Since the time for closure of balance sheet is fast approaching, every company liable to get audited should consider the preparation of forecast cash flows for each cash generating unit to comply with Accounting Standard (“AS”) 28 – Impairment of Assets.  As per AS 28, issued by the Institute of Chartered Accountants of India, every enterprise is required to assess at each Balance Sheet date to understand if there is impairment in any asset or not. In case there is impairment loss, it needs to be recognized. It is an auditor responsibility, at a time of auditing to comment on whether AS 28 has been complied with. Noncompliance may lead to auditor’s qualification.

It means damage or weakening of anything. Therefore, impairment of assets means that there is decline or weakening in the value of an asset. As per AS-28, in case carrying an amount of asset is more than its recoverable amount, an asset is said to be impaired.  

It means the amount of which asset is shown in the Balance Sheet. Usually, an asset is shown in the Balance Sheet at its cost less accumulated depreciation or amortization and accumulated impairment losses. Till the time, AS 28 came into operation, the impairment losses are not accounted for in the books of account, therefore the asset is shown at its cost less depreciation, but now; the impairment loss is also to be accounted for and therefore the asset to be shown in the Balance Sheet at its cost less depreciation less impairment loss.

Recoverable amount is higher of

Let us understand step by step factors for effective testing of impairment

Step 1 – What is Life of the CGU?

Firstly, we need to determine the life of CGU. This is to determine no. of years of projections required for testing.  In case, a life of CGU is only 4 years i.e. it will be sold in 4 years, then cash flows for only 4 years should be taken along with perpetuity or terminal value for arriving at an estimated sale price.

In case CGU has an indefinite life, then we shall take only cash flows for 5 years along with appropriate terminal value.

Step 2 – Movement in Working Capital requirement

Every growing company requires investment in working capital, however, increase in working capital affects the availability of free cash flows. It can be determined by financial statements as well as by average debtors, inventory, and creditors as well as their impact on working capital over the projection period.

Step 3 – Amount of Capital Expenditure Investment

One should also consider the amount of capital expenditure investment required by CGU to generate cash flows. The amount of future capital expenditure, as well as its timing, have a significant impact on the value of the CGU. 

Step 4 – Amount of Taxes Paid

While determining a weighted average cost of capital, an impact of taxes on debt should also be considered while determining the discount rate. The forecast tax payments should be determined on an ungeared basis. 

Step 5 – Appropriate Rate of Discounting.

While computing impairment testing, discount rate selected must be discount rate prevailing in an industry and not that of the particular business or CGU.  Therefore, proper research shall be done while determining an appropriate discount rate.

Step 6 – Determining Terminal Value

While determining terminal value, any of following methods may be considered:

• Maintainable Cash Flow: Here, we need to consider long-term cash flows taking into consideration working capital, capital expenditure, and tax payments. Cash flow multiples multiply These cash flow.
• Maintainable Forecast earnings (EBITDA): if Forecast EBITDA are utilized, then appropriate forecast earnings multiple must also be considered to determine a terminal enterprise value.  Multiple can be by comparable transactions or appropriate trading multiples with operations comparable to the CGU.

By steps above and taking into consideration cash flows, an enterprise value of CGUs are determined. It is also considered that discounting is done by average income received throughout the year and not only at year end. 

This value is then compared to the net operating assets of the CGU including the goodwill amount to determine if the CGU is impaired and accordingly appropriate disclosure are also made in books of accounts. 

Conclusion

In a case at any balance sheet date, an enterprise considers that the internal or external factors exist which indicates that there is a decline in value of its assets, it must follow all the steps above to ensure that there is effective testing of impairment and make proper disclosure in its books of accounts.

Where we can assist

We can assist in identification of external or internal factors providing an indication of decline in value of assets and providing complete solution relating to impairment testing of fixed assets involving steps above and its proper disclosure in books.