IAS 36 - How to avoid the pitfalls of impairment testing?

Most companies adhering to IFRS standards began their impairment testing in last quarter of the calendar year based on IAS 36, "Impairment of Assets." The aim is to ensure that the recoverable amount of a cash-generating unit (CGU) exceeds the carrying amount of assets and liabilities presented net.

The standard is certainly not new (although I believe it is in need of updating), and its fundamental principles are simple. However, practical application can be very time-consuming due to the occasionally very detailed guidance and the significant amount of management judgment it allows. This discretion provides flexibility, especially if the current fiscal year or market sentiment does not reflect what management believes to be the true earning capacity. At the same time, it complicates and burdens the standard for all parties involved.

In Finland, the Financial Supervisory Authority (FIVA), which is responsible for monitoring financial statements and sustainability reporting, has commented on the standard on several occasions, particularly in its so-called thematic supervision in 2022. At that time, the most significant observations concerned inadequate descriptions in the notes, such as management's approach and use of judgment, as well as poorly presented key assumptions or their ambiguous interpretation.

Here are five tips to avoid the biggest pitfalls of impairment testing:

• Allocate enough time for testing, reviewing its assumptions, preparing notes, and engaging in discussions, including with the auditor. What may seem like a simple process can quickly turn into chaos if a key person, for example, falls ill and/or obtaining information becomes difficult within an already tight schedule.

  Additionally, up-to-date information is crucial, which is why most tests are scheduled after the budget is completed but before the year-end. The standard requires comprehensive notes and a fairly detailed understanding of them.

• Be aware of how management's budget assumptions may differ from the requirements of the Standard. Often, the budget includes business arrangements or other measures aimed at improving profitability to which the company has not yet committed. The fundamental assumption of IAS 36 is to consider the CGU in its current earning capacity.

• The relationship of forecasted cash flows to history. This is one of the clearest aspects for auditors during an audit – what has management's forecasting accuracy been in recent years? If forecasts consistently fall short in a negative manner, the auditor should demand significantly more precise commentary and analysis to support the assumptions.

• Calculate the discount rate (WACC) in the normal manner post-tax and then iteratively determine the pre-tax WACC. The standard requires the disclosure of a theoretical pre-tax WACC, which does not exist in the real world. Instead of guessing, it is easier to calculate cash flows in the usual manner.

• Apples-to-apples and oranges-to-oranges. Cash flows and carrying value may involve various items with a risk of double counting. For example, if you do not include lease liabilities in the carrying value, then reverse the same lease expense from the cash flow statement. Consistent treatment of assumptions and assets is essential.

Impairment testing is not rocket science, and certainly not an exact science. The outcome consists of judgment and hard data – this is why having the background and transparency of assumptions during the testing phase saves effort for all parties involved.

If you need assistance with IAS 36 or IFRS 3 matters, please feel free to reach out!