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.
What is meant by Impairment?
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.
What is carrying amount?
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.
What is Recoverable amount?
Recoverable amount is higher of
Net Selling Price It means amount recoverable from an assets after considering its cost of disposal. Net selling price can be taken from: –
- Copy of sales agreement
- Price prevailing in active market
- On best estimate basis.
Value in use It is calculated by present computing value of –
- Estimated future cash flow arising from use of asset and
- Residual price (scrap value) at the end or its useful life.
- Present value is calculated by applying a discount rate to future cash flows.
Valuation of fixed assets shall be done properly in order to determine its net selling price as well as value in use.
Factors which indicates whether there is decline in value of assets
- In case of market value has declined significantly
- When there are negative changes in technology, markets, economy or laws
When there is increase in market rates of Interest materially affecting recoverable amount of asset
- In case assets became obsolescence or there is physical damage to asset
- When carrying amount of net assets of the reporting enterprise is more than its market capitalization
- When assets are held for disposal or when it is a part of restructuring
In case economic performance of the asset could be worse than
Steps to be considered for effective Impairment testing
Step 1 What is the life of the cash generating unit (CGU)
Step 2 The movement in working capital
Step 3 Amount of capital expenditure
Step 4 Amount of taxes paid
Step 5 Rate of Discount
Step 6 What is Terminal Value
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.
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.