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Steven Brice
Procedural Differences in Impairment Testing

The real cost implications of moving to international financial reporting standards (IFRS).

March 23, 2009
by Steven Brice

Given the current economic turmoil, more companies are looking at the value of the goodwill and long-lived assets that they are holding and recognizing that impairment losses are a very real prospect. This article addresses the procedural differences in impairment testing between international financial reporting standards (IFRS) and generally accepted accounting principles (U.S. GAAP) and considers which GAAP may have more impact on the value of your assets.

To date, the focus of attention on GAAP differences between IFRS and GAAP appears to be focused on recognition and presentation differences with little attention paid to impairment. Key differences in the testing for the potential impairment of long-lived assets held for use may lead to earlier impairment recognition under IFRS. The fundamental distinction between the impairment models is the application of a two-step model under GAAP that begins with undiscounted cash-flows, compared with the one-step model used in IFRS, which considers recoverability of the asset value from the application of an entity-specific discounted cash-flows or a fair-value measure. This distinction can make the difference between an asset being impaired or not!

Impairment of Long-Lived Assets

GAAP. This requires a two-step impairment test model:

  • Step 1. The asset carrying amount is first compared with the undiscounted cash-flows it is expected to generate. If the carrying amount is lower than the undiscounted cash-flows, no impairment loss is recognized and Step 2 is not necessary. If the carrying amount is higher than the undiscounted cash-flows then Step 2 quantifies the impairment loss.
  • Step 2. An impairment loss is measured as the difference between the carrying amount and fair value. Fair value is defined as the price that would be received to sell an asset or that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date.

IFRS uses a one-step impairment test. The carrying amount of the asset is compared with the recoverable amount, with any excess of recoverable amount over carrying amount representing the impairment loss. The recoverable amount is the higher of:

  1. the asset’s fair value less costs to sell or
  2. the asset’s value in use.

Fair value less cost to sell represents the amount obtainable from the sale of an asset or cash-generating unit in an arm’s-length transaction between knowledgeable, willing parties less the costs of disposal.

Value in use represents the future cash-flows discounted to present value by using a pretax, market-determined rate that reflects the current assessment of the time value of money and the risks specific to the asset for which the cash-flow estimates have not been adjusted.

Long-Lived Assets Impairment Testing Compared

Step 1 of the GAAP testing, the comparison of the carrying value of the asset to its undiscounted expected future cash-flows, inevitably results in a lower level of occurrence of impairment losses for long lived assets under GAAP than is prevalent under IFRS.

It should also be highlighted, that under IFRS it is an accounting policy choice whether companies choose to revalue long-lived assets. Revaluation gains and losses of long-lived assets (with the exception of investment properties) are recognized in equity. Therefore where an impairment has been identified and is attributable to a re-valued long-lived asset (except investment properties), that impairment loss is first set against the revaluation reserve with any excess impairment being recognized in profit or loss. Impairment losses recognized under GAAP always go directly to the income statement.

Impairment of Goodwill

GAAP. Goodwill is tested for impairment on a reporting-unit level. There is again a two-step approach for testing for impairment under GAAP:

  • Step 1. The fair value and the carrying amount of the reporting unit, including goodwill, are compared. If the fair value of the reporting unit is less than the carrying amount, Step 2 is completed to determine the amount of the goodwill impairment loss, if any.
  • Step 2. Goodwill impairment is measured as the excess of the carrying amount of goodwill over its implied fair value. The implied fair value of goodwill — calculated in the same manner that goodwill is determined in a business combination — is the difference between the fair value of the reporting unit and the fair value of the various assets and liabilities included in the reporting unit.

Any loss recognized is not permitted to exceed the carrying amount of goodwill. The impairment charge is included in operating income.

IFRS. Goodwill is assigned to a cash-generating unit (CGU) or group of CGUs. The goodwill impairment test under IFRS is a one-step approach:

The recoverable amount of the CGU or group of CGUs (i.e., the higher of its fair value minus costs to sell and its value in use) is compared with its carrying amount. Any impairment loss is recognized in operating results as the excess of the carrying amount over the recoverable amount.

The impairment loss is allocated first to goodwill and then on a pro rata basis to the other assets of the CGU or group of CGUs to the extent that the impairment loss exceeds the book value of goodwill.

Goodwill Impairment Testing Compared

There are two main implications of the differences in the goodwill impairment testing:

Reporting Unit vs. Cash-Generating Unit. A cash-generating unit is defined in IAS 36 Impairment of Assets as the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. Further a cash generating unit should represent the lowest level within the entity at which the goodwill is monitored for internal management purposes; and should not be larger than an operating segment (as defined by IFRS 8).

A reporting unit, which is the level that goodwill is tested for impairment under GAAP, is an operating segment or one level below an operating segment.

Therefore there is the potential that goodwill may be tested for impairment under IFRS at a lower level than under GAAP. Recovery of an asset value using the potentially smaller CGU level may result in a higher incidence of impairments.

Impairment in Excess of the Goodwill Carrying Value

Where the impairment test has resulted in the identification of an impairment, the level of this impairment in the case of GAAP is restricted to the carrying value of the goodwill. By comparison, under IFRS, the level of the impairment loss is not restricted, with excess impairment over the carrying value of goodwill being applied to reduce the carrying amount of other assets within the CGU.

Therefore there is the potential that under IFRS, the impairment loss recognized may be greater than would have been recognized under GAAP.

Reversal of Impairment Losses

An impairment loss recognized in prior periods for an asset (other than goodwill) may in accordance with IFRS, be reversed only where there has been a change in the estimates used to determine the asset's recoverable amount since the last impairment loss was recognized. A reversal of an impairment loss reflects an increase in the estimated service potential of an asset, either from use or from sale, since the date when an entity last recognized an impairment loss for that asset. Impairment losses recognized on goodwill are not permitted to be reversed under IFRS.

Under GAAP, the reversal of all impairment losses is prohibited.

Conclusion

While on the surface, it would appear that there is a degree of similarity between GAAP and IFRS in impairment testing, both accounting bases require annual tests for impairment for goodwill and indefinite-lived intangible assets and both accounting bases require definite-lived intangible assets to be tested for impairment in which there is an indicator of impairment. As illustrated in this article, the means by which that impairment test is conducted can potentially result in substantially different impairment losses being recognized.

It is arguable that under IFRS, impairment testing will result in a higher incidence of impairments being recognized and there is the further potential that even if an impairment loss is recognized, that it may be greater under IFRS.

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Remi Forgeas, CPA, is an audit and assurance partner for Mazars in the U.S. For European IFRS contact, you can reach Steven Brice, who is a technical partner in the financial reporting advisory group for Mazars in the U.K.
* The views expressed in this article are the author’s own.