Continuing on from August’s article on common errors in accounting for impairment, the following highlights instances where, despite the accounting standards being very clear on a particular accounting treatment, Tier 1 and Tier 2 preparers regularly ignore the clear instructions in the standard, resulting in their financial statements being potentially materially misstated.
While estimating an asset’s recoverable amount requires a great degree of judgement and estimation, in a number of cases there are a set of very clear rules, which are commonly overlooked. These include:
- Not testing for impairment when the standard clearly requires it
- Not testing for impairment at the correct ‘unit of account’
- Not including the correct assets in the impairment test
- Basic errors in determining recoverable amount
- Basic errors in determining ‘value in use’
- Basic errors in determining ‘fair value less cost of disposal’.
In August’s article (Part 2a), we identified 10 common errors preparers make when determining value in use (VIU) for recoverable amount calculations under NZ IAS 36 Impairment of Assets. This month Part 2b covers more common errors relating to VIU calculation, including:
- Projections of cash outflows required to get an asset ready for use
- Avoid double-counting cash flows
- Cash flows shall only include those for the asset in its current condition
- Not including refurbishment costs (day-to-day servicing)
- Including cash inflows or outflows from financing activities in the VIU model
- Treatment of income tax receipts or payments
- Estimating the net cash flows to be received (or paid) for the disposal of an asset at the end of its useful life
- Foreign currency future cash flows.
Projections of cash outflows required to get an asset ready for use
If an asset is not yet ready for use, cash flows to get that asset ready for use must be included in the VIU model.
Entity H is testing an intangible not yet ready for use for impairment.
Carrying value is $10,000,000.
VIU calculation is based on the forecast EBITDA. The asset is forecast to start generating revenue in nine months’ time.
Entity H determines the VIU using a 10% discount rate as follows:
The recoverable amount is determined to be $10,083,430 and Entity H concludes that no impairment charge is to be recognised (carrying amount is $10 million).
Entity H forecasts that a further $700,000 development spend is required to complete the asset.
Correct VIU calculation is therefore as follows:
Recoverable amount is $9,447,060 and an impairment charge of $552,940 should have been recognised ($10,000,000-9,447,600).
Avoid double-counting cash flows
Double counting cash flows from working capital - Cash inflows from other assets on the statement of financial position
When preparing VIU calculations, preparers must be careful not to ‘double count’ cash flows from assets recognised separately on the entity’s statement of financial position, that are independent from the asset being tested for impairment. This particularly relates to the receipts from trade receivables, receipts of refundable GST, and the receipts from the sale of finished inventory.
Manufacturer A prepares a VIU cash flow model using its forecast EBITDA budget as its basis. Manufacturer A typically has an inventory turnover of 120 days.
At 31 December 2016, it has 90 days of finished goods on hand and 60 days of work in progress.
It tests the long-term assets (goodwill and PPE) for impairment, without adjusting the EBITDA forecasts for working capital associated with inventory on hand.
Commentary - Assuming the entity sells goods on 90 day credit terms, and has at least 90 days finished goods on hand, the entity will not receive any cash from the producing assets for 180 days. The cash flow model must be adjusted for this.
Entity I has 90 day credit terms and sells approximately 25% of its annual sales in June each year.
At the year-end, 30 June 2016, Entity I has trade receivables of $10 million, which will be collected as follows:
- $1 million in July 2016
- $2 million in August 2016
- $7 million in September 2016.
Entity I uses its 30 June 2017 cash flow forecast as the basis for its VIU at 30 June 2016, without any adjustment for working capital.
Commentary - The cash flow model includes $10 million of cash flows that are not being generated by the assets which are being tested for impairment.
Double counting cash flows from working capital - Inclusion/ exclusion of liabilities
In a similar manner to adjustments required to VIU models in respect of assets recognised separately on the statement of financial position (receivables and inventories), preparers should be aware of adjustments required for working capital adjustments to be made for liabilities on the statement of financial position that represent future obligations to pay out cash. This includes trade payables, accrued wages, provisions for restoration, etc.
An area that can commonly lead to errors is the recognition of deferred revenue liabilities when determining VIU, and incorrectly deducting this liability from the carrying value of the asset to be impaired.
Software Co sells software licences.
It receives 100% of the sales proceeds when it sells the licence, and recognises a deferred revenue liability. It then recognises revenue over the life of the licence.
Software Co has assets (goodwill and intangibles) of $10 million and a deferred revenue amount of $2 million. When determining the value of the asset to be tested for impairment, it models out its cash flows, using expected cash inflows and adjusting for working capital in respect of trade receivables and trade payables.
It deducts the deferred revenue amount from the carrying value of the producing assets.
Commentary - By its nature, cash has already been received for the deferred revenue, therefore there should be no adjustment in the VIU model.
Cash flows shall only include those for the asset in its current condition
Factoring restructuring into the VIU
NZ IAS 36, paragraph 12(g) requires an entity to test for impairment when ‘evidence is available from internal reporting that indicates that the economic performance of an asset is, or will be, worse than expected.’ In such cases, it is reasonable to expect the entity to take actions to return the asset to its anticipated economic performance. This can be through reorganisations, cost cuttings, redundancies, etc. Preparers must be careful not to include cost savings from a planned restructuring unless they can demonstrate that they are clearly committed to such a plan.
There would appear to be an alignment with this requirement, and the entity recognising a redundancy provision under NZ IAS 37 Provisions, Contingent Liabilities and Contingent Assets. NZ IAS 36, paragraphs 44(a) and 45(a) clearly prohibit inclusion of savings from restructuring for which an entity is not committed.
Publisher A has two operating segments:
- Print publishing
- Online publishing.
In November 2016, it prepares its annual budget for 2017, which shows a significant downturn in the profitability of the print publishing division. This triggers the requirement to test the print publishing assets for impairment (NZ IAS 36, paragraphs 9 and 12 (g)).
Concurrent with modelling the VIU, a plan is derived to restructure the operation and merge the print and online businesses, resulting in savings through reducing head count by 100, mainly through reducing duplication of functions (sales, admin and editorial).
At 31 December 2016 this plan has not been communicated to management, staff or to the market. Publisher A incorrectly includes the anticipated savings and concludes that there is no impairment.
Factoring in enhancements into a VIU model
Entities may also look to improve the performance of an asset by making technological enhancements to the asset. Again, NZ IAS 36, paragraph 44 assumes that cash flows are estimated for the asset in its current condition, and paragraphs 44(b) and 45(b) prohibit the inclusion of the impacts of enhancements to an asset to which it is not yet contractually committed.
In October 2016, Manufacturer forecasts operating losses in its manufacturing operation in Auckland.
Manufacturer’s factory is over 30 years old, and management recognise that in order to compete with more modern factories operating in Taiwan, approximately $100 million of investment is required.
In accordance with NZ IAS 36, paragraph 9, the manufacturing operation is tested for impairment. The VIU includes the cost of $100 million for the required factory enhancements, together with the adjusted capacity and operating costs, and revenue forecasts from these enhancements.
This shows there is no impairment. The entity is in the process of selecting the supplier for these enhancements (i.e. not yet committed).
These enhancements cannot be included in the VIU model because they do not represent cash flows of the refinery in its current condition.
Not including refurbishment costs (day-to-day servicing)
A CGU comprises a mine, mining equipment, a processing plant and trucks.
The mine has a forecast useful life of 20 years.
The processing plant will require a midlife overhaul after ten years and trucks will need to be fully replaced after ten years.
The VIU model incorrectly excludes the cost of the mid-life refurbishment of the processing plant and the cost of replacing the trucks in ten years.
A hotel owner estimates the useful life of its hotel to be 20 years.
It uses a VIU model showing a steady revenue stream between years six and 20, assuming that it will be able to operate as a five star hotel in that city, and that demand and supply for hotel beds will remain in equilibrium.
In order to maintain its position as a five star hotel, it forecasts that it will have to undertake significant renovations every seven years to both its rooms and food and beverage outlets.The VIU model incorrectly excludes the cost of these refurbishments.
Including cash inflows or outflows from financing activities in the VIU model
Entity J borrows $100 million to finance the construction of its new factory.
It incurs cash outflows of $10 million per annum servicing this debt.
It wrongly includes these cash outflows in its VIU model.
Entity K forecasts that its operation will generate significant cash surpluses which it intends to place on deposit in high yield fixed rate bonds. It wrongly includes the forecast interest income in its VIU model.
Treatment of income tax receipts or payments
As the VIU model must use the pre-tax interest rate, it is incorrect to include cash receipts or payments in respect of income tax.
Entity L has a CGU with a carrying value of $10 million and determines its VIU to be $4,058,000 by wrongly including a 30% tax charge. It recognises an impairment loss of $2,942,000.
The above VIU model should have recorded no impairment charge because without the deductions for tax payments, the recoverable amount would have exceeded $10,000,000 (refer table below).
Estimating the net cash flows to be received (or paid) for the disposal of an asset at the end of its useful life
Entity M prepares the following VIU model for a CGU with a carrying amount of $10 million.
It determines the recoverable amount to be $9,773,000 and recognises an impairment loss of $227,000.
The VIU model incorrectly excluded the forecast scrap value ($500,000) of disposing of all of the assets that should have been included in the VIU model. This resulted in a VIU of $10,083,000 with no impairment write-down.
Estimating the fair value
Entity N prepares the following VIU model for a CGU with a carrying amount of $10 million.
It determines the recoverable amount to be $10,083,000 assuming that the scrap value of the equipment, including the impact of inflation, over the next five years of 5% per annum is $500,000.
The discount rate of 10% excludes inflation. Therefore the estimated fair value of the sale value of the asset should not have been adjusted for inflation and should instead have been recorded at $300,000 with an impairment loss of $41,000 (refer table below).
Foreign currency future cash flows
Entity O has an asset with a carrying value of $10 million.
It has cash inflows in USD and translates the forecasted cash flows at the forward rates available for the next two year period, then takes a consensus view with a steady weakening of the New Zealand dollar. The VIU recoverable amount is calculated as $11,892,000 and Entity O records no impairment loss.
The spot rate was 0.74 and the VIU impairment model should have been as follows:
This results in a recoverable amount of $9,282,000 and an impairment loss of $718,000.