Companies must cosy up to new accounting standards

Asish K Bhattacharyya / New Delhi March 23, 2007


In accounting, an asset is said to be impaired if its recoverable value falls below the value at which it is carried in the balance sheet. How can this happen?

Initially, an enterprise acquires an asset only if it finds it economically viable to do so, that is, if the net present value (NPV) from acquiring the asset is zero or positive. Hence, on the acquisition date, the recoverable value of the asset would generally be higher than its acquisition cost.

However, subsequent events, such as increase in competition in the market or reduction in demand for the product or service, might adversely affect the service potential of the asset, causing its recoverable amount to fall below the carrying amount. This results in impairment of the asset and requires changes in the carrying amount to reflect the new reduced value of the asset.

Accounting standards require enterprises to test assets for impairment, whenever events that lead to a fall in their recoverable value occur. If the carrying amount of an asset is higher than its recoverable amount — defined as higher of its ‘value in use’ and ‘net selling price’ — the enterprise recognises an impairment loss and writes down the carrying amount to the recoverable amount.

Goodwill and intangible assets that are not put to use (for example, patent or licence not put to use), are tested for impairment at least annually. On reversal of events that caused recognition of impairment loss, subject to certain conditions, the enterprise writes back the impairment loss. For impairment loss on account of goodwill, these conditions are so stringent that impairment on account of goodwill is written back only rarely.

The ‘value in use’ component in the definition of recoverable amount requires us to attribute cash flows generated by a firm to specific assets. This is difficult to do if assets are defined too narrowly.

For example, a particular piece of equipment in a factory does not produce cash flows independently from other facilities in the factory; it is the factory as a whole which generates cash flows. To deal with this, the recoverable amount is computed for a group of assets, and impairment loss, if any, is then allocated to individual assets that constitute the group.

A group of assets tested collectively for impairment is known as a ‘cash generating unit’ (CGU). A CGU is the smallest identifiable group of assets generating cash inflows from continuing use that are largely independent of the cash inflows from other assets or groups of assets. Identification of CGUs involves judgement and there is the possibility of a difference of opinion arising between auditors and management. Deviations are possible on both sides.

The management may be tempted to group assets at a higher level than appropriate, in order to cover impairment loss of some assets by the healthy performance of other assets in the group. On the other hand, auditors, who are averse to risks and avoid situations that might attract criticism or litigations for negligence, may insist on grouping assets at a level lower than appropriate.

Once the CGUs have been correctly identified, ‘value in use’ of an asset (or a group of assets) is calculated as the present value of estimated future cash flows expected to arise from the continuing use of the asset in its present condition and from its disposal at the end of its useful life. The present value is determined by discounting pre-tax cash flows by an appropriate pre-tax discounting rate.

The other source of recoverable amount, ‘net selling price’, is the amount obtainable from the sale of an asset in an arm’s length transaction between knowledgeable and willing parties, less the costs of disposal.

The best evidence of an asset’s net selling price is a price in a binding sale agreement, in an arm’s-length transaction, reduced by costs of the disposal. If there is no binding sale agreement, the net selling price is the asset’s market price (current bid price) in an active market, reduced by costs of disposal.

In case current bid prices are unavailable, the net selling price is estimated with reference to the price of the most recent transaction. There might be situations where neither a binding sale agreement nor an active market for an asset is available.

In such a situation, the net selling price should be based on the best information available regarding the amount that the entity could obtain, at the balance sheet date, for the disposal of the asset. Outcome of recent transactions for similar assets within the same industry should be used as the basis for estimating the amount.

Some experts take a restrictive view of the concept of net selling price stipulated in the accounting standards by not accepting the appraisal method — which is an otherwise well-accepted method to determine the value of land, buildings and other assets — as an appropriate method to determine the net selling price. It is inappropriate to take such a restrictive view of net selling price. Let us consider a hypothetical case. Suppose, a company has three divisions, one of which is making losses.

The company has decided to continue running the loss-making division due to strategic reasons. Therefore, there is no binding contract for sale. Further, let’s assume that there is no active market for the purchase and sale of the same or similar businesses. There is no merger or acquisition in the industry.

The book value of the assets of the division (which is a CGU) is Rs 26 crore. Their value in use is Rs 12 crore. These assets include a large freehold plot of land, which is carried in the balance sheet at Rs 3 lakh (the historical cost), and buildings.

While the division itself has been running at a loss, its land and buildings have appreciated beyond their book value, with the appraisal method providing an estimated net sale value of Rs 41 crore. There is no way to take into account this significant economic fact if we reject the appraisal method, and the company will have to provide a misleading impairment loss of Rs. 14 crores.

On the other hand if we accept the net selling price determined through the appraisal method, no impairment loss is to be recognised. Here rejection of the net selling price determined through the appraisal method is inappropriate, more so since another accounting standard permits upward revaluation of fixed assets based on value determined through the appraisal method. In this situation, the management might want to use the appraisal method to estimate the net selling price, while auditors might argue against it based of a restrictive interpretation of the standards.

In most situations, it is the auditor’s view which ultimately prevails since managements and audit committees of the board of directors have traditionally been averse to adverse comments in audit reports. This mindset of managements and the audit committees should change. Implementation of new accounting standards and revised accounting standards involve judgment. Moreover, accounting practices for new accounting standards, such as accounting for impairment, are yet to evolve.

Therefore, managements should assert their position on interpretation of new accounting standards, provided they are confident that their interpretation of the accounting rule is based on sound accounting principles and the spirit of the accounting standards. This also increases the responsibility of audit committees. Instead of passively going with auditor’s view, they should provide an independent review of the accounting policy of the company.

The writer is professor of finance and control at IIm-C

Real estate prices in Mumbai

R Ravimohan / New Delhi March 16, 2007



Over the medium term of a few years, real estate prices in Mumbai should become competitive against other cities.

Real estate prices in Mumbai, and most cities around the country, have skyrocketed in the past one year. Since Mumbai still remains the price-setter for the rest of the country, let us understand the dynamics of real estate prices in this city. The market is rife with razor-sharp speculations on the expected direction of property prices, with almost an equal probability of prices staying at current levels, or going up even further, or coming down. Is there any methodical conclusion we can reach on the future direction of realty prices?

Several factors have combined to push prices up in Mumbai. For the past four years—backed by soft real estate prices, easy availability of finance, lower interest rates, liberalising construction rules, and better houses being constructed—there was a sustained buying trend that kept growing steadily. The wealth effect of rising income levels due to better wages, combined with the relentless growth of services (financial services, technology, BPO, retail, etc.), spawned a huge unmet demand for quality office space. Additionally, continued buoyancy in the stock markets diverted a lot of funds to the real estate markets. Private equity and venture funds also started taking strong positions on real estate, which infused large fresh funds into real estate. Then came the conjecture about the large-scale rollout plans by Indian and global retail Goliaths, which gripped the market in a frenzy of speculation. During all this time, the retail homeowner’s demand continued unabated, given the easy availability of home loans, and perhaps even spurred by the fear that if they did not buy they might miss the bus. The high prices are also a result of the failure of developers to bring new areas under development fast enough to counter this price hike.

The factors that can moderate prices are obviously the opposite of what have been identified as the drivers above. Most importantly, prices are completely out of whack with global trends, and have now reached a level where services are no longer competitive and have begun seeking alternative locations. Further, the high prices have attracted a new frenzy of construction, which on completion over the next few months will exert pressure on prices. The Bandra-Worli sea link, which is going full steam ahead, is expected to open up more areas on the Western corridor to access downtown Mumbai faster, thereby increasing supply. But the real benefit of this project is the encouraging prospects for the Trans-Harbour link, which will vastly increase the supply from the mainland to the hitherto land-locked paradigm of Mumbai. The provisions in the latest Budget proposals to withdraw Section 801b from March 2007, service tax of 12.5 per cent on lease rentals, and rising costs will dampen demand for residential property.

The floor space index (FSI) too impacts real estates prices. The higher the FSI, the larger the floor space that can be constructed per square foot of ground area, and therefore the lower the real estate prices. Currently the average FSI for Mumbai is less than 2. To put this in perspective, Hong Kong is now running well above 14! Admittedly Mumbai's infrastructure, as it stands now, does not give much scope for increase in the FSI. But large integrated developments, which have become the trend, are now able to achieve a considerably higher FSI. This gives rise to the hope that the pressure on the land area and, effectively, prices will ease progressively as the FSI gets liberated in tandem with improvements in road infrastructure.

Ultimately market forces will prevail. Sensible businesses will look for alternative locations. Any major ITeS or IT company now operates with big delivery centre operations somewhere else in the world other than in India. While India is still the fountainhead of talent, companies are not going to find homes and offices at viable prices in India at these levels. Unless prices moderate, the trend to set up delivery and off-shore centres in faraway locations such as South America and East Europe will gather momentum. Retail demand will sag if prices do not ease. Overseas markets such as Singapore and Dubai have become favoured destinations for Indian investors in real estate, because those are more attractively priced and the quality of those properties and the environment are also far superior. Interest rates on mortgages will move up significantly, choking off the smaller home buyers. Government policies on FDI on real estate are likely to be delayed, and probably be incremental, given the political sensitivities. Given the high prices, it will really be a brave foreign heart who will now bet billions on Indian realty! These are fundamental reasons why I believe prices will moderate.

However, I do expect continued buoyancy in the economic growth of both India and Mumbai. Thus, the salary push and attraction of foreigners to invest in India will continue. Indeed, buying continues till now unabated. Funds are still being generated in sumptuous measures in the overseas market, targeting real estate investments in India. Surely this inflow will keep the prices up, at least in the short term. I also believe that the developers and land ownership have a strong influence on the market, which is yet to get the full effect of the buyer’s power. We are far from the perfect market; so leaving the prices of real estate entirely to the market is not going to moderate the prices quickly. However, over the medium term of a few years, I expect real estate prices in Mumbai to become competitive against other cities, which are vying for businesses to shift to their cities. The prices in these cities are at considerable lower level than in Mumbai today. This slow moderation could be accelerated if the government decides to step in and step up city development plans, which is good, or if the money supply growth is sharply yanked, giving rise to deflationary expectations, which might be ill-advised, as it can potentially choke off the larger economy itself. The scope for any further sharp increase in real estate prices appears limited, with no further good news left for the market to rise up on.

The author is managing director and CEO, Crisil, a Standard and Poor’s company