To impair or not to impair - this is not a question
Alison White CA(SA) − Lead Partner, Accounting Technical, Deloitte
Moana Overton CA − Principal, Accounting Technical, Deloitte
Darryl Dorfan CA – Director, Corporate Finance – Valuation, Deloitte
Impairment of non-current assets, such as goodwill, other intangible assets and property,
plant and equipment under AASB 136 Impairment of Assets is a hot topic for two reasons.
Firstly, many entities find themselves in a tough trading environment making it harder to
justify the value of such assets. Secondly, there has been an intense regulatory focus on
impairment over the last few years, which is likely to continue.
The determination of whether or not an asset is impaired is the result of the application of
complex accounting technical and valuation concepts. While there are many judgmental
areas involved in impairment testing, if the asset is considered to be impaired because the
value recognised on the balance sheet cannot be recovered that impairment loss must be
recognised at the time it is identified.
The Australian Securities and Investments Commission (ASIC) has focussed on impairment
for some years and has recently started issuing press releases identifying entities that have
restated results as a consequence of ASIC’s inquiries. At the time of writing, ten
restatements have been publicised with four related to impairment.
Specifically, ASIC has identified the following concerns:

the use of unrealistic or unsupportable cash flow assumptions when considering
historical results and economic and market conditions

material mismatches between the cash flows used and the assets that generate the
cash flows

entities not performing cross checks of valuations

entities not making disclosures which are important to investors and other users.
ASIC has also indicated its intention to focus on specific industries, including the resource
sector, mining services and industries expected to be affected by digital disruption.
How should entities address ASIC's concerns?
Use reasonable and supportable assumptions
Entities generally begin their impairment assessments by constructing a “value in use”
model in accordance with AASB 136. This model discounts the expected cash flows from
the ongoing use of an asset or group of assets to a present value to determine a
recoverable amount. Entities should base cash flow projections on reasonable and
supportable assumptions that represent management’s best estimate of the range of
economic conditions that will exist over the remaining useful life of the asset, giving greater
weight to external evidence.
In determining what are “reasonable and supportable” assumptions, management should
consider a range of factors. The first is budgeting accuracy, especially where management
prepares stretch or optimistic budgets. If for example, management is projecting $100 net
cash inflow in year one, but has consistently missed budget by 10% per annum for a
number of years, then a reasonable assumption of expected cash inflows may be $90. The
second is industry expectations. If an entity is projecting five percent growth, but actual
industry growth rates are projected to be three percent, a reasonable assumption supported
by external evidence might be three percent growth. However, if the entity concerned has
actually failed to grow at the same rate as other entities in the industry, the appropriate
growth rate assumption may be even lower.
Ensure consistency between the cash flows generated and the assets being tested
One common error is the exclusion of working capital and plant and equipment from the
carrying amount of a cash generating unit when testing goodwill for recoverability.
Another issue relates to the modelling of working capital movements in the cash flows. Many
models make either no allowance or insufficient allowance for further investment in working
capital. Yet without adequate levels of working capital it would be impossible to generate the
revenue required to support the carrying amount of the assets being tested, usually goodwill
and plant and equipment.
There are some fairly easy ways to test whether assumptions around these assets are
reasonable. One way is to model the asset balances using the assumptions in the cash flow
model and to then determine an asset turn ratio at the end of the projection period. In some
cases it is obvious that the model does not stack up; for example, the assumptions relating
to depreciation and capital expenditure may result in a negative asset balance at the end of
the projection period. Where it is less clear, the asset turn ratio provides perspective. By
doing a look back test or by comparing to other entities in the same industry, it may become
apparent that asset replacement assumptions ought to be revisited.
Perform cross checks
Once the initial valuation is complete, it is advisable to sense check whether it is reasonable.
The valuation can be checked by either using a secondary methodology or assessing
whether the implied valuation metrics are within an expected range by looking at trading
multiples of comparable listed companies.
Provide relevant disclosures
AASB136.134(f) requires entities assessing goodwill for impairment to make disclosures of
key assumptions, including whether they reflect past experience and if a “reasonably
possible change” in those assumptions would result in an impairment. The objective of the
disclosure is to enable users to form a view on the assumptions made, and form their own
view on the recoverability of the assets. For assets other than goodwill, management should
consider whether similar disclosures are required by AASB 101.125 Presentation of
Financial Statements.
To comply with this requirement, management should identify which assumptions in the
impairment model are key assumptions. The best way to do this is to vary each assumption
in the model individually and observe which have the most influence on the recoverable
amount. These are the “key assumptions”. The assumptions the model is most sensitive to
will vary by industry and to a lesser extent by individual entity. For example, in some
industries the model will be highly sensitive to changes in commodity prices, whilst for others
assumed gross profit margins will have a significant bearing on the outcome.
The next step is to form a view as to what might be considered a “reasonably possible
change” in the assumption. For example, in some industries, a change in discount rates of
5% may be unlikely, but perhaps a gross margin change of 5% might be considered
reasonably possible. Having identified what is a “reasonably possible change” management
determines whether such a change would cause an impairment. If it would, the entity would
make the appropriate disclosure, including the headroom, value of the key assumptions and
the amount by which each key assumption would need to change to result in an impairment.
How does the market react to impairment charges?
Many entities are understandably reluctant to recognise an impairment loss because of the
possible impact on share price.
We recently undertook a study of entities forming part of the ASX All Ordinaries index with
financial years ending between December 2013 and June 2014 that recorded an impairment
charge. The share price of each of these entities was analysed by considering the average
share price in the seven day and 30 day period immediately preceding and following the
announcement of the write-down.
Our research showed that the announcement of an impairment charge alone is unlikely to
result in a material share price movement. In the seven days following the announcement,
the share price of 84% of the entities reporting impairment either sustained a fall of less than
5% or had risen above the share price at the date of the announcement.
The market capitalisation of the entity appears to play some part. For the larger entities, our
analysis suggests share price is less likely to decline in response to an impairment
announcement. At the other end of the size spectrum, there is some evidence that share
price declines once the market is made aware of an impairment.
It is possible that smaller entities are more susceptible to adverse price movements because
there is less information in the public domain. Larger entities are continuously scrutinised by
the investment community, and the market may therefore anticipate the impairment loss so
that there is little impact from the subsequent announcement.
When analysing the detail there were other interesting observations. As there are a
relatively large number of entities reporting impairment that fall within the industrials
subgroup, the correlation between the nature of the asset that was impaired and the share
price was analysed. Out of the five entities that reported impairment of only goodwill, just
one reported a significant decline in share price over the seven day period. Interestingly,
eleven of the sixteen entities that reported impairment to property, plant and equipment, saw
their share price decline over the seven day period.
Our top tips
There are a myriad of other technical accounting and valuation concepts, as well as
professional judgments, that go into the development of an impairment model.
Our top tips for getting impairment models right are:

Start early so that any issues identified can be addressed before year-end and
sufficient time is provided for review by both the Board and the auditors

Consider and document responses to each of the technical requirements of
AASB 136

Document the basis for future cash flows and key assumptions

Challenge the assumptions, in light of past experience, knowledge of the business
and external evidence

Stress test the model to determine the key assumptions and, where necessary,
make the appropriate disclosures

Stand back and ask yourself whether the impairment testing provides a fair
reflection of the valuation of the entity and whether the information disclosed
enables investors to form their own view on the value of the entity.
Alison, Darryl and Moana are all members of the multi-disciplinary Deloitte Impairment
Taskforce which advises clients in the accounting and valuation requirements of impairment
testing