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
