Impairment of assets

Asset impairment is not usually a first priority for accountants or financial experts. It is considered to be a topic for auditors and management. It can be agreed that it is management that is responsible for accounting estimates and that impairment is one of the critical issues in financial accounting. However, from experience, management does not always have sufficient knowledge in this area and relies on the involvement of accountants, financiers. We will therefore look at the most important aspects and also the most common mistakes made in impairment testing.

The Annual Accounts and Consolidated Annual Accounts Act (AAR) classifies both the annual depreciation of non-current fixed assets and the additional recognised depreciation or impairment of any assets as impairment. For the purposes of this article, an impairment is a situation where the recoverable amount of an asset is less than the residual value of that asset in the financial statements, which would result in the recognition of an additional impairment loss.

Principles for determining impairment

Receivables

The APR requires the recognition of impairments when making provisions for receivables the receipt of which is in doubt. Cabinet of Ministers (Cabinet of Ministers) Regulation No. 775 "Regulations for the Application of the Law on Annual Financial Statements and Consolidated Financial Statements" clarifies that a debt is considered unsafe, for example, if the debtor is in financial difficulties, has insolvency proceedings, the debt has not been paid within the specified time limit or after a reminder or the debtor has contested the existence of the debt.

In general, these principles are clear, but require significant management judgment regarding the determination of the "doubtful debtors" criteria and the amount/percentage of impairment for each of these criteria.

It should also be noted that this method may also not give a true picture of the fair value of the assets, since it does not provide for the assessment of cases where there is as yet no reason to consider the debtor to be doubtful, but there is a likelihood that the carrying amount of the assets will not be recovered in full. For example, based on historical information, a real estate manager or payday loan lender may also not receive payment for a significant part of invoices that have not yet matured. In these cases, the company can apply the so-called expected loss model according to the international financial reporting standard No. 9 "Financial instruments". According to this method, impairment is recognized based on the probability-weighted estimate of the receivables' recoverable amount, also discounted to the present value.

Savings

Savings Under APR, inventories are valued at the lower of acquisition or production cost or net realizable value. Namely, the reduction in value should be recognized for those stocks listed in the balance sheet, which are not expected to be sold at least according to the accounting prices or used in the core business. In the regulations of the Cabinet of Ministers No. 775, it is explained that the net sales value is the estimated true (market) price of the inventory, from which the costs related to the sale, such as storage and transportation expenses, brokerage commissions, etc., have been deducted. Again, the method applied here is relatively clear, but it might require subjective estimates of the planned use/sale probability of slow-moving inventory or determining the expected selling price.

Non-current assets

 Long-term assets – fixed assets, intangible investments, capital investments – are assessed for impairment according to the net sale or use method. If the determined recoverable amount according to one of these methods is greater than the book value of the assets, then everything is in order - there is no need to reduce the value of the assets. 

Under what circumstances should it be assessed whether these assets have been impaired? The evaluation criteria are not always so obvious when comparing, for example, late payments of receivables or inventory without movement over a long period of time. 

Some signs at the asset level that asset impairment has occurred:

• the asset is damaged or is no longer used in the core business;
• the capacity of the asset / volume of use has significantly decreased;
• according to the report of an external appraiser, the market value of the asset is lower than the book value.

In addition, sale (comparable market) prices are usually not available for long-term assets, as a result of which the value-in-use method is often used in impairment tests, as well as the financial data of the company or the specific part is analyzed. Therefore, signs of asset impairment can also be analyzed at the company or macroeconomic level. Some of these signs:

• deterioration of the company's actual profitability indicators;
• budgets or forecasts prepared by management show negative trends in profitability indicators;
• significant changes in the company's industry, including technological, regulatory, market changes, such as reduced demand for the industry's products;
• adverse changes in or loss of the Company's sales markets;
• an increase in the interest rate, which will correspondingly increase the discount rate used in impairment tests.

Stages of impairment assessment 

Evaluation at the individual level 

Impairment of long-term assets is initially assessed at the individual asset level. If it is possible to determine the net realizable value of the asset and it exceeds the asset's book value, then the job is done, no additional tests need to be performed.

Example 1 

The company owns real estate - a production building with an accounting value of 1 million. euros, which the company uses in the production process. An independent appraiser has prepared an appraisal and determined the market value at 1.1 million. EUR, which is calculated based on comparable market transactions - 0.8 million. euros (with a coefficient of 50% in the evaluation), and according to the value of the renovation of the building - 1.4 million. euro (also with a factor of 50%).

For asset depreciation purposes, the determined replacement value cannot be used, as it does not correspond to either of the two accepted methods - the net sale method or the value in use method. In the example, the value according to the second method used - the determined market value according to comparable transactions - is less than the accounting value, therefore no evidence has been obtained that the decrease in value has not occurred, therefore additional impairment tests should be performed.

Example 2 

The company owns 100% shares in the capital of the subsidiary company with a total accounting value of 0.5 million. EUR, but its equity at the end of the year is negative, namely -0.8 million. euro. The biggest assets of the subsidiary company are real estate 1.5 million. in the accounting value of EUR, but its true value according to an independent appraiser's report is 3 million. euro. Largest creditors – a loan from the parent company, the accounting value of which does not differ significantly from its real value. 

In this case, the participation in the subsidiary company can be considered as an asset for which it is possible to determine the net sale value, since the fair (market) value of its assets and liabilities can be determined and there are no other factors that could significantly affect the fair value of the subsidiary company. In order to assess the value of the shares of the subsidiary company, the value of the equity capital is -0.8 million. EUR is adjusted for a positive difference between the real and accounting value of the asset (real estate) of 1.5 million. euro. As a result, the adjusted equity value is 0.7 million. euro is greater than the accounting value of the participation, therefore no impairment has been detected.

Evaluation by method of use

If it is not possible to determine the net sales value of the assets or it is lower than the book value of the assets, then it is evaluated whether the recoverable value of the assets can be determined according to the method of use.

International accounting standard No. 36 "Impairment" states that the value in use for the purposes of impairment testing can be determined for those individual assets that form a largely separate (from other assets or groups of assets) cash flow. As an example of assets that form a separate cash flow, we can mention a building that is rented out to tenants, software developed internally by the company, for which it receives licensing (rental) payments, etc.

Valuation of a group of assets 

If it is not possible to determine the value in use for individual assets, it is necessary to estimate the recoverable value of the group of assets that largely make up the separate cash flow - this group is called the "cash flow generating unit". Although very rarely realized in practice, a possible net realizable value can be determined for this group of assets. If there is no such possibility, then the use value should be assessed.

Example 3 

The company mentioned in example 1 uses a production building in its production process. Therefore, the building itself does not generate a separate cash flow, so the value-in-use method cannot be used at the asset (building) level. The company has two main product categories, the production building is used for the production of both product categories. The company does not have other significant (production) non-production types of income. Therefore, all the long-term assets (fixed assets) of the company will be included in the group of units generating cash flow - the use value of the entire company's activity must be evaluated for the impairment test of the building.

How to determine value in use? 

Value in use is the current – discounted – value of the future cash flows of an asset or cash-generating unit. In other words, the value in use shows how much the investments in the mentioned assets could be worth at the moment at the planned future cash flow of the assets and the estimated discount (yield) rate. 

How to determine value in use for asset impairment testing? The most important aspects of value-in-use calculations that should be paid attention to can be mentioned. 

• A cash flow must be prepared for the analyzed cash flow generating unit.

Example 4 

The company has two main activities - production of products and distribution of products of other suppliers. An impairment test is performed for fixed assets used for production purposes, which are part of the company's production cash flow generating unit. There is a general public budget in which it is possible to separate the cash flows of production and production distribution, but part of the costs apply to both directions. 

For the purposes of the impairment test, the cash flow related only to the production of products should be separated from the total company budget, and the corresponding part of the company's general costs should be added to it. 

• Cash flow is usually prepared based on income statement projections.

It is not necessary to include financing costs and all costs not related to cash flow, such as depreciation, etc., in the cash flow. Essentially, the analysis was performed at the level of earnings before depreciation, interest and taxes (EBITDA). Also, the cash flow is supplemented with expected long-term investments necessary to maintain assets in their current state, minus new investments in long-term assets for which a decision has not yet been made at the end of the year, as well as changes in revenues and costs related to these investments.

Example 5 

The company is depreciating a building that has been used as a three-star hotel (cash-generating unit). The management is evaluating the reconstruction of the building, as a result of which the price of rooms, hotel costs and profitability indicators will improve significantly, but the decision on the reconstruction of the building has not yet been made. For the purposes of depreciation, the management has prepared a hotel budget for the cash flow of the renovated hotel. 

Since the decision on the reconstruction of the building has not yet been made, the budget for the cash flow of the renovated hotel cannot be used. Cash flow should be prepared for the hotel in its current state.

• When the entire activity of the company or a significant part of it is defined as the cash flow generating unit, changes in the related working capital (current assets, liabilities to suppliers, etc.) in the following periods should be taken into account in the cash flow calculations (see example 7). 
• The cash flow forecast should be based on budgets prepared/approved by management. They are usually available for the next year, less often for a period of 2-3 years. It is assumed that the period that can be covered by management forecasts does not exceed 5 years. The company's management and financial staff can simplify their lives and that of the auditors by preparing well-thought-out and justified cash flow budgets in the context of checking the value of use of assets, because budgeting even in a 1-3-year perspective is often not developed for many companies. 
• After this period, cash flow can be predicted by extrapolating management budgets. Changes in income and expenditure generally use the flat or declining rate for subsequent years, unless an increasing rate can be justified. Macroeconomic indicators such as inflation or consumer price growth forecasts are often used. According to another approach, cash flows are not prepared for the entire period, but so-called terminal value calculations are applied to periods outside the budgeted years. Terminal value is usually estimated using the following formula: terminal value = cash flow of the last years / (discount rate – annual growth rate). 
• The period for which forecasts are made cannot exceed the expected useful life of the assets or cash-generating units being tested. 

Example 6

The cash flow generating unit is the company's cogeneration station, its biggest assets are equipment (turbines, etc.), their remaining useful life is 15 years. After 15 years, the expected net sale value of equipment and other assets is 1 million. euro. 

The estimated cash flow from the cogeneration operation for the remaining 15 years should be used for depreciation calculations. The expected sale value of the station should also be factored into the calculations by discounting it. 

• Cash flow discounting.

For the purposes of the impairment test, future cash flows must be discounted to their present value using a discount rate determined at the balance sheet date that includes the "market price" for investments with the lowest degree of risk (such as government bonds) and an additional rate (risk premium) for investments in assets under test ( including country risk, industry risks in which the company operates and company-specific risks). It is important to note that the discount rate is calculated at the time of valuation, that is, the end of the financial year, and it depends on the market situation (e.g. EURIBOR rate) at the time of valuation. 

In addition, to determine the discount rate, it is usually necessary to assess the rate for both capital investments and the rate for leveraged financing (loans), as they have different degrees of risk, and also determine the proportion of each of these rates in the total discount rate. Although the determination of the discount rate requires specific knowledge, there is basically nothing complicated about it - according to certain methods, the risk price for an investment in equity capital is calculated, or the return that any private investor would like to receive for investing in a given company, while the price of borrowed capital (financing) will usually be comparable to the value of to society's lending costs.

Attribution of discounted cash flow to the value of the tested assets. Discounting future cash flows will determine the present value of the asset. Attention should be paid to the fact that, in comparison with the book value of the tested assets, the book value of working capital and also the value of other assets belonging to the cash flow generating unit should be separated from the discounted value of the cash flow. 

• The above might seem very complicated and difficult to understand, so let's look at the impairment test on the basis of a simplified example.

Example 7 

An impairment test is performed for the production building mentioned in example 1 with an accounting value of 1 million. euro as of December 31, 2023. The accounting value of other fixed assets is 0.9 million. euro. All fixed assets of the company are defined as the cash flow generating unit, and the entire activity of the company - production - is evaluated. Working capital as of December 31 of the same year is 0.8 million. euro. The budget prepared by the management for 2024 is available, based on it, the management has also prepared forecasts for 2025-2027. Based on the cash flow of 2027, the final value is calculated. Below you can see the depreciation calculations. 

Cash flow, thousand euro:

Final value calculation:

• discount rate: 10%;
• increase (for final value): 1%;
• final value: 331 / (10% – 1%);
• discount factor: 1 / (1 + discount rate)x, where x is the year for which the cash flow is prepared, relative to the base year.