Blind Freddy – Common errors in accounting for impairment – Part 1

The whole essence of the ‘Blind Freddy’ series is to highlight instances where, despite the accounting standards being very clear on a particular accounting treatment, preparers regularly ignore the clear instructions in the standard, resulting in their financial statements being potentially materially misstated.

Perhaps the most common situation where this occurs is testing for impairment and application of AASB 136 Impairment of Assets. 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 that ‘Blind Freddy’ could recognise, 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’.

This month we will discuss the first ‘Blind Freddy’ error, i.e. not testing for impairment when the standard clearly requires it. We will discuss the remaining errors in future newsletters.

Basic requirement of AASB 136

The basic requirement of AASB 136 is very simple.

‘An asset is impaired when its carrying amount exceeds its recoverable amount.’

AASB 136, paragraph 8

Not testing for impairment, when the standard clearly requires it

There are five basic situations where AASB 136 requires an asset to be tested for impairment:

The asset is goodwill
The asset is an intangible asset with an indefinite useful life
The asset is an intangible asset not yet available for use
There are external indicators that an impairment trigger has taken place
There are internal indicators that an impairment trigger has taken place.

Testing goodwill for impairment

AASB 136 clearly says:

‘Irrespective of whether there is any indication of impairment, an entity shall also test goodwill acquired in a business combination for impairment annually in accordance with paragraphs 80–99.’

AASB 136, paragraph 10(b)

A common error is to assume that goodwill acquired during the current financial year is not subject to an impairment test. This is not true. All goodwill is subject to impairment testing, even if it arose as a result of a business combination during the current year.

Testing an intangible asset with an indefinite useful life for impairment

AASB 136 also clearly says:

‘Irrespective of whether there is any indication of impairment, an entity shall also test an intangible asset with an indefinite useful life for impairment annually by comparing its carrying amount with its recoverable amount…’

AASB 136, paragraph 10(a)

Therefore entities with intangible assets that they have determined to have indefinite useful lives, and are not amortising, must perform an impairment test on these brands, mastheads, licences, etc.

Testing an intangible asset not yet available for use

‘Irrespective of whether there is any indication of impairment, an entity shall also test an intangible asset not yet available for use for impairment annually by comparing its carrying amount with its recoverable amount…’

AASB 136, paragraph 10(a)

Note that this requirement also applies to entities capitalising development costs under AASB 138 Intangible Assets. It also raises the question of whether development of a mine is a tangible or intangible asset, remembering that at the point in time when an exploration and evaluation asset transfers to the development phase, it must be tested for impairment under AASB 6 Exploration for and Evaluation of Mineral Resources.

There are external indicators that an impairment trigger has taken place

At each reporting date (this includes the half-year), an entity is required to assess whether there is any indication of impairment. This includes goodwill and indefinite life intangibles.

‘An asset is impaired when its carrying amount exceeds its recoverable amount. Paragraphs 12–14 describe some indications that an impairment loss may have occurred. If any of those indications is present, an entity is required to make a formal estimate of recoverable amount.’

AASB 136, paragraph 8

‘An entity shall assess at the end of each reporting period whether there is any indication that an asset may be impaired. If any such indication exists, the entity shall estimate the recoverable amount of the asset.’

AASB 136, paragraph 9

External indicators of impairment

‘In assessing whether there is any indication that an asset may be impaired, an entity shall consider, as a minimum, the following indications:

External sources of information

there are observable indications that the asset’s value has declined during the period significantly more than would be expected as a result of the passage of time or normal use.
significant changes with an adverse effect on the entity have taken place during the period, or will take place in the near future, in the technological, market, economic or legal environment in which the entity operates or in the market to which an asset is dedicated.
market interest rates or other market rates of return on investments have increased during the period, and those increases are likely to affect the discount rate used in calculating an asset’s value in use and decrease the asset’s recoverable amount materially.
the carrying amount of the net assets of the entity is more than its market capitalisation.’

AASB 136, paragraph 12(a) to (d)

The above non-exhaustive list raises a number of ‘Blind Freddy’ conditions where, if one of the events listed above has occurred, an impairment test must take place. This is in addition to the usual annual impairment testing of goodwill.

If your net assets are greater than your market capitalisation, you must test for impairment.

You can also see from AASB 136, paragraph 12(b) requirements above, that an external indicator of impairment is ‘significant changes with an adverse effect on the entity have taken place during the period, or will take place in the near future, in the technological, market, economic or legal environment in which the entity operates or in the market to which an asset is dedicated.’ This requires you to perform impairment tests in advance of actually being impacted by new technology or new legislation, and arguably, impairment write- downs should occur at least a year in advance of operating losses.

There are internal indicators that an impairment trigger has taken place

AASB 136, paragraph 12 goes on to list the following internal indicators of impairment:

Internal indicators of impairment

‘In assessing whether there is any indication that an asset may be impaired, an entity shall consider, as a minimum, the following indications:

Internal sources of information

evidence is available of obsolescence or physical damage of an asset.
significant changes with an adverse effect on the entity have taken place during the period, or are expected to take place in the near future, in the extent to which, or manner in which, an asset is used or is expected to be used. These changes include the asset becoming idle, plans to discontinue or restructure the operation to which an asset belongs, plans to dispose of an asset before the previously expected date, and reassessing the useful life of an asset as finite rather than indefinite.
evidence is available from internal reporting that indicates that the economic performance of an asset is, or will be, worse than expected.’

AASB 136, paragraph 12(e) to (g)

These requirements highlight the importance of tying internal budget information into impairment testing assessments and calculations. Failing to do so may result in ‘Blind Freddy’ errors, for example, if you have no impairment write-downs but you have internal budgets showing that:

The asset is not as profitable as budgeted
The asset has cost more to construct than was budgeted, or
The asset has taken longer to construct or get into production than budgeted.

‘Evidence from internal reporting that indicates that an asset may be impaired includes the existence of:

cash flows for acquiring the asset, or subsequent cash needs for operating or maintaining it, that are significantly higher than those originally budgeted;
actual net cash flows or operating profit or loss flowing from the asset that are significantly worse than those budgeted;
a significant decline in budgeted net cash flows or operating profit, or a significant increase in budgeted loss, flowing from the asset; or
operating losses or net cash outflows for the asset, when current period amounts are aggregated with budgeted amounts for the future.’

AASB 136, paragraph 14

Again, preparers must realise that impairment testing is required to consider planned future events such as disposals, reorganisations, etc. If there are plans to close a facility early, or to undertake a major refurbishment of that facility, an impairment test must be performed.

It must also be recognised that this list is not exhaustive.

‘The list in paragraph 12 is not exhaustive. An entity may identify other indications that an asset may be impaired and these would also require the entity to determine the asset’s recoverable amount or, in the case of goodwill, perform an impairment test in accordance with paragraphs 80–99.’

AASB 136, paragraph 13

Next month

In next month’s Blind Freddy article we will look at the common error of not testing for impairment at the correct ‘unit of account’.