In this instalment of the Company Director accounting insight series, Nicci Steele explains how to calculate the true value of assets
How confident are you that the value of the assets on your company’s balance sheet is justifiable? This is a question for all directors.
Prior to each profit reporting season, the Australian Securities and Investments Commission (ASIC) releases a report that lists the areas it will focus on when assessing the financial reports of companies. It highlights the issues directors, auditors and chief financial officers need to consider when preparing a financial report.
Asset values and the impairment of assets have consistently been on this list. Impairments can have a significant impact on financial results and reduce a reported profit. These write-downs in asset values impact analysts’ ratings, buy/sell recommendations and may reduce key earnings ratios, including price/earnings ratios, and earnings per share.
ASIC’s report for the 31 December 2014 reporting period stated: “ASIC continues to find impairment calculations that use unrealistic cash flows and assumptions, as well as material mismatches between the cash flows used and the assets being tested for impairment. Particular focus should be given to assets of companies in extractive industries and mining support services, as well as asset values that may be affected by digital disruption.”
An asset is impaired when its value, either through use or sale, is less than the value recorded on the balance sheet (its carrying value). Impairment testing is the process and calculation of the amount by which the asset is to be reduced. Impairment testing is required for those assets that are not measured at fair value.
The accounting standards relevant when considering impairment are AASB 138 Intangible Assets, AASB 3 Business Combinations and AASB 136 Impairment of Assets. For inventories and accounts receivable it is pretty simple. The question is, what can I sell my inventories for and what are my customers going to pay me to settle their debts? It is for intangible assets, like acquired goodwill and other intangibles (for example, acquired mining rights and IT assets), that the calculations, judgments and estimates become significantly more complex. Directors need to consider inputs to the calculations and whether they are appropriate according to the directors understanding of the business.
AASB 136 requires that intangible assets with an infinite useful life should be tested at least annually and whenever there is an indication of impairment. AASB 136 sets out possible internal and external factors that may indicate impairment, including significant changes to the technological, market, economic or legal environment; obsolescence or physical damage of an asset; financial results not achieving previous expectations; or plans to discontinue or restructure the operation to which the asset belongs. Once the company has determined an asset may be impaired, it needs to calculate the recoverable amount. Accounting standards define the recoverable amount as the higher of the asset or cash-generating unit’s fair value, less costs to sell or its value in use.
An asset’s fair value is calculated by considering the hypothetical price that would be received between two independent market participants less the direct incremental costs of disposal. In determining the value in use, a company would calculate the present value of future cash flows expected to be derived from the asset or cash-generating unit. Common pitfalls in the impairment calculations include not using the right discount rate and ignoring the impact of tax issues on the calculations.
The top 10 questions to ask when reviewing an impairment calculation
1. What external and internal factors impacting on the company may indicate that the assets may be impaired?
2. How was the impairment calculation prepared?
3. How did we determine the cash-generating unit? Is this at the right level?
4. What discount rate did we use? How does this compare with our expectations?
5. How have the forecasts of costs and resulting benefits been calculated and are they reasonable?
6. Did we use an expert to assist with the calculations? Do they have the appropriate experience and qualifications to perform such a calculation?
7. What assumptions have we made? Are these assumptions reasonable?
8. What do our auditors think about this valuation?
9. How confident are we that the valuation reflects what someone may be willing to pay for the assets?
10. What will we disclose in the financial report about the impairments?
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