Analysis of Impairment Test, Calculation and Journal Entries

This finance assignment explores the concept of impairment testing, focusing on the calculation of recoverable amounts and the comparison with carrying amounts. The solution details the determination of 'value in use' as the present value of future cash flows, considering factors like discount rates and cash flow projections. It also explains 'fair value less cost of selling.' The assignment includes a practical example with a table showing carrying amounts, recoverable amounts, and impairment losses for various assets, followed by the corresponding journal entries to record the impairment loss. The solution references key financial reporting concepts and provides a comprehensive overview of impairment testing methodologies.

FINANCE

Solution 1:
The recoverable amount of a particular asset is the higher of the ‘value in use’ and ‘fair value
less cost of selling’. While carrying out an impairment test, recoverable amount is compared
to the carrying amount. For the purpose of the impairment test, recoverable amount for each
asset in the cash generating unit is determined. A cash generating unit is a pool of assets that
helps the company to generate cash inflows. (Edwards, 2014)
As we know, we will require ‘value in use’ to determine the recoverable amount. Therefore,
let us now understand about it. Value in use can be defined as the present value of the
estimated future cash flows derived by a particular cash generating unit. The calculation of
value in use includes the following:
 A forecast of the future cash flows that the company is expecting to derive from the
asset. (Girard, 2014)
 Possibility of the variations of these cash flows and the timing at which these cash
flow are expected to be generated.
 A discount rate is required to calculate the present value of the cash flows. Therefore,
there is a requirement of discount rate which can be determined by taking various
factors into consideration such as liquidity, risk bearing etc. (McLaney & Adril, 2016)
The cash flow projects that are made by the company while measuring value in use:
 Must be ascertained based on certain valid reasons and supportable assumptions
as it would represent the economic condition of the remaining life of the asset.
 It should be based on the current forecast, financial reports and budgets made and
approved by the management (Pratt, 2009). However, it should exclude any cash
outflows that would arise on the reconstruction until the company has no
commitment for it.
 Certain item should always be excluded such as borrowing cost, capital expenses
and tax receipts or payments those results into the improvement or enhancement
of any asset.
It is highly recommended to compare the estimates of the cash flows made earlier to the
actual cash flows. It will help the company to know the variance and then the management
will be able to take corrective measure towards it so that the company is able to make

adequate estimates in the future. This should compulsorily be done when the company has
been continuously understating or overstating the cash flow projections. (Schroeder, 2014)
The present value is calculated by any of the two approaches- ‘traditional’ or expected’ ‘cash
flow approach. The result of the impairment test will be same irrespective of the approach
that we follow. In the traditional cash flow approach, a single set of projected cash flows and
only one discount rate is used (Siciliano, 2015). The discount rate that is used is in relation to
the level of risk undertaken. In the expected cash flow approach, the probabilities of the cash
flows are not the same and therefore, different discount rates are used.
If there are similar assets available in the market then one should go for the traditional cash
flow approach. A company should maintain consistency in regards to the discount rate i.e. it
should either use real rate every year or use nominal rate consistently. The cash flows that are
used in the calculation of value in use should be pre tax and pre tax discount rates. Since
many companies use the capital asset pricing model- they use post tax cost of equity in order
to determine the discount rate.
Fair value less cost of sell is easier to understand as it is the amount that can be obtained from
the selling an asset in the market to a knowledgeable and a person willing to obtain that asset
less the cost required to dispose the asset.
 The most evident way to determine the fair value less cost of selling is by determining
the price mentioned in a sales agreement in which the adjustment will be made if
there will be any incremental cost that will be incurred while disposing off the asset.
 There may not be sales agreement, but it might have a ready market for sale. In such a
case the market price should be determined and the cost of disposal should be
deducted. (Zyla, 2013)
 If both the above situations are not available i.e. if there is no sale agreement and also
there is no ready market then the entity should obtain the information regarding the
amount that it would receive if it sells the asset at the end of the reporting period in an
arm’s length transaction after subtracting the cost that will be incurred in relation to
this disposal.
There is an alternative available if the market price is not available. The alternative
approach is called the discounted cash flow approach or DCF. In order to carry out the
valuation through this approach, we need to keep the following points in mind:

 All the future events that will have an effect on the cash flows directly or
indirectly should be taken into consideration while calculating the fair value in
use. (Scott, 2014)
 There should not be a high cost involvement in ascertaining the stream of future
cash flows.
 The assumptions that are market based should be reliable and in accordance to the
current scenario.
 If there is difference in the assumptions stated by the company and the market
participants. Then in such a case, the company must make changes to the
assumptions. (Schroeder, 2014)
 Any transaction cost that is incurred in the process of disposal shall be considered.
Risk and uncertainty should be reflected in the value in use as well as Fair value less cost of
sell. An adjustment in the risk can be made by either adjusting the cash flows or adjusting the
discount rate. However, it is difficult to determine the discount rate because of so many
assumptions and the dynamic nature of the business activities.

Solution 2:
Account Carrying Amount Recoverable Amount Impairment
Factory 195200 1,87,922 7,278
Trademar
k 45000 6,735
Vehicle 28000 4,191
Inventory 12000 1,796
Goodwill 10000 10,000
Total CA 290200
2,60,200 30,000 12,722
85,000
The distribution of the impairment loss on the basis of the carrying amount is shown below:
Particular
s Carrying Amount Ratio Impairment Loss
Trademark 45000 0.53 6,735
Vehicle 28000 0.33 4,191
Inventory 12000 0.14 1,796
85,000 12,722
The journal entries are as follows:
Particulars Dr Amt Cr Amt
Accumulated Impairment Loss ...
…..Dr 30,000.00
To Factory 7,278.00
To Equipment 6,735.18
To Building 4,190.78
To Inventory 1,796.05
To Goodwill 10,000.00
(Being impairment on assets realised)

Impairment loss……Dr 30,000.00
To accumulated impairment loss 30,000.00