Understanding Value Concepts in Impairment Testing

Impairment testing was introduced to ensure that the carrying amount of an asset recognized on the balance sheets does not exceed its recoverable amount. Therefore, basically all assets are subject to a test for impairment, under either IAS 36 (Impairment of Assets), or another standard.
An academically sound standard, IAS 36 sets out sets of rules covering how tangible and intangible assets, including goodwill, have to be tested for impairments. However, in applying it, due to two different value concepts, several issues lead to difficulties and ambiguity, especially with goodwill. Those two value concepts are: fair value less cost to sell (FVLCS), and value in use (VIU) to test the integrity of the carrying amount of an asset.
While FVLCS is market price based, representing the value in exchange, VIU, however, represents the reporting entity’s assessment of its very specific ability to exploit the asset to generate cash flows: It is the entity’s present value over its economic useful life. By introducing those two concepts, considered to be of equal reliability, IAS 36 deviates significantly from the concepts applied in IAS 16 (Property, Plant and Equipment) or IAS 39 (Financial Instruments: Recognition and Measurement), as well as under U.S. generally accepted accounting principles (GAAP). Read on for more details.
The fair value concepts of IAS 36 differ significantly from those of IAS 39, Financial Instruments: Recognition and Measurement, or IAS 16, as it defines an asset’s recoverable amount as the higher of its FVLCS and its VIU. Therefore, it is not always necessary to determine both the FVLCS and the VIU; if either exceeds the asset’s carrying amount, there is no impairment.
For assets held for sale, the VIU will consist mainly of the net disposal proceeds, because the future cash flows from their continuing use until disposal are likely to be negligible; therefore, the recoverable amount will be FVLCS (IAS 36.21). In some cases, estimates, averages, and computational shortcuts may provide reasonable approximations for determining FVLCS or VIU; of course, this heavily depends on materiality.

Fair Value Less Costs to Sell (FVLCS)

Basically FVLCS is the fair value of an asset from observable prices in an active market or observable comparable transactions; in other words using Level-1 or Level-2 inputs:

• Level-1 inputs are “quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access as of the measurement date.”
• Level-2 inputs are “inputs other than quoted prices included within Level-1 that are observable for the asset or liability either directly or indirectly through corroboration with observable market data”.

While a Level-1 input requires an observable market quote for an identical asset in an active market, a Level-2 input is characterized as an observable market quote (a) for a “comparable (similar)” asset in an active market or (b) for an identical or similar asset in a market that is not active.
The difference from fair value as discussed in other IFRS is the recognition of transactional expenses in cost to sell; these have to be carefully estimated and reflected unless they are negligible. As a result, the FVLCS concept cannot be applied to all classes of assets in a sensible manner. For example, price and transaction data should be observable for general equipment, such as machine tools that can be broadly used.
However, specialized machines or, even more important, intangibles may be so unique that the Market Approach is not applicable; in such a case, only the VIU needs to be determined.
IAS 36.25 through 36.29 provides guidance on determining an asset’s FVLCS and establishes the order of methods recommended:
1. If there is a binding sale agreement, use that price less costs of disposal: IAS 36.25: “the best evidence of an asset’s FVLCS is a price in a binding sale agreement in an arm’s-length transaction, adjusted for incremental costs that would be directly attributable to the disposal of the asset.”
2. In the absence of a binding sales agreement, for an asset that is traded in an active market, FVLCS is the market price less the costs of disposal. The appropriate market price is the current bid price if available; if not available, the most recent transaction price may provide a basis from which to estimate FVLCS, provided that there has not been a significant change in economic circumstances since the transaction date (IAS 36.26). This information should be used with great care, as an impairment test is triggered by external or internal indicators, which usually reflect a change in circumstances.
3. Without a binding sale agreement or an active market, FVLCS should be estimated based on the best information available, such as the outcome of recent transactions for similar assets within the industry, diligently considering the reliability of such data. The idea is to reflect the amount that an entity could obtain, at the balance sheet date, from the disposal of the asset after deducting all related costs. Values determined in forced sales do not constitute FVLCS, unless the firm is compelled to sell immediately (IAS 36:27).

Besides applying to single assets, IAS 36 applies to Cash-generating Units (CGUs). In the absence of a binding sales agreement or an active market, the best estimate for the FVLCS of an asset/CGU will most likely be the present value of the future cash flows anticipated from that asset/CGU reflecting the average market participant’s capabilities to exploit it. For CGUs, the use of an appropriate multiple to estimate FVLCS can be feasible.
Thus, if management projections are used, they need to be free from any specific synergies or conditions that another entity does not have; synergies available to any market participant should be considered.
Therefore, the use of projections from external sources, such as broker or analyst reports, industry estimates, or the like, should be preferred, as the FVLCS is not the same as the VIU. Consequently, the discount rate needs to be derived from an appropriate peer group, not from the entity’s cost of capital and leverage.
The use of replacement costs, suggested as a way to determine fair value in IAS 16.31, is explicitly prohibited in IAS 36, as the mere cost to replace an asset does not reflect the economic benefit it will deliver in the future (IAS 36:BZ28 and 36:BZ29).
The costs of disposal are the additional direct costs only, not existing expenses or overhead (IAS 36.28). They are deducted from fair value to determine FVLCS if they have not been previously recorded as liabilities in connection with the recognition of the asset. Examples of such items are:

• Sales commissions
• Legal fees
• Stamp duties and similar transaction taxes
• Dismantling and removal charges
• Direct incremental costs to bring the asset into salable condition

For the FVLCS of CGUs used for goodwill impairments, mergers and acquisitions (M&A) advisory fees could be a cost of disposal. However, termination benefits (as defined in IAS 19, Employee Benefits) and expenditures associated with reorganizing a business following the disposal of an asset are not costs of disposal. Sources of information for costs of disposal include observable transactions, quoted disposal prices, consultants’ databases, management estimates, and industry rules.

Value in Use (VIU)

As stated by its name, VIU is not a transaction price but rather the value of the asset or CGU to the reporting entity. To calculate VIU, only the Income Approach can sensibly be applied. To determine the VIU of an asset, the entity first estimates the future net cash flows to be derived from its ultimate disposal, and then applies an appropriate discount rate to them. The cash flow calculations should take into account the entity’s specific capabilities to exploit the asset or CGU, while the discount rate needs to reflect the firm’s specific WACC.
Thus, it is explicitly not fair value as determined in other IFRS or in the FVLCS concept. For the cash flow projections, the use of management budgets is recommended, provided that they are based on reasonable and supportable assumptions, represent the most recent forecasts, and can be sensibly extrapolated for future periods (IAS 36.33).
The discount rates used to determine VIU must be pretax rates that reflect both the time value of money and the risks, specific to the asset, for which adjustments have not been made in the projections of the future cash flows (IAS 36.55). In practice, a posttax discount rate is used which is applied to posttax cash flows (see below).
The assumptions underlying the cash flow projections should be reasonable and supportable concerning the economic conditions expected over the remaining useful life of the asset; greater weight should be given to external evidence, which should not just be a market-based view. This external evidence is used to validate the assumptions regarding total market volume, market share, market growth, price developments, and general economic environment.
Sources for such external evidence would be brokers’ and industry reports and competitors’ reflections of the business environment, market intelligence, and banks’ assessments of the respective economies.

Fair Value Less Costs to Sell (FVLCS) versus Value in Use (VIU)

The recoverable amount is defined by IAS 36 as the higher of FVLCS or VIU based on the assumption that rational business decision-making would always opt for the more economical way of exploiting the asset: that is, sale or continued use (IAS 36.BZ9). As shown earlier, the FVLCS uses the market’s assessment of the general value of the asset, referred to as the market price at which it can be sold (value in exchange). The VIU actually considers the specific entity’s capability to exploit the asset by assessing the cash flows expected from it (IAS 36:33).
IAS 36 explicitly considers management’s assessment of the VIU of the asset to be as reliable as the general market’s assessment used to estimate the FVLCS. This is evidenced by the fact that the higher of both values determines the recoverable amount. The bases for this conclusion (IAS 36:BZ17) are listed below:

• Preference should not be given to the market’s expectation of the recoverable amount of an asset (basis for fair value when market values are available and for net selling price) over a reasonable estimate performed by the individual enterprise that owns the asset (basis for fair value when market values are not available and for VIU). For example, the enterprise may have information about future cash flows that is superior to that available in the market. In addition, it may plan to use the asset in a different manner from the market’s view of the highest and best use.
• Market values are a way to estimate fair value but only if they reflect the fact that both parties, the buyer and the seller, are willing to enter a transaction. If an enterprise can generate greater cash flows by using an asset than by selling it, it would be misleading to base recoverable amount solely on the market price because a rational entity would not be willing to sell. Therefore, “recoverable amount” should not refer only to a transaction between two parties (which is unlikely to happen) but should also consider an asset’s service potential to the enterprise.
• Recoverable amount of an asset is the amount that an enterprise can expect to recover from that asset, including the effect of synergy with other assets that are relevant. The International Accounting Standards Board (IASB) believes that VIU would be a reasonable estimate of fair value as stated in other IFRSs in the absence of a deep and liquid market. Due to the unique nature of many assets within the scope of IAS 36, it is assumed that observable market prices are unlikely to exist for goodwill, for most intangible assets, and for many items of property, plant and equipment (IAS 36:BZ18).

Current Issues in Determining the Recoverable Amount

Regarding the use of external evidence especially with respect to goodwill impairment testing, there is disagreement as to whether the sum of the recoverable amounts of the CGUs tested for impairment, including allocated goodwill, should be reconciled to the market capitalization of a publicly listed company. If so, it is suggested that input parameters derived from the market capitalization should be used to derive input factors in determining VIU.
This discussion was originated in the United States, where the Securities and Exchange Commission (SEC) and the American Institute of Certified Public Accountants (AICPA) stated that the reconciliation of the total of the fair values of an entity’s reporting units (RUs) to its market capitalization would be a good test for the appropriateness of the RUs’ fair values.
The SEC’s chief accountant stated that reconciliation does not necessarily need to be only quantitative but also can be qualitative. For example, an entity should be able to explain why any difference between the total enterprise value (TEV) (or the sum of the values of the RUs) and the market capitalization is not indicative of an impairment issue.
The argument is based on the fair value hierarchy set out in SFAS 157, Fair Value Measurements, which assumes that observable prices in active markets are the most reliable indicators of fair values. Although the IASB issued SFAS 157 as a discussion paper (DP), Fair Value Measurements, according to IAS 36, it is not appropriate to apply this GAAP practice to the impairment testing procedures as the DP is not a binding document and has no relevance for IFRS.
The argument does not consider that the determination of “fair value” to estimate recoverable amounts according to IAS 36 significantly deviates from the determination of fair value according to other standards. The hierarchy in applying IFRS is first always to consider the specific standard; as IAS 36 explicitly states how the recoverable amount is to be determined, it is inappropriate to apply a different scheme.
To close a potential gap between the total of the fair values of the CGUs and market capitalization, it has been suggested that management’s existing cash flow projections and the market capitalization be used to estimate an implicit cost of capital. This implicit cost of capital would then be applied to determine the VIU of the CGU to be tested, thus incorporating an adequate risk premium in the discount rate.
The above technique raises five issues and should be avoided:
1. Calculating implicit discount rates by using the market cap and management projections leads to a circularity problem.
2. In theory, markets work efficiently, assuming all participants have full information. In reality, external sources, such as broker reports, have less information than management itself and hence external sources are a less reliable or at least different basis for decision making. Using an appropriate management forecast and market capitalization, which is based on external analyses, for discount rate estimation will not generate meaningful results.
3. IAS 36:BZ18 explicitly states: “Observable market prices are unlikely to exist for goodwill, most intangible assets and many items of property, plant and equipment.” A “market-based” VIU is inappropriate; to determine the recoverable amount, either concept, FVLCS or VIU, needs to be applied consistently.
4. The VIU is designed by IAS 36 to be a value concept and explicitly supports the idea that management’s assessment is as reliable as the market value used in FVLCS. Mixing market values and management assessment will significantly damage the integrity of either methodology or lead to wrong and meaningless results.
5. Risk premiums derived from implicit discount rates may assume too optimistic expectations of future cash flows. If the projections are diligently reviewed, proven to be supportable, and in line with IAS 36, there is no need to apply additional risk premiums.

As mentioned earlier, external information should be used to verify the cash flow projections. If they seem too optimistic, they need to be corrected directly. It is not advisable to use inappropriate cash flow projections and to apply an unrelated risk premium. Simply applying the implicit discount rates derived from market cap and management projections would be purely a quantitative reconciliation.
Nevertheless, a decline in market capitalization is a triggering event which should cause a critical look at the possibility of impairment. Moreover, a significant difference between the market capitalization at the reporting date and the sum of the VIUs of the CGUs should cause a thorough challenge to the underlying forecasts.