What’s the issue?
Trigger for impairment testing
War and conflict may significantly affect individuals, economic activity and financial markets on a global scale. In the case of the Russian government’s military invasion of Ukraine, the ensuing sanctions imposed by the international community on the Russian government and Russian companies and countermeasures by Russia significantly impacted individuals and companies in the region and beyond. Although war and conflict is first and foremost a human tragedy for those involved, many companies’ operations or assets are affected and they need to consider the possible accounting implications, including potential impairment triggers that may affect the measurement of their non-financial assets.
In the case of the Ukraine-Russia war, the likelihood that a triggering event has occurred for non-current assets has increased significantly for companies that:
- have significant assets or operations in Russia, Belarus or Ukraine;
- are significantly affected by the sanctions imposed and/or Russia’s countermeasures;
- are adversely affected by the volatility in the prices of commodities; and/or
- are significantly affected by supply chain disruption.
IAS 36 Impairment of Assets requires a company to assess at each reporting date whether there is any indication of impairment (or an indication that a previously recognised impairment loss has reversed). [IAS 36.9]
Irrespective of any indicator of impairment, IAS 36 requires goodwill, intangible assets with indefinite useful lives and intangible assets not yet available for use to be tested for impairment at least annually. The annual test is required in addition to any impairment tests performed as a result of a triggering event. [IAS 36.10]
An impairment loss recognised for goodwill is not reversed in subsequent periods, even if it was recognised in an interim period of the same financial year. [IAS 36.124, IFRIC 10.8]
Challenges in estimating cash flows
When a triggering event has occurred, management needs to determine the recoverable amount – the higher of value in use (VIU) and fair value less costs of disposal (FVLCD) – of an asset or cash-generating unit (CGU), which usually requires management to forecast future cash flows. Budgets and cash flow forecasts prepared by management generally serve as the starting point for the discounted cash flows used in calculating the recoverable amount. Significant assumptions, such as forecast sales, growth rates and inflation rates, profit margins, capital expenditure and discount rates will need to be reassessed and updated as appropriate due to the significant changes in economic and market conditions. Cash flows used in determining FVLCD should be updated to reflect the assumptions that market participants would use based on market conditions and information available at the reporting date. [IAS 36.4, 9, 33, IFRS 13.2]
Reflecting risks in the discount rate
The discount rate used to discount the forecast cash flows under both VIU and FVLCD may be significantly affected due to the increase in uncertainty and risks. The discount rate should reflect the impact of changes in interest rates and the risk environment at the reporting date. [IAS 36.56]
If the expected cash flow approach is used, then the discount rate should exclude risks that have been reflected in the cash flows to avoid double counting.
In the case of the Ukraine-Russia war, even companies that do not operate in Russia or Ukraine may need to test non-current assets for impairment if they have been significantly impacted by the sanctions, rising commodity prices or supply-chain disruption.
Getting into more detail
Trigger for impairment testing
IAS 36 applies to a variety of non-financial assets including property, plant and equipment (PP&E), right-of-use assets, intangible assets and goodwill, investment properties measured at cost and investments in associates and joint ventures1. [IAS 36.2, 4]
IAS 36 provides examples of indicators of triggering events, including (not exhaustive):
- when there is physical damage to an owned asset;
- when there are significant changes in the extent or manner in which an asset is (or is expected to be) used that have (or will have) an adverse effect on the company;
- when there are indications that the performance of an asset is, or will be, worse than expected;
- when there is a significant and unexpected decline in the asset’s market value;
- when net cash flows or operating profits are lower than originally budgeted;
- when significant changes have taken place during the period (or will take place in the near future) in the market, economic or legal environment in which the company operates and these changes will have an adverse effect on it; and
- when the carrying amount of the company’s net assets is higher than its market capitalisation. [IAS 36.9–10, 12]
In the case of the Ukraine-Russia war, the ensuing sanctions have directly impacted companies with significant assets or operations in Russia, Belarus or Ukraine. Over a thousand companies have curtailed operations in Russia.
Furthermore, some companies are no longer able to transact with their customers or suppliers in Russia, Belarus or Ukraine due to the inability to ship goods or transfer cash payments. Companies that continue to operate in these countries may be adversely affected by the deteriorating economic and business environment and may also suffer reputational damage.
Companies may be indirectly affected by the volatility of commodity prices (mainly energy, metals and agricultural commodities), supply chain disruption and the volatility in certain foreign exchange rates.
Challenges in estimating cash flows
In estimating future cash flows, companies need to reflect the impact of sanctions, changes in commodity prices and the changes to the economic and business environment in which they operate. In the case of the Ukraine-Russia war, estimating future cash flows has been particularly challenging for companies with significant operations or assets in Russia, Belarus or Ukraine. The complexities involved include uncertainty on shorter-term developments during the active conflict and the longer-term post-war arrangements and recovery.
- Under VIU, the cash flow projections should be based on reasonable and supportable assumptions that represent management’s best estimate of the range of economic conditions that will exist over the remaining useful life of the asset or CGU. Greater weight is given to external evidence.
- Under FVLCD, the estimates and assumptions used are from the perspective of market participants. [IAS 36.33(a), IFRS 13.22]
It could be helpful to base forecasts related to the impact of the war on the economy on external sources such as economic projections by respected central banks and other international organisations if they are available.
Reflecting risks in the discount rate
The war in Ukraine may have had a significant impact on entity-specific risk premiums (e.g. financing risk, country risk and forecasting risk) used in determining the appropriate discount rate to discount future cash flows. [IAS 36.A1, A16, A18]
- Financing risk: a premium that takes into account the potential difficulty of funding working capital or maintainable capital expenditure in the short to medium term.
- Country risk: a premium that takes into account the additional risk associated with generating and incurring cash flows in a particular country – e.g. Russia, Ukraine.
- Forecasting risk: a premium that takes into account the greater uncertainty in making economic and financial forecasts in the near term, due to the difficulty in forecasting the magnitude of the impact of the war and sanctions imposed (if it is not already included in the cash flows). [Insights 3.10.300.170]
Significant judgement may be needed to quantify risk premiums and other adjustments for these risks.
Considering which approach to use to project cash flows
Two approaches can be used to project cash flows – the traditional approach, which uses a single cash flow projection, and the expected cash flow approach (ECF), which uses multiple, probability-weighted cash flow projections. [IAS 36.A2, A4–A14]
The ECF approach (rather than the traditional approach) may be useful in identifying and modelling various potential outcomes. For example, modelling different scenarios in determining the value of operations suspended in Russia. [IAS 36.A2, A7]
Whichever approach a company adopts, the rate used to discount cash flows should not reflect adjustments for factors that have been incorporated into the estimated cash flows and vice versa. Otherwise, the effect of some factors would be double counted. [IAS 36.55–56]
Impact on useful life and residual value
In the case of the Ukraine-Russia war, some companies have abandoned, or have adopted a plan to abandon, properties or certain operations in Russia, Belarus or Ukraine. For example, some companies have vacated owned or leased facilities in Ukraine due to the war. In these cases, the company needs to accelerate depreciation of the property and/or to impair it. [IAS 16.51, 56(a), 57]
PP&E is not abandoned if it is only temporarily idle – e.g. when a company temporarily shuts a manufacturing facility but intends to resume operations after military activities in the area abate. Although temporarily idling a PP&E item may trigger an impairment of that item (or the CGU to which it belongs), a company does not stop depreciating the item while it is idle (unless it is fully depreciated or is classified as held-for-sale). However, under usage methods of depreciation, the depreciation charge can be zero while there is no production. [IAS 16.55]
Companies may change their usage or retention strategy for some of their PP&E items as a result of conflict. Management should review whether the useful life and residual value of these assets, and the depreciation method applied to them, remain appropriate. This review may also be required after testing a CGU or an asset for impairment or if an indicator of impairment exists. Any such changes are accounted for prospectively as a change in accounting estimate. [IAS 16.61, IAS 36.17, Insights 3.10.350.30]
Considering the impacts of war on the economic and business environment and the elevated risks and uncertainty, disclosures related to impairment testing are likely to be a focus area for investors.
In the context of impairment testing of goodwill and indefinite-lived intangible assets, IAS 36 requires disclosure of the key assumptions used to determine the recoverable amount. Where significant estimation uncertainty exists, a higher number of key assumptions may need to be disclosed – e.g. whether and when suspended operations will be resumed. Management should also consider disclosing how uncertainty was factored into the impairment test.
IAS 36 also requires sensitivity disclosures if a reasonably possible change in a key assumption would cause a CGU’s carrying amount to exceed its recoverable amount. Furthermore, IAS 1 Presentation of Financial Statements requires disclosure of the key assumptions that a company makes about the future and other major sources of estimation uncertainty at the reporting date that have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities in the next financial year. [IAS 1.125, 129, 36.134(d)–(f)]
Where the uncertainty associated with management’s assumptions about the future is likely to be significant, it is important that management develops robust disclosures to help users understand the sensitivity of recoverable amount estimates to significant changes in key assumptions affected by war or conflict. For example, it may be appropriate to disclose management’s views about the degree of uncertainty associated with the macroeconomic outlook. The scale of reasonably possible changes in the key assumptions may be larger than usual. [IAS 1.129(b)]
Interim condensed reports
IAS 34 Interim Financial Reporting requires disclosure of the nature and amount of changes in estimates. Impairment losses are examples of events and transactions that require disclosure under IAS 34 if they are significant. Under IAS 34, when an event or transaction is significant to an understanding of the changes in a company’s financial position or performance since the last annual reporting period, as may be the case with material impairment losses recognised in an interim period, the company’s interim financial report should provide an explanation of and an update to the relevant information included in the financial statements of the last annual reporting period. IAS 36 provides relevant disclosures to be considered in this regard. [IAS 34.15B(b), 15C, 16A(d)]
Actions for management
- any indicators of impairment exist for the company’s CGUs or assets that are tested on a stand-alone basis;
- budgets and cash flow projections used in valuations have been updated to reflect information available at the reporting date;
- discount rates used in valuations have been updated to reflect the risk environment at the reporting date; and
- sensitivity disclosures and disclosures about the key assumptions and major sources of estimation uncertainty need to be enhanced in the interim and annual reports.
1 The guidance in IAS 28 Investments in Associates and Joint Ventures is used to determine whether it is necessary to perform an impairment test for investments in equity-accounted investees. If there is an indication of impairment, then the impairment test follows the principles of IAS 36. [IAS 28.40–42]
References to ‘Insights’ mean our publication Insights into IFRS®
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