Understanding Impairment Tests in Corporate Accounting

This report delves into the crucial topic of impairment tests within corporate accounting. It explains the necessity of these tests to determine if the recoverable amount of assets exceeds their carrying amount, highlighting the resulting impairment loss. The report clarifies the complexities of determining recoverable amounts, especially for individual assets, and introduces the concept of cash generating units (CGUs). It details the disclosures required when assets are transferred between CGUs or when impairment losses are reversed. The report further outlines the process of determining the value in use, including the calculation of present value of future cash flows, and the importance of making estimations based on reliable data and assumptions. It also explains the fair value less cost of disposal, along with the two approaches for calculating present value, the traditional and cash flow approach. The report emphasizes the need for companies to estimate future cash flows efficiently and to document the assumptions made during these calculations. Finally, it underscores the importance of adapting these calculations based on changing market conditions and provides a comprehensive overview of the key elements involved in impairment testing, supported by relevant references.

CORPORATE ACCOUNTING

A company needs to record in its books of accounts if the recoverable amount of assets held
by them exceeds their carrying amount. The process of identification of such assets and
recoding them is known as the impairment test. The difference between the two amounts is
known as impairment loss. The determination of recoverable amount is a complex job and so
it is very difficult to ascertain the recoverable amount for each asset separately. Therefore, the
recoverable amount for the cash generating unit (CGU) is determined. Cash generating asset
is the pool of assets that helps in generating cash inflow. Such assets which are contained in
the unit must have an active market or could be consumed within the company itself. Few
disclosures that a company has to make is when there is a transfer of any particular asset from
one CGU to another, if the company has reversed any impairment losses or if it has made any
sort of payments. However, the recoverable amount is dependent that is derived from the cash
flows and also the efficiency by which the assets are being used (Alvarez, 2013).
The impairment test for a normal asset and a CGU is done almost in the same manner. the
recoverable amount that is ascertained is compared with the carrying amount. The difference
between the two is allocated among all the assets of the CGU in the ratio of their carrying
value (Easton, 2010). The value of each asset gets decreased because impairment loss is
deducted against each asset that is contained in the cash generating unit.
In order to determine the recoverable amount, we require the value in use and the fair value
less cost of disposal. Let us now understand the process to determine the value in use
(Fridson & Alvarez, 2012).
Value in use can be determined by calculating the present value (PV) of the future cash flows
that are expected to be generated from the CGU (Girard, 2014). The steps that have to be
followed for calculating value in use are as follows:
 The company must be efficient enough to estimate the future cash flows using the
information available.
 Estimates are based on certain assumptions and are a judgemental process. Therefore,
the management must state about the variations that might occur.
 In order to calculate the present value, the company will require a discount rate which
is based on certain assumptions. The other factors that are taken into consideration is
risk bearing as well as liquidity.
The estimations of cash flows that are made by the company must be:

 The economic condition of the asset based on its remaining life has to be determined.
The estimation of the cash flows or the remaining life should be based on proper
reasons or valid assumptions.
 The company must record any reconstruction charges in its book if it has not
promised it earlier (Ittelson, 2009).
 The budgets and estimations that are made by the company using the data for the
current year and not the past years.
 Any capital expense, tax receipt or payment and borrowing cost should be excluded
while doing the calculation.
The estimations are based on the judgement and there may be variation on comparing it with
the actual results. The management of the company must find out the reasons behind such
variations and take corrective measures for future.
In order to calculate the present value, there are two approaches that can be adopted. The first
one is the traditional approach and the second one is the cash flow approach. The result of the
impairment test under both the situations will be the same. In the traditional approach a single
discount rate is determined and then used to calculate to present value whereas in the cash
flow approach different discount rates are used for each cash flow and then the present value
is calculated. The discount rate is determined after identifying and measuring the level of risk
that is undertaken (McLaney & Adril, 2016).
In case, similar assets are present in the market for the purpose of sale then the company
adopts for traditional approach. The company should use real weights or the nominal rates in
order to maintain consistency. Both cash flow and discount rate is used for the purpose of
calculation of present value should be pre tax. Only if the company adopts capital asset
pricing model, it can use post tax cost of equity as the discount rate.
Fair value less cost of sell is easily understandable. It is the cash inflow on selling of any
particular asset to a person who is willing to buy such asset after subtracting the selling
expenses (Parrino, 2013).
- Usually if any price is mentioned in the sales agreement, then it is considered to be
the fair value. But if there arises any incremental cost then such cost should be
deducted from the fair value.

- If there is no sales agreement present, then the price for which the buyer is ready to
buy the asset shall be ascertained and any cost related to disposal should be
subtracted.
- If both the above situations are not possible, then the company must forecast the cash
flows that it might generate if it keeps the asset at the end of the reporting period.
If the market price is unavailable then the company may also go for the discounted cash flow
approach. All the cash flows that are obtained from the asset either directly or indirectly has
to be taken into consideration. The management of the company must not incur high costs for
the purpose of identification of the cash flows. Any transaction cost should be treated as cost
of disposal and should be deducted (Penman, 2012). The assumptions that are made while
doing these calculations must be reliable and it should also be modified based on the
changing market situations.

Bibliography
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Easton, P. (2010). Financial statement analysis & valuation. Cambridge, UK: Cambridge
Business Publishers.
Fridson, M., & Alvarez, F. (2012). Financial Statement Analysis: A Practitioner's Guide.
New York: John Wiley & Sons.
Girard, S. L. (2014). Business finance basics. Pompton Plains, NJ: Career Press.
Ittelson, T. (2009). Financial Statements: A Step-by-Step Guide to Understanding and
Creating Financial Reports. Franklin Lakes, N.J.: Career Press.
McLaney, E., & Adril, D. P. (2016). Accounting and Finance: An Introduction. United
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Parrino, R. (2013). Fundamentals of Corporate Finance, 2nd Edition. Milton: John Wiley &
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Penman, S. (2012). Financial statement analysis and security valuation. Boston, Mass.:
McGraw-Hill.