Impairment 2015 – US GAAP & IFRS

Grahame Nanson (BA Hons, Dunelm, FCA, CA)

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Overview

• Impairment in 2015

• Impairment under US GAAP & IFRS

• Impairment- Different US GAAP Models

• Triggering events and/or changes in circumstances

• Impairment process

• Impairment under IFRS

• Impairment- A Practical CFO Guide

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Impairment 2015

• Impairment is an increasing area of regulatory focus

• Addressed by US PCAOB in 2 discrete Audit Practice Alerts

• Main topic of “Failed” PCAOB Audit Inspections of Top-Tier Firms • Key topics of Failure included:

• Fair Value Measurement • Goodwill Impairment • Long-Lived Asset Impairment

• Over 235 SEC Comment Letters and Enforcement proceedings in relation to

Impairment

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Impairment 2015

• Current Global Markets experiencing increased volatility

• Fall in Oil Prices & Political Instability

• Underperformance of Eurozone

• Increases risk of increased “Indicators of Impairment” (IAS 36) or “Triggering Events” ASC 360-10 requiring Impairment reviews

• Other Areas of Impairment modelling impacted include: • Discount Factors • Accuracy of Budgets and Forecasts • Accuracy of Associated Cashflow Forecasts

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Impairment under IFRS & US GAAP

• Same concept, but the “devil is in the detail”

• Key US GAAP • ASC 350 Intangibles – Goodwill & Other (FAS 142, Goodwill & Other Intangible Assets) • ASC 360 Property, Plant & Equipment (FAS 144, Accounting for the impairment or

Disposal of Long-Lived Assets)

• Key IFRS

• AASB 136 Impairment of Assets (IAS 36)

• Impairment Models are different under IFRS and US GAAP • Basis is different:

• IFRS is based around “Cash-Generating Unit” or “CGU” • US GAAP has asset group/ reporting units

• Models are different in calculation • Accounting is different

Practical Outcomes will be very different!

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Impairment under IFRS &US GAAP Key differences in Models IFRS • One stage impairment model • leverages discounted cash flows for value in use • Or fair value less costs to sell • Impairment loss is the excess of book cost over recoverable amount • Impairment can reverse under IFRS for assets other than Goodwill • Impairment losses are offset against revaluation surplus in Other Comprehensive

Income (OCI) with excess losses recorded in the income statement

US GAAP • Generally use a two-step impairment model • Use undiscounted cashflows to determine whether impairment exists • Use discounted cashflows if impairment present to determine loss • Impairment more likely under IFRS • Loss larger under US GAAP • No reversal of Impairment • Impairment losses to Income Statement

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Impairment – Differing Models under US GAAP

Goodwill Indefinite-lived Intangible Assets

Amortizable Intangible Assets, Other Long-Lived Assets & Internal Use Software

Accounting Guidance ASC 350 ASC 350 ASC 360

Frequency Annual Test Annual Test/ Trigger Based

Trigger-Based

Methodology Two Step One Step Two Step

Level at which Impairment test performed

Reporting Unit

Individual asset/ combined unit of accounting

Asset Group*

Focus Implied Fair Value of Goodwill

Individual Asset Fair Value

Recoverability of carrying amount of the asset group

An asset group is the lowest level of identifiable cash flows. Any Discrete contract or operating unit may constitute an Asset Group

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Definitions under US GAAP • Evaluate the carrying value of long-lived whenever events and circumstances

indicate that the carrying amount may not be recoverable – “Triggering Events”

• Impairment exists when undiscounted cash flows < asset carrying value

• Long-lived assets include fixed assets and deferred contract costs, as well as other intangible assets

• Cash flows may include operating income, expected proceeds from sale of assets and early termination fees

• Cash flows must not include further investment or projected alternate use, or additional revenues post investment

• Cash flows should only be discounted to quantify the potential amount of any impairment – This is an area of key difference from IFRS!

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Trigger events &/or changes in circumstances (1) • A significant decrease in the market price of a long-lived asset

• A significant adverse change in the extent or manner in which a long-lived asset is being used,

or in its physical condition

• A significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset, including an adverse action or assessment by a regulator

• An accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset (asset group)

• Macroeconomic conditions e.g. a deterioration in general economic conditions, limitations on accessing capital, fluctuations in Foreign Exchange rates, or other developments in equity & Credit Markets

• A significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset (asset group), including an adverse action or assessment by a regulator

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Trigger events &/or changes in circumstances (2)

• A current-period operating or cash flow loss combined with a history of operating or cash flow losses, or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset

• A current expectation that a long-lived asset will more likely than not be sold or otherwise disposed of significantly before the end of its previously estimated useful life

• When a contract is materially under-performing or is expected to under-perform in the future.

• Other relevant entity-specific events such as changes in management, key personnel, strategy or customers; contemplation of bankruptcy or litigation.

• Events affecting a reporting unit such as a change in the composition or carrying amount of it’s net assets; a more- likely than not expectation of selling or disposing all, or a portion of a reporting unit:

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Impairment process under US GAAP; Progressing to the two-step process

• Step 1: Test to determine if an impairment exists => if carrying value of assets > undiscounted cash flows

• Step 2: Measurement of an impairment loss; use discounted cash flows

• When an operating unit is materially under-performing or is expected to under-perform in the future or whenever any of the “impairment triggers” are present.

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Impairment process under IFRS will be carried out at a Cash-Generating Unit (CGU) level

• AASB 136 definition of a CGU: “the smallest identifiable group of assets that generates cash inflows.. Largely independent from the cash inflows from other assets or groups of assets”.

• AASB 136.80 “each unit ..to which goodwill is so allocated...shall not be larger than an operating segment determined in accordance with AASB 8 “Operating Segments”

• Under IFRS Impairment more likely as all cashflows are discounted un the model

• Impact is less severe than Impairment under US GAAP and may go through OCI

• Impairment also reversible (except for goodwill) under IFRS

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Impairment process under IFRS will be carried out at a Cash-Generating Unit (CGU) level using Cashflows discounted for the Time Value of Money

• Time Value of Money should reflect: • Weighted average cost of Capital, leveraging Capital Asset Pricing Model

(CAPM) • Entity’s incremental borrowing rate; and • Other market borrowing rates • Need to adjust for specific risks associated with cash flows, including

country risk, price risk and currency risk • Need to exclude risks irrelevant to estimated cash flows or for which

already adjusted estimated cash flows

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CFO Practical Tips for Mastering Impairment Review

Ensure Cash Flows are Reasonable and Supportable •Review forecast revenue growth to historical performance, & to forecast growth within your wider Industry. •Review the forecast Profitability and cash flow, consider:

•Historical and Market predictability; •Capex vs Depreciation; (remember that Value in Use ("VIU") is purely maintenance capex, but Fair Value less costs of Disposal (FVD) should also reflect enhancement capex.)

•Review allocation of Centrally booked provisions to individual Cash Generating Units ("CGU") or Operating Units to avoid overstating the Discounted Cash Flow ("DCF") •Ensure all forecasts are based on the most current information; those prepared months ago may be "stale-dated"and require revision. •Examine the validity and disclose all key assumptions, •May need disclosures for sensitivity analysis in volatile market conditions.

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CFO Practical Tips for Mastering Impairment Review

Remember "Sanity-checks"on the results •Check External Market Data: If your peers are showing impairment but you are not, you have a problem! •Compare the sum of the groups recoverable amounts (adjusted for net debt) with the quoted market capitalization. If the market Capitalization is significantly lower than the sum of the recoverable amounts, you should, at least, revisit your assumptions very carefully.

Review the carrying values

•Make sure the exercise was not comparing “apples and oranges". •Ensure all assets and liabilities within each carrying value are consistent with the cashflows. •Ensure that all of the net operating assets within the business are subject to the impairment assessment and not simply goodwill! •Further, when testing goodwill for Impairment, do not deduct the value of financial assets from the net operating assets.

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CFO Practical Tips for Mastering Impairment Review

Terminal Value - Timing is key to success! •Ensure that the associated cash flows are actually sustainable in the longer term •If business is cyclical in nature, ensure cashflows are aligned with mid-point in economic cycle •Assess long-term growth forecasts both in light of long-term inflation expectations, but also GDP growth. If long-term growth rate significantly above GDP growth, you believe your company will be larger than the Australian Economy. •Given the current economic conditions, consider whether a "prudent" view may be appropriate when considering forecasting.

Discount Rates – Don’t keep it too simple! •Even if Central Banks were reduce the risk free rate based on government bonds, this would be unlikely to translate into a corresponding reduction in the overall Weighted Average Cost of Capital ("WACC"). •The increase in both country risk and equity risk giving rise to this reduction would be likely to offset any such reduction, and there may well still be an overall net increase. •Given that Cashflows should relate all of the operating activities of your business, the discount rates used when reviewing cashflows should be based on WACC rather than equity •For those dealing with Multinational operations, do not apply a "one-size-fits all" model. Ensure rate is appropriate for each country in which the asset or discrete CGU operates, and the currency in which it derives it's major cashflows.

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If you have any questions or comments on the enclosed please contact me via Linkedin:https://www.linkedin.com/profile/view?id=17820042&trk=nav_responsive_tab_profile

Grahame R Nanson BA (Hons, Dunelm), FCA, CA grnanson@gmail.com