Australia: Impairment Calculations – Tips And Traps

Last Updated: 23 July 2009
Article by Alan Max

The global economic slowdown is having an adverse impact on many businesses, often resulting in lower cash flows. Lower cash flows increase the likelihood that asset carrying amounts may be "impaired" in terms of AASB 136 "Impairment of Assets" ("the Standard").

An asset or cash generating unit ("CGU") is impaired when its carrying amount is greater than its "recoverable amount". Recoverable amount is the higher of an asset's fair value less cost to sell and its "value in use" ("VIU"), a discounted cash flow determination. An entity must test goodwill and certain other intangible assets for impairment annually.

ASIC has highlighted asset impairment as one of its focus areas when it undertakes its review of 30 June 2009 financial reports. Entities should ensure that impairment calculations are robust and support its position in terms of the requirements of the Standard. The following practical tips may assist in calculating the recoverable amount of assets and CGUs:

  • How do discount rates compare with those used in previous periods? Should discount rates differ between different assets?

The discount rate should reflect the risk profile that market participants would apply in pricing the expected future cash flows. While government bond rates have fallen recently, it does not automatically follow that the required rate of return of an asset has also fallen. It is necessary to consider specific risk adjustments to compensate for current market conditions which have generally deteriorated since the last balance date.

The weighted average cost of capital ("WACC") of an entity is often used as a starting point in calculating an asset's discount rate. However, entity WACC should be adjusted to reflect a market assessment of an asset's specific risks, where appropriate. Discount rates would differ for assets with differing risk profiles.

  • Should a pre-tax or post-tax discount rate be used?

The discount rate is usually a post-tax rate by default where WACC is used as a starting point. Care should be taken that a post-tax discount rate is only applied to post-tax cash flows. Similarly, a pre-tax discount rate should only be applied to pre-tax cash flows.

Even where a post-tax discount rate has been used, a pre-tax discount rate requires disclosure in the financial statements. A pre-tax discount rate can be determined by an iterative computation so that the VIU determined using pre-tax cash flows and a pre-tax discount rate equals the VIU determined using post-tax cash flows and a post-tax discount rate. Because of the differences in the timing of tax payments, a post-tax discount rate may not be a pre-tax discount rate multiplied by the tax-rate.

  • Do cash flow projections reflect current market conditions and the requirements of the Standard?

The assumptions used to project cash flows must be reasonable and supportable. Greater weight should be given to external evidence, such as industry research, broker analysis, economic forecasts, etc. The global economic slowdown is likely to negatively impact cash flows, with an immediate and potentially cumulative effect on the recoverable amount.

The Standard requires estimated future cash flows to reflect the asset in its current condition. An entity should exclude the impact of plans to improve, enhance or restructure a particular asset unless an entity has committed to the restructuring.

Cash flow projections should be based on budgets / forecasts approved by management covering a maximum period of 5 years. Cash flow projections beyond the period covered by management's budgets / forecasts should be based on a steady or declining rate of growth, not exceeding the long-term average growth rate of the product, industry, country or market.

  • Has the reasonableness and sensitivity of the discounted cash flow calculation been tested?

Useful tests may include:

  • Comparing the aggregate recoverable amount for all assets to the market capitalisation (where listed) or entity value implied by recent share transactions, adjusted for net debt.
  • Comparing the earnings multiple implied by the recoverable amount (i.e. recoverable amount divided by estimated future earnings) with prospective market multiples for the entity (where listed), comparable quoted companies and comparable transactions, if any.
  • Performing a sensitivity analysis on key or highly subjective assumptions.

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.

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