Non-Financial Asset Impairment: Understanding Recoverable Amounts and Their Assessment

Non-Financial Asset Impairment: Assessment and Treatment of Recoverable Amounts

When assessing non-financial asset impairment, the recoverable amount of an asset or cash-generating unit (CGU) must be the greater of (i) fair value less costs to sell (FVLCS) or (ii) value in use (VIU) as per IAS 36.18/Ind AS 36.

Both approaches are defined as follows (Ind AS 36/IAS 36.6):

Fair Value Less Costs to Sell (FVLCS): The amount obtainable from the sale of an asset or CGU in an arm’s length transaction between knowledgeable, willing parties, minus disposal costs.
Value in Use (VIU): The present value of future cash flows expected to be derived from the asset or CGU.

It’s important to note that if either the FVLCS or the VIU exceeds the asset’s carrying amount, then the asset is not considered impaired, and the calculation of the other amount is unnecessary (Ind AS 36/IAS 36.19).

This article aims to clarify how to treat specific transactions when calculating recoverable amounts using the VIU technique and how to determine the carrying value.

I. Recognition of Leases for Lessees Under Ind AS 116/IFRS 16

Under Ind AS 116/IFRS 16, all lease obligations must be reflected on financial statements. Previously, Ind AS 17/IAS 17 classified leases into two categories: (i) operating leases and (ii) finance leases. Operating lease obligations were recognized on an accrual basis, with future contractual obligations merely disclosed. In contrast, the new standard mandates that all future fixed lease payments are discounted and recognized as lease obligations, together with the corresponding right-of-use (ROU) asset on the balance sheet.

Impact on Cash Flows

The lease obligation represents financing from the lessor for the leased asset. As per Ind AS 36/IAS 36.50, cash outflows from financing activities should not be included in future cash flow estimates. Since lease payments are essentially for servicing this financing, they are excluded from future cash flow estimates.

However, certain future lease payments—such as variable lease payments or those for short-term leases—should be included when estimating cash flows for the CGU.

Typically, unless a lease asset is subleased, the ROU does not generate independent cash flows. Thus, ROU recoverable amounts are calculated based on the underlying CGU’s recoverable amount (Ind AS 36/IAS 36.22).

If a lease asset is subleased as an operating lease, cash inflow from lease payments can guide the estimation of future cash flows for calculating the VIU or determining FVLCS via a discounted cash flow (DCF) model. Conversely, if classified as a finance lease, the ROU will be derecognized, and the lease's net investment will be reported on the balance sheet. The impairment testing for this net investment falls under Ind AS 109/IFRS 9 (Ind AS 109/IFRS 9.2.1(d)).

Carrying Amount Consistency

The standard stipulates that the carrying amount of a CGU must be determined in a manner consistent with the recoverable amount calculation (Ind AS 36/IAS 36.75). Consequently, since lease payments are not included in the VIU for a CGU, the carrying value of lease obligations also does not factor into the CGU's carrying value.

When an asset or CGU is disposed of, if the buyer assumes a liability, the FVLCS (or projected cash flows from ultimate disposal) is computed as the estimated selling price for both assets and liabilities, minus disposal expenses. For a meaningful comparison between the carrying amount and recoverable amount, the liability’s carrying amount is excluded when evaluating the asset or CGU’s value in use (Ind AS 36/IAS 36.78).

Thus, the carrying value of lease obligations that the buyer must assume on disposal should be deducted from the recoverable amount determined via either the VIU or FVLCS approaches.

II. Asset Retirement and/or Restoration Obligation

Under Ind AS 37/IAS 37, the asset retirement and/or restoration obligation is recognized as the present value of obligations that must be fulfilled at the end of an asset’s useful life.

To avoid double counting, cash outflows related to recognized obligations should not be included when estimating future cash flows (Ind AS 36/IAS 36.43). Thus, the asset retirement obligation recognized on the financial statements is excluded from future cash flow estimates for the asset or CGU.

When an asset or CGU is sold to a buyer who assumes a liability, the estimation of selling price must exclude the liability's carrying amount when calculating both the value in use and carrying amount (Ind AS 36/IAS 36.78). Hence, the carrying value of the asset retirement obligation must be deducted from the recoverable amount determined through either the VIU or FVLCS approaches.

The IASB has extensively studied this subject, and staff papers summarize the rationale for excluding the asset retirement obligation from the recoverable and carrying values.

III. Freehold Land

Freehold land presents a unique situation; typically, its value appreciates, and since it does not generate independent cash flows, assessing impairment on a standalone basis can be complex. Furthermore, when included in a CGU, determining the VIU often becomes more intricate.

General Principle

The standard dictates that recoverable amounts are calculated for individual assets unless the asset generates cash inflows that are significantly independent of other assets or groups. When this is the case, recoverable amounts are assessed for the entire CGU, except when an asset’s FVLCS exceeds its carrying amount (Ind AS 36/IAS 36.22).

Scenarios of Recoverable Amounts for Freehold Land

Freehold Land - Own Use
- If the FVLCS is greater than carrying value, there's no need to determine the CGU recoverable amount. The freehold land's FVLCS is the recoverable amount.
- Conversely, if the FVLCS is less than the carrying value, calculate the recoverable amount for the pertinent CGU.
Freehold Land - Leased as Operating Lease
- Classified as investment property per Ind AS 40/IAS 40, lease payments generate cash inflows that can help estimate future cash flows for determining VIU or FVLCS through a DCF model.
Freehold Land - Leased as Finance Lease
- The land will be derecognized, and net investment in the lease will be recorded on the balance sheet, with impairment testing requirements governed by Ind AS 109/IFRS 9.
Freehold Land - Held for Capital Appreciation
- Categorized as investment property under Ind AS 40/IAS 40. Unlike IAS 40, which allows both cost and fair value models, Ind AS 40 only permits the cost model. If employed, the recoverable amount becomes FVLCS, as the land does not generate independent cash flows useful for calculating VIU.

When 'freehold land - own use' is part of the CGU, it can occur in two scenarios:

When the FVLCS is less than the carrying value, it's included in the CGU for recoverable amount determination.
When accounted for goodwill allocation and annual impairment testing.

Treatment of Freehold Land in CGU VIU

To estimate a CGU's VIU, future cash flows during its useful life are analyzed. The useful life aligns with that of the assets generating cash flows, such as plants. Distinctively, land has an indefinite useful life, which complicates its treatment concerning the CGU’s useful life.

When estimating future cash flows, it’s crucial to account for the net cash flows associated with land disposal at the CGU’s end-of-life—however, accurately gauging this can be difficult, particularly for long-lived CGUs.

Management's intention typically may not involve land disposal post-CGU life, leading to the exclusion of projected land disposal cash flows during this calculation. However, land fair value should be included when determining recoverable amounts using the FVLCS approach, as management is expected to receive its value upon the CGU's impairment testing date.

Goodwill Impairment Delay Due to Land Appreciation

Goodwill must be allocated to CGUs expected to benefit from synergies created by business combinations (Ind AS 36/IAS 36.80). If goodwill is allocated to existing CGUs with 'freehold land - own use,' it may have been recorded at historical cost, potentially shielding goodwill impairment due to unrecorded fair value appreciation.

The underlying rationale for recognizing goodwill is derived from expected synergy benefits from operations integration. Unrecorded fair value appreciation is influenced by external factors and is not directly attributed to business combination synergies. The IASB is exploring the development of a new approach, namely the pre-acquisition headroom method for goodwill impairment testing. This approach, still in development, does not currently account for appreciation of asset fair value not related to business combination synergies.

IV. Capital Expenditures

As per the standard, when estimating future cash flows, inflows and outflows expected from enhancing asset performance should not be included (Ind AS 36/IAS 36.44). Cash flows anticipated in future estimates for assets in their present state should not consider enhancements or related inflows from such expenditures (Ind AS 36/IAS 36.45).

Estimates must include outflows necessary to maintain anticipated economic benefits from the asset in its existing condition. The assumption is that replacing assets with shorter useful lives is part of normal operations.

Moreover, to avoid double counting, any capital expenditures associated with liabilities already recognized are excluded from future cash flow projections (Ind AS 36/IAS 36.43).

V. Working Capital Considerations

Estimating an asset or CGU's future cash flow is challenging without considering working capital components such as trade receivables, payables, and other financial assets. Ind AS 36/IAS 36 implicitly allows for this adjustment in impairment testing.

The standards dictate that, when estimating cash flows, expenditures required to generate inflows from continuous asset use, including preparation costs for the asset, must be considered (Ind AS 36/IAS 36.39).

Any changes to working capital that affect the CGU's operations must be factored into future cash flow estimates. Furthermore, when determining the recoverable value of a CGU, assets and liabilities not part of the CGU (e.g., receivables and payables) may also influence calculations. The carrying amount of the CGU will be adjusted based on these working capital components (Ind AS 36/IAS 36.79).