Question

Critical analysis of some of the complexities and key issues involved in impairment testing

Answer 1

Concept of Impairment:

Impairment refers to a permanent reduction in the value of a company's asset, usually a fixed asset. While testing for Impairment, the asset's cash inflows and other benenfits is compared with the book value of that particular asset and if the benefits are lower than its book value, its high time to impair the same.

Calculation of Imapirment:

Carrying value - Recoverable Value

....... where, Carrying value = Book value of the asset arrived after reducing depreciation/ accumulated depreciation.

Recoverable Value = Higher of Fair Value and Value-in-use

Complexities involved in Impairment Test and suggestions to avoid the errors:

• Difference between Fair value and Value-in-use: While Fair value refers to what a rational person can pay today to acquire a specific asset, whereas Value-in-use refers to the NPV of the cash flows that an asset is expected to arise. Also Value-in-use can include economies to scale that can be specific to your business which can increase the cashlows but same cannot be considered for determining Fair value.
• Use of right discount rate : For computing the value-in-use, use of an appropriate discount rate is of high importance. In practice, different cash generating units within the same company consider different discount rates due to difference in country risk, currency risk, product risk, etc. Finally, discount rate should reflect the borrowing rate in the market which may be different from the company's cost of capital.
• Tax Component : The most common error here occurs is using a post tax discount rate for discounting the pre-tax cash flows. So, this common error should be strictly avoided!
• Comparability: The cash flows to be discounted should be of the same asset which is tested for impairment. You cannot take cashflows of the entire business unit comprising of 100 assets if you are considering impairment test for only 2 assets.
• Continuining Process: To sum up, impaired asset should be usually tested in the intervals of 1 year to check if the the testing mode needs any change so as to keep the impairment testing model updated.