Impairment of Assets and Goodwill
2(a) Why should asset impairment losses be accounted for in IFRS financial statements? Analyze the different circumstances that could indicate that an entity's assets may have been impaired.
Impairment of an asset occurs when the carrying value exceeds the actual recoverable amount of the asset (Norton, Diamond and Pagach, 2006, pp. 418). The carrying amount which is the amount reflected in the balance sheet is the original amount less the accumulated depreciation and impairment losses to date. The recoverable amount on the other hand refers to the amount that is higher of the assets fair value less associated selling costs and the asset’s value in use. The fair value refers to the amount the owner of an asset would sell the good at in the market place in an arm’s length transaction. The value in use of the asset is what the business expects in terms of cash flows in the future and the disposal price of the asset when it comes to the time of selling the asset.
Impairment of assets and treatment in the financial assets is covered in IAS 36. The standard covers impairment of assets such as land, buildings, machinery and equipment, investment property, intangible assets and goodwill. Impairment should also be disclosed in financial statements where it occurs in a company’s subsidiaries, associates, joint ventures that were reflected at cost. Assets that have also been re-valued under IAS 16 and IAS 38 where impairment has occurred, this should also be recorded.
A company asset may be impaired or lose part of its value and the impairment loss should be recorded in the financial statements.
It is important that the disclosure be made in order for the financial statements to show the true and fair value of the business. There are internal and external indicators of impairment of an asset. Looking at external indicators of impairment, the stock price may be lower than the book value. There may also be a decrease in the market value of the asset. Adverse changes in technological, legal or business environment thus affecting the worth of the asset (Duchac, Reeve and Warren, 2006, pp. 538).
Another indicator is increase in the market interest rates. Internal indicators of impairment of an asset are obsolescence and physical damage to the good. The asset performs economically worse than expected. The business realises that there shall be current, historical or future operating or cash flow losses from the asset. There will be significant cost overruns in use of the asset. Another indicator is where the asset is part of a restructuring process or it is expected to be disposed.
(b) The entity ABCD is preparing its annual IFRS financial statements to 31 December 2010. The following situations have been identified by the internal impairment review team:
On 1 January 2010 ABCD acquired two subsidiary companies, XA and WB, in separate transactions. Consolidated goodwill was calculated as follows:
Purchase Price: XA ($m) 12 and WB ($m) 4.5
Estimated Faire Value: XA ($m) 8 and WB ($m) 3
Consolidated goodwill: XA ($m) 4 and WB ($m) 1.5
A review of the fair value of each subsidiary's net assets was undertaken in December 2010. Unfortunately, both companies' net assets had declined in value. The estimated value of XA's net assets as at 1 January 2010 was now only $7 million.
This was due to more detailed information becoming available about the market value of its specialized properties. WB's net assets were estimated to have a fair value of $500,000 less than their carrying value. This fall was due to some physical damage occurring to its plant and machinery.
The carrying value of goodwill in the financial statements should be the fair value less impairment loss. Purchased goodwill is the difference between the value of the net assets of the subsidiary and the purchase price of the subsidiary. There should be an annual review of the goodwill of the subsidiary so that the company ensures that the goodwill asset is not being overstated in the group accounts. The company will compare the fair value of the enterprise with the book value of the enterprise including goodwill.
Goodwill has to be capitalised in the financial statements. This is required by the accounting standards. Goodwill is a peculiar asset in that it is not amortised. The amount of goodwill is not apportioned to different time periods the way the cost of an asset is depreciated over a period of time. The impairment loss is calculated and reflected as a loss in the income statements (Nikolai, Bazley and Jones, 2009, pp. 574).
Indicators of impairment of goodwill may be loss of key personnel, unanticipated competition or adverse legal and economic changes in the external environment. The impairment loss goes to reduce the income in the consolidated profit and loss statements. Secondly the amount of goodwill in the equity statements should be reduced to reflect the correct value.
The consolidated goodwill that will be reflected in the accounts will be as follows:
Assuming the company had purchased 80% of the subsidiaries then the group company will only be concerned with the 80% impairment loss. The impairment loss for XA limited is $8-$7=$1M. The impairment loss for WB is $500,000. Therefore the reflected impaired goodwill in group accounts is 80% of $1M and $500,000= $800,000 and $400,000. The goodwill reflected in the accounts was 80% of $4 and $ 1.5 which is $3.2M and $1.2M as follows:
ABCD has an item of earth-moving plant, which is hired out to companies on short-term contracts. Its carrying value, based on depreciated historic cost, is $400,000. The estimated selling price of the asset is only $250,000 and there would be associated selling expenses of $5000.
Discuss, with numerical illustrations where possible, how the information above would affect the preparation of ABCD's consolidated financial statements to 31 December 2010.
The carrying value of the asset has now gone down. The carrying value of the asset in the financial statements should now be reflected as the estimated market value less the selling expenses. In the statements the value reflected will be $250,000-$5,000=$245,000. The impairment loss is therefore $400,000- $245,000 =$155,000. The company will also have to recalculate the depreciation amount annually that will be used to reflect the carrying value of the asset. If the asset had a useful life of 10 years remaining with no scrap value, the depreciation that was used before was: $400,000/10 =$40,000. The new depreciation cost annually will be $245,000/10 =$24,500.
Compare and contrast this formulation with that of 1AS 37 in respect of provisions.
According to IAS 37, a provision is planned future expenditure that must be recognized in the financial statements. A liability will involve future outflow of cash resources however the timing of payment is not known but the amount can be estimated. This definition is similar and different to the Article 20(1978). Under IAS, the amount should be known or can be estimated while in Article 20, the amount is uncertain. However, for both IAS 37 and Article (20), the origins of the transaction must have already occurred.
FAMI SA prepares IFRS financial statements with a reporting date of 31 December 2010. Assess, in the following two situations, whether or not a provision should be recognized (and if so, how much) in the 2010 financial statement:
(i) On 30 November 2010, the board of directors decided to close down one of the company's operations. This would involve redundancy payments being made of $375,000. A detailed plan for closure was drawn up by the board but it was neither announced nor acted upon before the end of 2010.
Under IAS 37 which covers provisions, contingent liabilities and contingent assets a company should make a provision based on the past events that have created a liability. Contingent liabilities on the other hand refer to a possible obligation that may occur based on some probable event occurring in the future. When the event occurs is when a liability will crystalize for the company to pay. The amount of the liability cannot also be ascertained with clarity.
An example of a contingent liability is where a company may have been sued for malpractice and the case is under deliberation in the courts (Stolowy and Lebas, 2006, pp. 416).
It is probable the plaintiff may win; the amount may not be known with certainty.
A contingent asset refers to an asset which may arise out of past events. The existence of the asset depends on the occurrence of an event in the future for which the company may have no control over. These contingent assets and liabilities should be reflected in the financial statements only as notes to the financial statements so that the users may understand and know their nature, timing and amount.
A provision should only be created for a liability when three conditions are met. It should be a liability that arises out of past events. Secondly, the amount can be estimated reliably and the payment is more likely than not. The redundancy payments do not satisfy the three conditions therefore it should not be reflected as a provision in the financial statements. The board of directors just drew a plan for closing one of the company’s operations however it was not acted upon. It is not a past event. It has not yet occurred. It may crystallize in the future or it may not depending on other future events.
The directors of the company however should disclose the future plans in the notes to the financial statements so as to let the stakeholders know the state of the company affairs. It is also good to mention the expected future liability so that every stakeholder is aware of the amount of redundancy payments. The redundancy payments are therefore contingent liabilities that are dependent on the occurrence of the closure of the company operations in the future.
(ii) At 31 December 2010, FAMI owns and controls a fleet of motor trucks, all of which require an annual service. The servicing work is expected to occur in the first few months of the financial year 2011, at an estimated cost of $250,000.
Annual service costs should affect the period for which they refer to. Although the payment will be made next year it should be accounted in the year 2010 and not 2011. The company needs to follow the matching concept of accounting. It is a principle that states the expenses and incomes of the business should be matched to the specific period in which they were incurred or earned respectively (Bierman, 2010, pp. 92). This is done to ensure that the profit calculated at the end of the year reflects the actual and correct profit that was earned that year.
A provision therefore needs to be created in the financial statements. The amount of the liability of the company is known, it is $250,000. However the timing of the payment of the annual service expense to the service provider or third party is unknown. The company accountants cannot tell the exact date that the costs will be paid. Where a liability is known but the timing of the payment or the amount to be paid is uncertain, then the provision needs to be created. The company should provide for the whole amount of $250,000 since the amount is known. The provision should not be understated or overstated as this will distort the financial statements unnecessarily.
The annual service expense costs will therefore be reflected in the 2010 financial statements. Its impact will be to reduce the income or profit earned in the year 2011. This will therefore reduce the retained profit for the year that will be reflected in the equity statements. The provision will be shown in the equity statements as at the end of the year under the item “Current Liabilities”.
Bierman, H. (2010). An Introduction to Accounting and Managerial Finance: A Merger
of Equals. Singapore: World Scientific Publishing Company.
Duchac, J., Reeve, J. and Warren, C.(2006) Financial accounting: an integrated
statements approach. Mason: Thomson-Southwestern publishing.
Nikolai, L., Bazley, J. and Jones, J. (2009). Intermediate Accounting. United States:
South-Western College Publishers.
Norton, C., Diamond, M. and Pagach, D. (2006). Intermediate accounting: financial
reporting and analysis. United States: South-Western College Publishers.
Stolowy, H. and Lebas, M. (2006). Financial accounting and reporting: a global
perspective. United States: Cengage Learning Business Press.