value less costs of disposal and value in use.
Compare Values
Compare carrying amount to recoverable amount to determine if impairment exists.
Recognize and Allocate Loss
Record impairment loss and allocate appropriately within the CGU if applicable.
Identifying Cash-Generating Units
One of the most challenging aspects of impairment testing is identifying appropriate Cash-Generating Units (CGUs). A CGU is the smallest identifiable group of assets that generates cash inflows largely independent of other assets or groups of assets. This determination requires significant judgment and consideration of how management monitors operations and makes decisions about continuing or disposing of assets.
Factors to Consider When Identifying CGUs
- How management monitors operations (e.g., product lines, businesses, individual locations)
- How management makes decisions about continuing or disposing of assets
- The existence of active markets for the outputs produced by the assets
- The interdependence of cash flows between different assets or groups of assets
- The level at which corporate assets contribute to multiple cash-generating units
Goodwill Allocation and Testing
Goodwill acquired in a business combination must be allocated to the CGUs or groups of CGUs expected to benefit from the synergies of the combination. This allocation is performed at the lowest level at which goodwill is monitored for internal management purposes, which cannot be larger than an operating segment as defined in IFRS 8.
When testing a CGU containing goodwill for impairment, the carrying amount of the CGU must include the carrying amount of the goodwill allocated to it. If goodwill cannot be allocated on a non-arbitrary basis to individual CGUs, it should be tested for impairment at the level of the group of CGUs to which it relates.
Key Consideration for Goodwill Testing
When a reorganization changes the composition of CGUs to which goodwill has been allocated, the goodwill must be reallocated using a relative value approach similar to when a business is disposed of. This reallocation should be based on the relative values of the operations remaining in the original CGUs and those being moved to different CGUs.
Determining Recoverable Amount
The recoverable amount is defined as the higher of an asset's (or CGU's) fair value less costs of disposal and its value in use. Calculating these two values involves different approaches and considerations.
Fair Value Less Costs of Disposal
Fair value less costs of disposal (FVLCD) is the amount that could be obtained from selling an asset or CGU in an orderly transaction between market participants at the measurement date, less the costs of disposal. This measurement is based on IFRS 13 Fair Value Measurement principles and can be determined through several methods:
Market Approach
Using quoted prices in active markets for identical assets or liabilities, which provides the most reliable evidence of fair value.
Comparative Transactions
Using prices and other relevant information from market transactions involving identical or comparable assets, liabilities, or groups of assets and liabilities.
Income Approach
Using valuation techniques that convert future amounts (e.g., cash flows or income and expenses) to a single current discounted amount, reflecting current market expectations about those future amounts.
Costs of disposal include legal costs, stamp duties, transaction taxes, removal costs, and direct incremental costs to bring an asset into condition for its sale. Termination benefits and costs associated with reducing or reorganizing a business following the disposal of an asset are not considered direct incremental costs of disposal.
Value in Use
Value in use (VIU) is the present value of estimated future cash flows expected from the continuing use of an asset and from its disposal at the end of its useful life. Calculating VIU involves the following steps:
Figure 2: Financial analyst developing a value in use model with projected cash flows
Cash Flow Projections
- Based on reasonable and supportable assumptions
- Reflect most recent financial budgets/forecasts approved by management
- Cover a maximum period of five years, unless a longer period can be justified
- Beyond the forecast period, extrapolate using a steady or declining growth rate
- Growth rate should not exceed the long-term average for the products, industries, or countries in which the entity operates
Cash Flow Components
- Cash inflows from continuing use of the asset/CGU
- Cash outflows necessary to generate the cash inflows, including maintenance expenditures
- Net cash flows from disposal at the end of useful life
- Exclude cash flows from financing activities and income tax receipts or payments
- Exclude cash flows from future restructurings or improvements not yet committed
Discount Rate
The discount rate used in VIU calculations should be a pre-tax rate that reflects:
- Current market assessments of the time value of money
- Risks specific to the asset for which future cash flow estimates have not been adjusted
In practice, the discount rate is often derived using the Weighted Average Cost of Capital (WACC) adjusted to reflect specific risks related to the asset or CGU being tested. The pre-tax discount rate can be approximated by iteratively solving for the rate that, when applied to pre-tax cash flows, gives the same result as applying a post-tax discount rate to post-tax cash flows.
Discount Rate Considerations
The selection of an appropriate discount rate is one of the most critical judgments in VIU calculations. A small change in the discount rate can have a significant impact on the recoverable amount. Organizations should document their discount rate methodology thoroughly, including all assumptions and inputs used in the calculation. This documentation is particularly important for audit purposes and for sensitivity analysis disclosures required by IAS 36.
Choosing Between FVLCD and VIU
IAS 36 does not require an entity to determine both FVLCD and VIU. If either of these amounts exceeds the carrying amount of the asset, the asset is not impaired, and it is not necessary to estimate the other amount. In practice, entities often calculate the value that is more readily determinable or the one expected to be higher based on the nature of the asset and available information.
| Scenario | Recommended Approach | Rationale |
|---|---|---|
| Active market exists for the asset | FVLCD | Market prices provide reliable evidence of value |
| No active market, but reliable estimates of future cash flows available | VIU | Entity-specific cash flow projections may better reflect the asset's value to the business |
| Asset held for disposal | FVLCD | Better reflects the recoverable amount through sale |
| Specialized assets with limited market information | VIU | Difficult to determine reliable fair value due to lack of market transactions |
| Significant synergies or entity-specific value | VIU | Captures value from entity-specific synergies not reflected in market prices |
Best Practices
Implementing effective impairment testing procedures requires a systematic approach and attention to detail. The following best practices can help organizations enhance the quality and efficiency of their impairment testing process:
Establish a Robust Impairment Testing Framework
Develop Comprehensive Policies and Procedures
Create detailed documentation outlining the impairment testing methodology, including CGU identification, recoverable amount calculation, and allocation of impairment losses.
Implement a Structured Timeline
Establish a clear timeline for impairment testing activities, including indicator assessment, model development, management review, and disclosure preparation.
Assign Clear Responsibilities
Define roles and responsibilities for different aspects of the impairment testing process, ensuring appropriate expertise and oversight at each stage.
Develop Standardized Templates
Create standardized templates for documenting impairment indicators, CGU identification, cash flow projections, and key assumptions to ensure consistency and completeness.
Enhance Cash Flow Projections
Align with Strategic Planning
Ensure cash flow projections are consistent with the most recent budgets and forecasts approved by management and aligned with the organization's strategic plan.
Document Key Assumptions
Clearly document all significant assumptions underlying cash flow projections, including growth rates, profit margins, and working capital requirements, with supporting evidence for their reasonableness.
Incorporate Multiple Scenarios
Consider developing multiple cash flow scenarios (base case, optimistic, pessimistic) to understand the sensitivity of recoverable amounts to changes in key assumptions.
Perform Retrospective Reviews
Regularly compare previous cash flow projections with actual results to assess the accuracy of forecasting and refine the projection methodology over time.
Optimize Discount Rate Determination
The discount rate is a critical input in value in use calculations and requires careful consideration:
Discount Rate Best Practices
- Develop a robust methodology for determining discount rates, considering industry practices and academic research
- Ensure consistency in the discount rate methodology across different CGUs while reflecting their specific risk profiles
- Document all inputs and assumptions used in the discount rate calculation, including risk-free rate, market risk premium, and beta
- Consider using external valuation specialists to validate the discount rate methodology and inputs
- Regularly update the discount rate to reflect current market conditions and changes in the risk profile of the assets or CGUs
Enhance Documentation and Review
Comprehensive documentation and thorough review processes are essential for effective impairment testing:
Document CGU Determination
Maintain detailed documentation of the rationale for CGU identification, including how management monitors operations and makes decisions.
Record Valuation Inputs
Document all significant inputs and assumptions used in recoverable amount calculations, with supporting evidence for their reasonableness.
Implement Multi-level Review
Establish a multi-level review process involving finance, operations, and senior management to challenge key assumptions and methodologies.
Conduct Sensitivity Analysis
Perform and document sensitivity analyses to understand how changes in key assumptions affect recoverable amounts and potential impairment.
Engage with Auditors Early
Discuss impairment testing approach and significant judgments with external auditors early in the process to address potential concerns.
Prepare Robust Disclosures
Develop comprehensive disclosures that meet IAS 36 requirements and provide meaningful information to financial statement users.
Leverage Technology Solutions
Modern technology solutions can significantly enhance the efficiency and effectiveness of impairment testing:
Specialized Valuation Software
Implement specialized valuation software that automates complex calculations, maintains audit trails, and provides robust documentation capabilities.
Data Analytics Tools
Use data analytics tools to monitor impairment indicators continuously, analyze historical performance, and identify trends that may affect future cash flows.
Integrated Financial Systems
Integrate impairment testing processes with financial planning and reporting systems to ensure consistency in data and assumptions across different financial processes.
Common Challenges
Organizations face numerous challenges when implementing IAS 36 impairment testing requirements. Understanding these challenges and developing strategies to address them is essential for effective compliance:
Identifying Appropriate CGUs
Challenge
Determining the appropriate level at which to identify CGUs, particularly in integrated businesses where cash inflows are interdependent.
Solution Strategies
- Analyze how management monitors and makes decisions about operations
- Document the rationale for CGU identification, including consideration of product lines, geographical areas, and regulatory environments
- Maintain consistency in CGU identification over time, unless changes in circumstances warrant reconsideration
- Consider consulting with operational managers to understand the interdependence of cash flows between different parts of the business
Challenge
Developing reliable long-term cash flow projections in volatile or rapidly changing markets.
Solution Strategies
- Base projections on the most recent budgets and forecasts, with adjustments for known market developments
- Develop multiple scenarios to capture a range of possible outcomes
- Consider using shorter projection periods with a more conservative terminal value approach
- Regularly compare actual results with previous projections to refine forecasting methodologies
- Incorporate input from various departments, including sales, operations, and strategic planning
Challenge
Determining appropriate discount rates that reflect current market assessments and asset-specific risks.
Solution Strategies
- Develop a robust methodology for calculating discount rates based on WACC with appropriate adjustments
- Consider using external valuation specialists to validate discount rate calculations
- Ensure consistency in methodology while reflecting the specific risk profiles of different CGUs
- Document all inputs and assumptions used in discount rate calculations
- Regularly update discount rates to reflect changes in market conditions and risk profiles
Challenge
Allocating goodwill and corporate assets to CGUs in a non-arbitrary manner.
Solution Strategies
- Develop a systematic approach for allocating goodwill based on expected synergies from business combinations
- For corporate assets, establish a reasonable basis for allocation, such as relative carrying amounts, revenues, or headcount
- Document the rationale for allocation methodologies and apply them consistently
- Consider whether bottom-up and top-down testing approaches are needed for corporate assets
- Reassess allocations when there are significant changes in the organization structure or operations
Impact of Economic Uncertainty
Economic uncertainty, such as that experienced during the COVID-19 pandemic, creates additional challenges for impairment testing:
Strategies for Managing Economic Uncertainty
- Multiple Scenarios: Develop multiple cash flow scenarios reflecting different recovery paths and economic outcomes
- Probability-Weighted Approaches: Consider using probability-weighted expected cash flows to reflect the range of possible outcomes
- Shorter Forecast Periods: Use shorter explicit forecast periods with more conservative terminal growth assumptions
- More Frequent Testing: Perform impairment testing more frequently when economic conditions are volatile
- Enhanced Disclosures: Provide transparent disclosures about the impact of uncertainty on impairment assessments
Case Studies
Case Study 1: Retail Industry CGU Identification
Background
A multinational retail company with operations across 20 countries faced challenges in identifying appropriate CGUs for impairment testing. The company operated both physical stores and an e-commerce platform, with increasing integration between these channels.
Approach
The company analyzed how management monitored operations and made decisions about continuing or disposing of assets. This analysis revealed that:
- Store performance was monitored individually, with decisions about store continuations made at the individual store level
- E-commerce operations were managed centrally by country, with shared infrastructure and marketing
- Supply chain and distribution centers served multiple stores and e-commerce operations within geographical regions
Solution
Based on this analysis, the company identified CGUs as follows:
- Individual stores were identified as separate CGUs for store-specific assets
- E-commerce operations were identified as country-level CGUs
- Distribution centers were treated as corporate assets and allocated to store and e-commerce CGUs based on usage
- Goodwill from acquisitions was allocated to groups of CGUs at the country level, reflecting how management monitored goodwill internally
Outcome
This approach allowed the company to identify impairment at the appropriate level, resulting in more targeted impairment charges for underperforming stores while recognizing the integrated nature of e-commerce operations. The company documented its CGU identification methodology comprehensively, providing a clear rationale that satisfied external auditors and regulators.
Case Study 2: Technology Company Value in Use Calculation
Background
A software company had acquired several smaller companies in recent years, resulting in significant goodwill on its balance sheet. Following a market downturn and increased competition, the company needed to perform impairment testing for its CGUs containing goodwill.
Challenge
The company faced several challenges in calculating value in use:
- Rapidly changing technology landscape making long-term forecasting difficult
- Significant planned product development investments affecting near-term cash flows
- Uncertainty about long-term growth rates in emerging markets
- Determining appropriate discount rates for different product lines with varying risk profiles
Approach
The company implemented the following approach to address these challenges:
- Developed detailed five-year cash flow projections based on product roadmaps and market analysis
- Created three scenarios (base case, optimistic, pessimistic) to capture the range of possible outcomes
- Used a probability-weighted approach to determine expected cash flows
- Applied different discount rates to different CGUs based on their specific risk profiles
- Conducted sensitivity analysis on key assumptions, including growth rates, profit margins, and discount rates
Outcome
The comprehensive approach to value in use calculation identified impairment in one CGU related to a recent acquisition targeting an emerging market. The company recognized an impairment loss of $15 million, primarily related to goodwill. The detailed documentation of assumptions and sensitivity analysis provided transparency to stakeholders and satisfied regulatory requirements.
Case Study 3: Manufacturing Company Impairment Reversal
Background
A manufacturing company had recognized significant impairment losses on its production facilities during an economic downturn three years earlier. Following a recovery in market conditions and operational improvements, the company needed to assess whether these impairment losses should be reversed.
Approach
The company implemented the following approach to assess potential impairment reversal:
- Identified indicators of potential reversal, including improved market conditions, increased capacity utilization, and enhanced profitability
- Recalculated the recoverable amount of the CGUs using updated cash flow projections and discount rates
- Compared the new recoverable amount with the carrying amount that would have existed had the impairment loss not been recognized (adjusted for depreciation)
- Documented the evidence supporting the change in estimates that led to the increased recoverable amount
Outcome
The analysis supported the reversal of $28 million of previously recognized impairment losses. The company provided detailed disclosures explaining the circumstances that led to the reversal, including specific operational improvements and market developments. The reversal was limited to the carrying amount that would have existed had the original impairment not been recognized, adjusted for depreciation that would have been charged.
Conclusion
Effective implementation of IAS 36 impairment testing requirements is essential for ensuring that assets are properly valued in financial statements. While the standard presents numerous challenges, organizations that develop robust methodologies, document key judgments, and leverage appropriate technology solutions can enhance the quality and efficiency of their impairment testing processes.
Key Takeaways
- Impairment testing is not merely a compliance exercise but a valuable process that provides insights into asset performance and future cash flow generation
- Identifying appropriate CGUs is a critical first step that requires careful consideration of how management monitors operations and makes decisions
- Developing reliable cash flow projections requires input from various departments and should be aligned with strategic planning processes
- Discount rate selection significantly impacts value in use calculations and should be based on a robust methodology that reflects current market assessments and asset-specific risks
- Comprehensive documentation of key assumptions and judgments is essential for audit defense and regulatory compliance
- Regular monitoring of impairment indicators should be integrated into financial processes to ensure timely identification of potential impairment issues
Future Considerations
As business environments and accounting standards continue to evolve, organizations should consider the following future developments in their impairment testing approaches:
Climate-Related Risks
Incorporating climate-related risks and opportunities into impairment testing, including potential impacts on asset useful lives, future cash flows, and terminal values
Digital Transformation
Assessing the impact of digital transformation on business models and asset values, particularly for traditional industries facing disruption
Regulatory Developments
Monitoring potential changes to accounting standards and regulatory requirements related to impairment testing and fair value measurement
Advanced Analytics
Leveraging advanced analytics and artificial intelligence to enhance cash flow forecasting and identify impairment indicators more proactively
By implementing the best practices outlined in this article and staying attuned to emerging developments, organizations can navigate the complexities of IAS 36 impairment testing while enhancing the quality and transparency of their financial reporting. This not only ensures compliance with accounting standards but also provides valuable insights that can inform strategic decision-making and asset management practices.
References
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International Accounting Standards Board. (2023). International Financial Reporting Standard 13 Fair Value Measurement. IFRS Foundation.
Deloitte Touche Tohmatsu Limited. (2023). iGAAP 2023: A Guide to IFRS Reporting - Impairment of Assets. LexisNexis.
Ernst & Young. (2023). International GAAP 2023: Impairment Testing Under IAS 36. John Wiley & Sons.
KPMG International. (2022). Insights into IFRS: KPMG's Practical Guide to IFRS Standards - Impairment of Non-financial Assets. KPMG IFRG Limited.
PricewaterhouseCoopers. (2022). Manual of Accounting: IFRS 2023 - Impairment. PwC Global.
International Valuation Standards Council. (2022). International Valuation Standards. IVSC.
Association of Chartered Certified Accountants. (2021). IAS 36 Impairment of Assets: Technical Articles. ACCA Global.
Institute of Chartered Accountants in England and Wales. (2022). Application of IAS 36: Practical Challenges and Solutions. ICAEW.
Chartered Professional Accountants of Canada. (2023). Impairment Testing Under IFRS: A Canadian Perspective. CPA Canada.
About the Author
Tiago Jeveaux is the Chief Operating Officer at CPCON Group with extensive experience helping organizations implement effective financial reporting and compliance frameworks. His expertise spans IFRS implementation, impairment testing, and strategic financial management across multiple industries. As a thought leader in the field, he regularly contributes insights on best practices in financial reporting and asset management.
