“Challenges in impairment reporting” by Cyril Jasmin B. Valencia (May 21, 2012)
SUITS THE C-SUITE By Cyril Jasmin B. Valencia
Business World (05/21/2012)
There may be signs that the global economic environment is recovering, but to many, such a recovery would seem slow and unsturdy. Scarcity of capital and greater aversion to risk are driving investors and lenders to focus on reliable information for investment decisions. But the need to have a reliable basis for valuing businesses and underlying assets is more challenging today, due to long-drawn out uncertainty resulting in difficulty in coming up with reasonable valuation assumptions.
With the economic uncertainty, users of financial statements are more skeptical about the levels of impairments being disclosed. Information may include revenue projections, mid- to long-term growth and strategic plans that are closely examined and compared with peers. When one reads the financial statements of a company, the big items in the statements of financial position will, more often than not, be property, plant and equipment, investments in subsidiaries, goodwill and investment properties. That said, how do companies assure users of financial statements that the reported assets are fully recoverable?
Philippine Accounting Standard (PAS) 36, Impairment of Assets, prescribes the procedures that a company should apply to ensure that its assets are carried in the books at no more than their recoverable amount or the amount that can be recovered through use or sale of the asset. Otherwise, the asset is described as impaired, and PAS 36 requires the entity to recognize an impairment loss. PAS 36 also specifies when an entity may reverse an impairment loss. It also prescribes impairment-related disclosures.
At the end of each reporting period, a company is required to assess whether there is any indication that an asset may be impaired. If any such indication exists, the company should estimate the recoverable amount of the asset. There is, however, a special requirement for impairment testing of intangible assets with indefinite useful life and goodwill acquired from business combination, due to the fact that these assets are not amortized. Regardless of whether there is any indication of impairment for these intangible assets and goodwill, these should be tested for impairment annually by comparing their carrying amounts with their respective recoverable amounts.
PAS 36 provides examples of indicators of impairment. The list provided by the standard is not exhaustive and other events that may have valuation implications, such as business prospects, restructuring plans and defaults in debt covenants, should be considered.
The process of impairment testing requires significant judgment, assumptions and input from the company. Critical assumptions which drive impairment testing are discount rates, cash flow forecast, foreign exchange rate forecast, terminal values, fair values, and costs to sell. Because of the extent of the company’s judgments in the inputs to the impairment process, users of financial statements may be more inquisitive, demanding more transparency and discussion of the assumptions that management makes about the company’s future. They will refer to various sources of information to validate the assumptions and sensitivity analysis used. Companies should therefore be ready for increased scrutiny and should present reasonable assumptions and coherent information.
In order to build such confidence in investors, lenders, analysts, regulators and other users of financial statements, it is vital that a robust impairment testing process is integrated into the company’s system. Below are the steps and the challenges that maybe encountered in each step:
• Involve the other functions of the organization. While the accounting and finance team are the process owners, input from other departments such as sales, business development, asset management and purchasing department is critical. In the case where recoverable value is from continuing use of the asset, these functions will be able to provide information on market-driven assumptions like forecasted sales, sales mix, pricing and the assumed market share. It should be noted, however, that cash flows from products to be produced by assets which are yet be constructed or invested in should be excluded from the impairment testing exercise because the cash flows should be generated by the assets being tested. In case the recoverable amount will be based on fair value less cost to sell, the asset management or purchasing department will be the best source of the fair values based on recent market transactions for the same assets with the estimated cost of sales considering their experience in purchasing these assets and their existing network.
• Build proficiency in the impairment process. Robust knowledge of the impairment process and requirements under PAS 36 is important. There should be a designated person who will perform the impairment testing every year. This person should update his or her knowledge on the requirements of PAS 36 considering the continuing changes in the accounting standards. A valuation specialist should be consulted as well. The latter’s input will be critical in the selection of the appropriate valuation model and the appropriateness of the discount rate used.
• Involve top level management and integrate forecasts with capital management and company plans. Cash flow forecasts are usually used in management committee or board of directors meetings. Such forecasts should be in line with the strategic plans and capital management of the Company as approved by senior management. There should be caution that such approval should be as at or near the impairment testing date and if not, assumptions should be updated based on revised and approved plans as of the testing date.
• Ensure availability of reliable information. The company should have reliable and steady sources of information for forecasting market rates, economic and industry trends. They can subscribe to financial information websites or terminals for up-to-date information or have direct communication with banks that can provide the most recent data. Subscription to market data providers will also be helpful in gathering economic and industry trends.
• Determine the impact on other areas of financial reporting. Possible impairment in an asset may also indicate that the remaining useful life, the depreciation (amortization) method or the residual value for the asset needs to be reviewed and adjusted in accordance with the standard applicable to the asset, even if no impairment loss is recognized for the asset.
• Communicate information that stakeholders need. Users of the financial statements will require improved and transparent disclosures of the assumptions used and sensitivity analyses performed. In some cases, companies avoid giving away information which are strategic or might be useful to competitors. Management, however, should find a way to balance its responsibilities to include in the financial statements the detailed disclosure requirements of PAS 36 and making strategic information available to the public.
If companies focus successfully on these areas and provide transparent disclosures in financial statements, they can build greater confidence and trust in stakeholders which, ultimately, will lead to better access to capital.
Cyril Jasmin B. Valencia is a Partner of SGV & Co.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.