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Assessing the recoverable amount for non-financial assets

Mike Thornton Mike Thornton

Current events are creating serious challenges for businesses, and financial performance is likely to be significantly affected by the direct or indirect impacts of these events. It won't, however, just be your finances that could be harmed, but also your non-financial assets, explains Michael Thornton.

Both IAS 36, ‘Impairment of Assets’, and Chapter 27 of FRS 102,’ 'The Financial Reporting Standard applicable in the UK and Republic of Ireland’, seek to ensure that an entity’s assets are carried at not more than their recoverable amount (ie, the higher of fair-value, less costs of disposal and value in use).

Under IAS 36, entities perform annual impairment assessments of goodwill, intangible assets with an indefinite useful life and intangible assets not yet available for use. As a result of the impact of COVID-19, entities may also need to perform an impairment assessment of other non-financial assets in addition to the annual requirement. Entities reporting under FRS 102 may have to carry out additional impairment reviews.

Assessing recoverable amount

It is recognised that sometimes it will not be possible to measure fair value less costs of disposal under IAS 36, because there is no basis for making a reliable estimate of the price at which an orderly transaction to sell the asset would take place between market participants at the measurement date under current market conditions. If the entity chooses to use the market method using comparable company benchmarks, then in the current uncertain conditions, it may well be challenging to make that reliable estimate. In that case, the entity may use the asset’s value in use as its recoverable amount.

In contrast, where a potential impairment is identified under UK GAAP, FRS 102 requires an entity to determine both the fair-value less costs to sell and the value in use of either an asset or a cash generating unit. The exception being when management considers that the value in use will not be materially higher than the fair-value less costs to sell valuation.

When value in-use is used by management to estimate the recoverable amount, the forecasted cashflows should reflect management’s best estimate of the economic conditions that will exist over the remaining useful life of the asset based on conditions that existed at the balance sheet date.

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Cashflow projections

Careful consideration of the cashflow projections is essential in terms of the supportability and reasonableness of the calculations given the current market conditions. In particular, the projected cashflows need to be defensible based on what was known or could have reasonably been known at the reporting date of the conditions that existed as at that date.

Appendix A of IAS36 sets out two approaches that can be used to help determine present value:

1 The traditional approach, which uses a single cashflow projection, or most likely cashflow

2 The expected cashflow approach, which uses multiple, probability-weighted cashflow projections

Both above approaches can also be used by entities that report under FRS 102.

The expected cashflow approach to non-financial assets

Given the high degree of uncertainty due to the current conditions, it may be beneficial to

consider applying the expected cashflow approach as opposed to the traditional approach. Under the traditional approach, risk in relation to the cashflows is reflected in the estimation of the discount rate. Under the expected cashflow approach, the uncertainty about future cashflows can be reflected in the probability-weighted cashflow projections used, rather than in the discount rate.

The expected cashflow approach can, therefore, provide a better reflection of the range of possible future outcomes and can allow for both short- and long-term impacts. However, the probabilities that are applied to the cashflow projections equally need careful consideration and thought.

By using an expected cashflow approach, the financial impacts of COVID-19 can be modelled, however, it is not without complications.

Key items to consider in cashflow forecasting:

  • How long and to what extent will revenues be impacted by COVID-19?
  • What are the challenges to cash collection?
  • Can cost savings be put into place?
  • What government assistance will be available and for how long?
  • When is it realistic to assume economic activity and the business financial performance may return to previous levels, if ever?

Determining discount rate

The discount rate used in a single predicted outcome approach may need to be adjusted to incorporate the uncertainty of the forecast cashflows associated with COVID-19. Management should ensure that appropriate risk is reflected in either the cashflows or the discount rate. Care should be taken not to double-count risk. If cashflows have been adjusted for the impact of the crisis then the discount rate should reflect those forecasts.

Many entities use the capital asset pricing model to determine the discount rate. One of the key elements is the risk-free rate that is generally based on the yield on government bonds. In many countries, the yield on long-term government bonds has decreased in the first quarter of 2020. For example, 10-year UK government bonds are at 0.23% on 30 April 2020 compared to 0.74% on 31 December 2019.

The decline in the risk-free rate does not, however, necessarily lead to a lower discount rate as there are potential increases in other inputs, such as the equity market-risk premium, that need to be considered together with, for example, possible increases in credit risk.

Supported valuation conclusions

Whichever approach management chooses to use to address possible variations in the expected future cashflows, ultimately the conclusion needs to be supported and to be reasonable, reflecting the expected present value of the future cashflows of the asset or group of assets being tested.

If you would like to discuss this further, get in touch with Michael Thornton.

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