While we are hopeful that the global economy might soon be emerging from the turmoil created by the credit crisis and the somewhat disastrous effects it has had on asset values around the world.
The issue of impairment remains one that demands careful consideration for financial assets held by many entities. Higher interest rates, lower equityprices and illiquid markets for certain investment holdings are likely to be triggers that require holders to conduct impairment testing to ascertain whether write downs are necessary.
Requirements for impairment testing
An entity must assess at each reporting date whether there exists objective evidence of impairment as a result of events that may have impacted the estimated future cash flows expected to be generated. Where such evidence exists, a formal impairment test must be conducted.
In making the assessment, an entity should first review those financial assets that are individually significant. Financial assets not assessed in this manner are reviewed either individually or collectively for evidence of impairment. Those financial assets individually assessed for evidence of impairment and determined not to be affected must be assessed at a collective level.
Examples of observable evidence that may come to the attention of the holders of financial assets include the following:
- significant and prolonged changes in equity and debt pricing that go beyond what might be considered normal market volatility (e.g. fall in ASX, increasing interest rates)
- financial difficulties of the issuer such as inability to meet principal and interest payments, business restructuring, business closures, appointment of administrator, granting of special concessions by the holder; and
- absence of liquid markets in relation to a particular asset or general increase in risk profile of financial assets or groups of assets held (e.g. increasing trends of delinquencies for the same or similar assets).
Permanency of impairment
Determining whether evidence will actually lead to impairment may involve significant judgement and should take into consideration the severity, frequency and combination of occurrence of such events. For instance, the fact that the fair value of an equity instrument has dropped below its carrying value may not necessarily be evidence that an impairment loss has occurred where it is still anticipated that the asset will continue to produce the same cash flows as were estimated at the time of initial recognition. This would particularly be the case where the stock is subject to normal volatility around its acquisition price.
However, where fair value has declined significantly and for a prolonged time, this is likely to be evidence of impairment. The holder should ascertain whether an event has occurred that has permanently impacted the anticipated cash flows and which has now been priced into the security by the market (e.g. extensive bad debts resulting in management declaring dividend suspension for indefinite period).
Accounting for impairment
Where it is determined that evidence of impairment exists, the required accounting for the decline in value is dependent upon the categorization of the financial asset.
Financial assets carried at amortised cost
For financial assets carried at amortised cost, impairment would represent an excess of the asset's carrying amount over the present value of estimated future cash flows discounted at the asset's original effective interest rate. Alternatively, the holder could also measure the impairment of the asset with reference to its fair value using observable market prices. The asset must be written down by the amount of the excess and the impairment loss recognised through the income statement.
Unquoted financial assets carried at cost
In the rare cases where an entity holds financial assets whose fair value cannot be reliably measured, the recoverable amount will be measured with reference to the future estimated cash flows expected to be generated discounted to present value using a yield that might be found in the market for a similar financial asset. The impairment loss is measured as the excess of the asset's carrying value over the present value calculated and is recognised through the income statement.
Available-for-sale financial assets
Equity securities are commonly classified as available-for-sale financial assets. Debt securities may also be found in this category. Changes in the fair value of such financial assets are recognised directly through the equity section of the balance sheet. Declines in fair value below cost may result in debit equity reserves. However, where the decline becomes associated with impairment, the loss should be recognised by transferring the cumulative loss in value associated with that asset (or group of assets) from equity to the income statement.
Determining fair value
Published prices in an active market for financial assets should be used for determining their fair value and the need for any impairment. Where the market is not active, fair value must be established using valuation techniques to establish what the transaction price would have been on the measurement date in an arm's length exchange. Valuation methodologies include reference to recent arm's length market transactions, current fair values of other similar financial assets, discounted cash flow models and other pricing models.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.