Edwards 0507

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52 student accountant May 2007

t e c h ni c a l

theory andpractice

This article outlines the circumstances in which an impairment

review is required, and provides students with a short question

to work through, as well as the solution. It also examines recent

impairment reviews reported by Unilever and Vodafone, and considers

both the potential and pitfalls associated with this new method of

financial reporting.

THE RULES

The purpose of an impairment review, conducted under IAS 36,Impairment of Assets, is to ensure that tangible and intangiblenon-current/fixed assets are not carried in the accounts at a figurein excess of their recoverable amount. Goodwill and indefinite-livedintangible assets have to be annually reviewed for impairment. Othernon-current/fixed assets have to be reviewed for impairment only when

there is an indicator that carrying amounts may not be recoverable, iecarrying value > recoverable amount, where recoverable amount is thehigher of value in use (VIU) and net selling price (NSP).

Circumstances that trigger the need for a review may arise fromexternal or internal sources. Internal sources include:

physical damage to, or obsolescence of, a non-current/fixed asset a significant reorganisation of business operations the loss of key employees internal reports that indicate that the economic performance of an

asset is, or will be, worse than expected.

IAS 36, paragraph 14, gives the following examples of evidence frominternal reporting that indicate impairment has occurred:

impairment reviewsrelevant to Professional Scheme Papers 2.5 and 3.6 andnew ACCA Qualification Papers F7 and P2

Cash flows for acquiring the asset, or subsequent cash needsfor operating or maintaining it, are significantly higher thanoriginally budgeted.

Operating profit or loss, or actual net cash flows, are significantlyworse than those budgeted.

A significant decline in budgeted net cash flows or operating profit, ora significant increase in budgeted loss.

Operating losses or net cash outflows for the asset, if current periodamounts are aggregated with budgeted amounts for the future.

External sources include:a significant fall in the asset’s market value

an adverse change in the company’s competitive or regulatoryenvironment

a significant increase in market interest rates a key employer in the locality where a company carries on business

closes down the balance sheet value of an entity exceeds market capitalisation.

EXAMPLE 1: IMPAIRMENT REVIEW AT DRUMMOND PLC

At 31 December 20X5, the directors of Ramsey plc carry out a reviewfor impairment of the net assets of a company, Drummond plc, acquiredat the beginning of 20X5. Drummond plc comprises a single cashgenerating unit within the activities undertaken by Ramsey plc.

The net assets of Drummond plc immediately before theimpairment review (which took place on 31 December 20X5) consistedof the following:

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Calculation of recoverable amount

Higher of:Net selling price 154Value in use 277Recoverable amount 277

Calculation of impairment loss

Carrying value 481

Impairment loss 204

Allocation of impairment loss

Goodwill Reduced to zero value by impairment loss -84Production No adjustment: future economic benefitslicence ≥ carrying value 0Specialist plant Restated at scrap value (97 - 20) -77Net current assets No adjustment: already stated at lower of

cost and NRV 0Other tangible NCAs Remainder of impairment loss written-off -43Impairment loss 204

Revised values of net assets of Drummond plc

Original values Share of loss Revised values

$m $m $m

Goodwill 84 -84 0.0Production licence 40 0 40.0Specialist plant 97 -77 20.0Net current assets 60 0 60.0Other tangible NCAs 200 -43 157.0

277.0

IMPAIRMENT IN PRACTICE

Unilever

Unilever is one of the world’s leading suppliers of consumer goods,particularly in the foods, home, and personal product categories. Incommon with other companies, Unilever reviews relevant assets forimpairment each year. The write-offs recognised in the income statement,in respect of goodwill, indefinite-life intangible assets, and property,plant, and equipment amounted to 431m in 2005 and 1,242m in the

previous year. The Slim.Fast division was responsible for the majority ofthese losses.

A review of the Slim.Fast business was triggered by the decliningperformance of the weight management segment of Unilever ’s business.Senior management appeared to have failed to predict changes inconsumer taste, in particular the fall in demand for low calorie, lowcarbohydrate, low salt, and low sugar products. The result has beena downturn in the sales outlook for Slim.Fast and write-downs for theAmericas region, based on value-in-use, amounting to 363m in 2005and 791m in 2004. Operating profit increased by 5,314m in 2005compared with 4,239m in 2004, and the operating margin rose to13.4% compared with 11% in the previous year. However, excluding theeffect of non-recurring items, the operating margin declined by 0.8%. In

Net assets Carrying value prior to

impairment review

$m

Goodwill arising on acquisition 84Production licence 40Specialist plant 97Other tangible non-current assets 200Net current assets 60

481

The following information is relevant to the impairment review: Ramsey plc’s accountants have budgeted the future cash flows

expected to arise from the continuation of the activities of Drummondplc. These are: 20X6 – $106m, 20X7 – $124m, 20X8 – $70m, and20X9 – $45m.

Drummond plc could be sold on 31 December 20X5 for $154m.

Further investigations revealed the following: The production licence has no ascertainable market value, but is

expected to generate future economic benefits for the entity at leastequivalent to its present carrying value.

The specialist plant had been damaged and cannot be used in thebusiness. It can be sold for scrap for $20m.

None of the ‘other tangible non-current assets’ has a net realisablevalue (net selling price) that is greater than their carrying value.

The net current assets are stated at the lower of cost and netrealisable value.

Required

a Compute the amount of the impairment of the Drummond plc cashgenerating unit arising from the impairment review.

b Allocate the impairment loss between the components of the netassets of Drummond plc.

c Show the values of each of the components of the net assets ofDrummond plc for inclusion in Ramsey plc’s financial statements,immediately after the necessary adjustments have been made, toreflect the results of the impairment review.

NotesThe discount rate appropriate to the activities of Drummond plcis 11%.Assume you are making your calculations on 31 December 20X5.

Solution

Calculation of value in use

Net cash flows $m Discount factor 11% $m

20X6 106 0.901 95.520X7 124 0.812 100.720X8 70 0.731 51.220X9 45 0.659 29.7Value in use 277.0

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other words, much of the increase in profit is attributable to the reductionin unfavourable non-recurring items, of which the impairment loss wasa major component, and so the underlying recurring performance ofthe Unilever Group appears flat. Further, the earnings reported in theaccounts of Unilever appear to have benefited from the move fromsystematic amortisation to impairment reviews. It is also interestingto note that amortisation charges for the years 2002–04 averaged 1,214m compared with the impairment losses, which averaged 836m

for 2004 and 2005. The change from systematic amortisation to annualimpairment reviews has therefore resulted in significant reductions inamounts written off intangibles at Unilever.

Vodafone

Vodafone is a world-leading mobile telecommunications company andhas encountered significant problems in the recent past. In the words ofone financial commentator: ‘Vodafone’s problem in Europe is that it findsitself in three [UK, Italy and Germany] of the most competitive markets’1.Also, its areas of operation have been the subject of growing regulation.An impairment review conducted in 2005–6 resulted in a massivewrite-down of goodwill associated, pr incipally, with European operationswhich amounted to £23.5bn. The loss of £21.8bn reported for 2005–6,compared with a profit of £6.5bn in 2004–5, was substantiallyattributable to the increase in the impairment loss, up from just £0.5bn

the previous year.Vodafone’s problems in Germany, which accounted for £19.4bn

of the write-down, were – to a significant extent – a consequence ofthe acquisition of Mannesmann, in 2000, at a time when share pricesin the telecommunications sector were significantly higher than theylater became. According to Morten Singleton, equity research directorat the international bank, WestLB AG, Vodafone ‘paid top dollar forMannesmann when the market was booming. Something had to give atsome point on its balance sheet. It simply wasn’t logical to keep it theway it was.2’ As at Unilever, Vodafone’s management has been obliged todowngrade its assessment of growth prospects.

Further press commentary (October 2006), under the heading‘Vodafone in Trouble’2, reported the company’s announcement of lowerprofit margins in its Japanese business for the first half of 2005–6, andthat it had to pay $8.6bn in the form of a tax bill after its acquisition of

Mannesmann AG in 2000. This revelation saw Vodafone’s share priceplummet by 11%, the biggest one-day drop in the company’s share pricein seven years. Prior to the application of IAS 36, Vodafone amortisedgoodwill at the rate of roughly £13bn per annum. We can thereforeconclude that switching to impairment reviews can have a significanteffect on reported earnings in either direction. In 2004–5 it was muchlower but in the following year much higher.

IMPAIRMENT REVIEWS: THEORY AND ACCOUNTING SIGNIFICANCE

An impairment review is intended to help ensure published accountscomply better with the objectives of financial reports as set out in theIASB’s Framework for the preparation and presentation of financial

statements. Central to the Framework are four ‘qualitative characteristics’

designed to make published financial information useful to investors,creditors, and others. These are: understandability, relevance, reliability,and comparability.

The use of fair values, rather than depreciated historical cost,should lead to the publication of accounts that are more comprehensibleto many user groups unfamiliar with the technicalities of accounting,and should result in the publication of information which is morerelevant for decision making. However, the concept of fair value may

not result in the publication of more reliable financial information and,in such circumstances, the accounts may become less, rather thanmore comparable.

Chris Higson of the London Business School and Mark Sproul ofCompany Reporting3 expressed these kinds of sentiments when observingthat the ‘increased use of fair values and of impairment reviews willmake a firm’s income more volatile’. Whereas the previous regime ofamortisation resulted in a steady charge over an asset’s useful economiclife, an impairment review can produce huge fluctuations in reportedearnings, as demonstrated earlier in the case of Vodafone. In this context,it is worth recalling the need to exercise subjective judgement in anumber of different directions when carrying out an impairment review.For example:

The prediction of future cash flows for the purpose of computingvalue in use is inevitably a subjective exercise.

There is a possible need to allocate a global goodwill figurebetween cash generating units for the purpose of conducting theimpairment exercise.

There can be problems in identifying the appropriate discount rate. There can be problems identifying the cash generating unit to be

used for the purpose of conducting the exercise.

Each of these problem areas increases the risk of error and enhances thescope for manipulation of financial information. For example, a boardof directors, faced with the need to recognise impairment, might do soon a grand scale in order to get all the bad news out of the way in onego. Also, the impression sometimes conveyed in the accounts, when animpairment exercise reveals the need for a major write-down of assetvalues, is that it is a non-recurring event that stakeholders do not need toworry too much about. But, as history shows, non-recurring events have

an unwelcome habit of surfacing regularly in company accounts, albeit indifferent forms. The idea of an impairment review is theoretically sound.Over the next few years it will be possible to gather empirical evidencewith which to judge its practical value to users of financial information.

REFERENCES

1 http://networks.silicon.com/mobile/0,39024665,39156791,00.htm2 http://www.icmr.icfai.org/casestudies/catalogue/

Business%20Strategy/BSTR213.htm3 http://www.london.edu/assets/documents/PDF/

Chris_Higson_paper_IFRS.pdf

Richard Edwards is professor of accounting at Cardiff Business School

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Edwards 0507