On improving compliance with impairment disclosures
By Benjamin N. Villacorte
First Published in Business World (8/5/ 2013)
THE OVERALL objective of general purpose financial reporting is to provide reliable and relevant financial information about the reporting entity to help various users make informed decisions. The quality of disclosures in the financial statements enhances the usefulness of financial information presented in the financial statements.
In January 2013, the European Securities and Markets Authority (ESMA) released its report, “European enforcers’ review of impairment of goodwill and other intangible assets in the International Financial Reporting Standards (IFRS) financial statements,” which examined the accounting practices of a sample of 235 European issuers from 23 countries. The ESMA is responsible for coordinating the IFRS compliance activities of regulators from the European Economic Area.
The report disclosed that despite the global financial crisis and the resulting poor economic outlook, significant impairment losses in 2011 were limited to a handful of issuers. This raised questions on whether impairment losses were timely and appropriately recognized, and whether the level of impairment disclosed in the 2011 financial statements appropriately reflected the difficult economic operating environment for companies.
The report, however, did not directly answer these questions. It instead focused on the quality of disclosures in the financial statements. Disclosures were criticized for being “boilerplate,” not entity-specific, and in some cases, not compliant with the requirements of International Accounting Standard (IAS) 36, Impairment of Assets.
Below is a brief overview of the major areas on impairment disclosures covered in the report:
Disclose key assumptions properly. Key assumptions are ones to which the recoverable amount is most sensitive, such as discount rates and long-term growth rates. Management must disclose its approach to determining the underlying assumptions from which the cash flows are derived, e.g. assumptions about sales volumes, prices, and margins and the extent to which they reflect past experience and external sources of information.
Be specific about the discount rates. Entities must disclose the discount rates that apply to each cash generating unit (CGU) or CGU group to which a significant amount of goodwill or intangible assets with indefinite lives has been allocated. A CGU is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. It is neither acceptable to disclose a range of discount rates for CGUs or CGU groups, nor appropriate to disclose a single weighted average discount rate. This practice potentially obscures information that may be relevant to financial statement users.
Be careful with long-term growth rates. IAS 36 states that, unless a higher rate can be justified, this rate must not exceed the long-term average for the product, industry or country. Using overly ambitious and optimistic long-term growth rates may lead to overstated recoverable amounts, and impairment losses are not identified. It is important that companies provide realistic estimates of future growth rates that correspond to forecasts of economic development.
Improve the quality of disclosures about cash flows when applying fair value less costs of disposal (FVLCD). In impairment assessments, IAS 36 requires the carrying amount of the asset to be compared with the recoverable amount, which is the higher of value in use (VIU) and FVLCD. VIU is the present value of the future cash flows expected to be derived from an asset or CGU. If entities use a discounted cash flow (DCF) approach to calculate FVLCD, they have to make similar disclosures to those for VIU. Entities need to disclose the period over which management has projected the cash flows, the growth rate used to extrapolate them and the discount rate. Key assumptions, management’s approach in determining them, and the level in the fair value hierarchy — i.e., whether valued using quoted prices, valued using inputs observable in the market or valued using inputs that are not observable in the market — must always be disclosed.
The sensitivity analysis should be relevant and realistic. IAS 36 requires an entity to make additional disclosures if a “reasonably possible change in a key assumption” could reduce the recoverable amount to be equal to the carrying amount (in other words, erode all headroom). The entity must disclose the headroom and the value assigned to the key assumption and the amount by which that value must change to erode the headroom. Management should be realistic about the possibility of changes in key assumptions eroding the headroom.
Although these disclosures are required for a single key assumption, entities should take into account the consequential effects on other variables. They may then consider whether it is more meaningful to make similar disclosures for a combination of changes in key assumptions (i.e., scenario-analysis). Some entities may elect to show the effect of a percentage change on assumptions. While this is useful additional information to assist users in assessing the reliability of the impairment review, it cannot substitute for the standard’s requirement to disclose sensitivity analysis for a possible change in the key assumptions that could lead to, or increase, an impairment charge.
What, then, are the main lessons from the report? First, companies should start considering, from the local business perspective, the findings of the ESMA report in their preparation of financial statements. Second, companies should focus on the rigor in impairment test of goodwill and other intangible assets, the reasonableness of cash flow forecast and key assumptions, the relevance and appropriateness of sensitivity analysis and the sufficiency and relevance of disclosures. This would require greater managerial involvement to avoid the tendency to use boilerplate language.
All these improvements in compliance with impairment disclosures should increase the ability of financial statement users to evaluate the reliability of management’s judgments and estimates on impairment of assets, and thus, make more informed decisions.
Benjamin N. Villacorte is a senior director 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.