Blind Freddy – Common errors in accounting for impairment – Part 2b

The ‘Blind Freddy’ proposition is a term used by Justice Middleton in the case of ASIC v Healey & Ors [2011] (Centro case) to describe glaringly obvious mistakes.

The whole essence of the ‘Blind Freddy’ series is to highlight instances where, despite the accounting standards being very clear on a particular accounting treatment, preparers regularly ignore the clear instructions in the standard, resulting in their financial statements being potentially materially misstated.

While estimating an asset’s recoverable amount requires a great degree of judgement and estimation, in a number of cases there are a set of very clear rules that ‘Blind Freddy’ could recognise, which are commonly overlooked. These include:

  • Not testing for impairment when the standard clearly requires it
  • Not testing for impairment at the correct ‘unit of account’
  • Not including the correct assets in the impairment test
  • Basic errors in determining recoverable amount
    • Basic errors in determining ‘value in use’
    • Basic errors in determining ‘fair value less cost of disposal’.

In last month’s article (Part 2a), we identified 10 ‘Blind Freddy’ errors preparers make when determining value in use (VIU) for recoverable amount calculations under AASB 136 Impairment of Assets. This month, Part 2b covers more ‘Blind Freddy’ errors relating to VIU calculation, including:

  • Projections of cash outflows required to get an asset ready for use
  • Avoid double-counting cash flows
  • Cash flows shall only include those for the asset in its current condition
  • Not including refurbishment costs (day-to-day servicing)
  • Including cash inflows or outflows from financing activities in the VIU model
  • Treatment of income tax receipts or payments
  • Estimating the net cash flows to be received (or paid) for the disposal of an asset at the end of its useful life
  • Foreign currency future cash flows.

Projections of cash outflows required to get an asset ready for use

If an asset is not yet ready for use, cash flows to get that asset ready for use must be included in the VIU model.

When the carrying amount of an asset does not yet include all the cash outflows to be incurred before it is ready for use or sale, the estimate of future cash outflows includes an estimate of any further cash outflow that is expected to be incurred before the asset is ready for use or sale. For example, this is the case for a building under construction or for a development project that is not yet completed.

AASB 136, paragraph 42

Example 9

Entity H is testing an intangible not yet ready for use for impairment.

Carrying value is $10,000,000.

VIU calculation is based on the forecast EBITDA. The asset is forecast to start generating revenue in nine month’s time.

Entity H determines the VIU using a 10% discount rate as follows:

2017

2018

2019

2020

2021

$'000

$'000

$'000

$'000

$'000

EBITDA

           600

      1,000

      3,000

      4,000

      6,000

10%

$545.45

$826.45

$2,253.94

$2,732.05

$3,725.53

The recoverable amount is determined to be $10,083,430 and Entity H concludes that no impairment charge is to be recognised (carrying amount is $10 million).

Entity H forecasts that a further $700,000 development spend is required to complete the asset.

Correct VIU calculation is therefore as follows:

2017

2018

2019

2020

2021

$'000

$'000

$'000

$'000

$'000

EBITDA

           600

      1,000

      3,000

      4,000

      6,000

Capital Spend

(700)

Cash flow

          (100)

      1,000

      3,000

      4,000

      6,000

10%

-$90.91

$826.45

$2,253.94

$2,732.05

$3,725.53

Recoverable amount is $9,447,060 and an impairment charge of $552,940 should have been recognised ($10,000,000-9,447,600).

Blind Freddy Error 11 – Cash flows to get an asset ready for use

VIU model does not include cash outflows required to get an asset ready for use.

Avoid double-counting cash flows

To avoid double-counting, estimates of future cash flows do not include:

  • cash inflows from assets that generate cash inflows that are largely independent of the cash inflows from the asset under review (for example, financial assets such as receivables); and
  • cash outflows that relate to obligations that have been recognised as liabilities (for example, payables, pensions or provisions).

AASB 136, paragraph 43

Double counting cash flows from working capital - Cash inflows from other assets on the balance sheet

When preparing VIU calculations, preparers must be careful not to ‘double count’ cash flows from assets recognised separately on the entity’s balance sheet, that are independent from the asset being tested for impairment. This particularly relates to the receipts from trade receivables, receipts of refundable GST, and the receipts from the sale of finished inventory.

Example 10

Manufacturer A prepares a VIU cash flow model using its forecast EBITDA budget as its basis. Manufacturer A typically has an inventory turnover of 120 days.

At 31 December 2016, it has 90 days of finished goods on hand and 60 days of work in progress.

It tests the long-term assets (goodwill and PPE) for impairment, without adjusting the EBITDA forecasts for working capital associated with inventory on hand.

Commentary - Assuming the entity sells goods on 90 day credit terms, and has at least 90 days finished goods on hand, the entity will not receive any cash from the producing assets for 180 days. The cash flow model must be adjusted for this.

Example 11

Entity I has 90 day credit terms and sells approximately 25% of its annual sales in June each year.

At the year end, 30 June 2016, Entity I has trade receivables of $10 million, which will be collected as follows:

  • $1 million in July 2016
  • $2 million in August 2016
  • $7 million in September 2016.

Entity I uses its 30 June 2017 cash flow forecast as the basis for its VIU at 30 June 2016, without any adjustment for working capital.

Commentary - The cash flow model includes $10 million of cash flows that are not being generated by the assets which are being tested for impairment.

Blind Freddy Error 12 – Double counting cash inflows for working capital

Double counting cash inflows for receivables and inventory in VIU impairment testing.

Double counting cash flows from working capital - Inclusion/exclusion of liabilities

In a similar manner to adjustments required to VIU models in respect of assets recognised separately on the balance sheet (receivables and inventories), preparers should be aware of adjustments required for working capital adjustments to be made for liabilities on the balance sheet that represent future obligations to pay out cash. This includes trade payables, accrued wages, provisions for restoration, etc.

An area that can commonly lead to errors is the recognition of deferred revenue liabilities when determining VIU, and incorrectly deducting this liability from the carrying value of the asset to be impaired.

Example 12

Software Co sells software licences.

It receives 100% of the sales proceeds when it sells the licence, and recognises a deferred revenue liability. It then recognises revenue over the life of the licence.

Software Co has assets (goodwill and intangibles) of $10 million and a deferred revenue amount of $2 million. When determining the value of the asset to be tested for impairment, it models out its cash flows, using expected cash inflows and adjusting for working capital in respect of trade receivables and trade payables.

It deducts the deferred revenue amount from the carrying value of the producing assets.

Commentary - By its nature, cash has already been received for the deferred revenue, therefore there should be no adjustment in the VIU model.

Blind Freddy Error 13 – Double counting deferred revenue liabilities

Deducting deferred revenue liabilities from CGU assets when determining carrying amount of CGU assets tested for impairment.

Cash flows shall only include those for the asset in its current condition

Future cash flows shall be estimated for the asset in its current condition. Estimates of future cash flows shall not include estimated future cash inflows or outflows that are expected to arise from:
  • a future restructuring to which an entity is not yet committed; or
  • improving or enhancing the asset’s performance.

AASB 136, paragraph 44

Because future cash flows are estimated for the asset in its current condition, value in use does not reflect:

  • cash outflows or related cost savings (for example reductions in staff costs) or benefits that are expected to arise from a future restructuring to which an entity is not yet committed; or
  • future cash outflows that will improve or enhance the asset’s performance or the related cash inflows that are expected to arise from such outflows.

AASB 136, paragraph 45

Factoring restructuring into the VIU

AASB 136, paragraph 12(g) requires an entity to test for impairment when ‘evidence is available from internal reporting that indicates that the economic performance of an asset is, or will be, worse than expected.’ In such cases, it is reasonable to expect the entity to take actions to return the asset to its anticipated economic performance. This can be through reorganisations, cost cuttings, redundancies, etc. Preparers must be careful not to include cost savings from a planned restructuring unless they can demonstrate that they are clearly committed to such a plan.

There would appear to be an alignment with this requirement, and the entity recognising a redundancy provision under AASB 137 Provisions, Contingent Liabilities and Contingent Assets. AASB 136, paragraphs 44(a) and 45(a) clearly prohibit inclusion of savings from restructuring for which an entity is not committed.

Example 13

Publisher A has two operating segments:

  • Print publishing
  • Online publishing.

In November 2016, it prepares its annual budget for 2017, which shows a significant downturn in the profitability of the print publishing division. This triggers the requirement to test the print publishing assets for impairment (AASB 136, paragraphs 9 and 12 (g)).

Concurrent with modelling the VIU, a plan is derived to restructure the operation and merge the print and online businesses, resulting in savings through reducing head count by 100, mainly through reducing duplication of functions (sales, admin and editorial). 

At 31 December 2016 this plan has not been communicated to management, staff or to the market. Publisher A incorrectly includes the anticipated savings and concludes that there is no impairment.

Blind Freddy Error 14 - Restructuring

Including increased cash inflows from a restructuring to which an asset is not yet committed.

Factoring in enhancements into a VIU model

Entities may also look to improve the performance of an asset by making technological enhancements to the asset. Again, AASB 136, paragraph 44 assumes that cash flows are estimated for the asset in its current condition, and paragraphs 44(b) and 45(b) prohibit the inclusion of the impacts of enhancements to an asset to which it is not yet contractually committed. 

Until an entity incurs cash outflows that improve or enhance the asset’s performance, estimates of future cash flows do not include the estimated future cash inflows that are expected to arise from the increase in economic benefits associated with the cash outflow (see Illustrative Example 6).

AASB 136, paragraph 48

Example 14

In October 2016, Oil Refiner forecasts operating losses in its refinery operation in Sydney.

The refinery is over 30 years old, and management recognise that in order to compete with more modern refineries operating in Singapore, approximately $100 million investment is required.

In accordance AASB 136, paragraph 9, the refinery is tested for impairment. The VIU includes the cost of $100 million for the required plant enhancements, together with the adjusted capacity and operating costs, and revenue forecasts from these enhancements.

This shows there is no impairment. The entity is in the process of selecting the supplier for these enhancements (i.e. not yet committed).

These enhancements cannot be included in the VIU model because they do not represent cash flows of the refinery in its current condition

Blind Freddy Error 15

Including increased cash inflows from improving or enhancing the asset’s performance which do not represent future cash flows of the asset in its current condition.

Not including refurbishment costs (day-to-day servicing)

Estimates of future cash flows include future cash outflows necessary to maintain the level of economic benefits expected to arise from the asset in its current condition. When a cash-generating unit consists of assets with different estimated useful lives, all of which are essential to the ongoing operation of the unit, the replacement of assets with shorter lives is considered to be part of the day-to-day servicing of the unit when estimating the future cash flows associated with the unit. Similarly, when a single asset consists of components with different estimated useful lives, the replacement of components with shorter lives is considered to be part of the day-to-day servicing of the asset when estimating the future cash flows generated by the asset.

AASB 136, paragraph 49

Example 15

A CGU comprises a mine, mining equipment, a processing plant and trucks.

The mine has a forecast useful life of 20 years.

The processing plant will require a midlife overhaul after ten years and trucks will need to be fully replaced after ten years.

The VIU model incorrectly excludes the cost of the mid-life refurbishment of the processing plant and the cost of replacing the trucks in ten years.

Example 16

A hotel owner estimates the useful life of its hotel to be 20 years.

It uses a VIU model showing a steady revenue stream between years six and 20, assuming that it will be able to operate as a five star hotel in that city, and that demand and supply for hotel beds will remain in equilibrium.

In order to maintain its position as a five star hotel, it forecasts that it will have to undertake significant renovations every seven years to both its rooms and food and beverage outlets.

The VIU model incorrectly excludes the cost of these refurbishments.

Blind Freddy Error 16

Not including future cash flows necessary to maintain the level of economic benefits expected to arise from the asset in its current condition.

Including cash inflows or outflows from financing activities in the VIU model

Estimates of future cash flows shall not include:

  • cash inflows or outflows from financing activities; or
  • income tax receipts or payments.

AASB 136, paragraph 50

Estimated future cash flows reflect assumptions that are consistent with the way the discount rate is determined. Otherwise, the effect of some assumptions will be counted twice or ignored. Because the time value of money is considered by discounting the estimated future cash flows, these cash flows exclude cash inflows or outflows from financing activities. Similarly, because the discount rate is determined on a pre-tax basis, future cash flows are also estimated on a pre-tax basis.

AASB 136, paragraph 51

Example 17

Entity J borrows $100 million to finance the construction of its new factory.

It incurs cash outflows of $10 million per annum servicing this debt.

It wrongly includes these cash outflows in its VIU model.

Example 18

Entity K forecasts that its operation will generate significant cash surpluses which it intends to place on deposit in high yield fixed rate bonds. It wrongly includes the forecast interest income in its VIU model.

Blind Freddy Error 17

Including cash inflows or outflows from financing activities in the VIU model.

Treatment of income tax receipts or payments

As the VIU model must use the pre-tax interest rate, it is incorrect to include cash receipts or payments in respect of income tax.

Example 19

Entity L has a CGU with a carrying value of $10 million and determines its VIU to be $7,058,000 by wrongly including a 30% tax charge. It recognises an impairment loss of $2,942,000.

2017

2018

2019

2020

2021

$'000

$'000

$'000

$'000

$'000

Profit before tax

           600

      1,000

      3,000

      4,000

      6,000

Tax at 30%

       (180)

(300)

(900)

(1,200)

(1,800)

Cash flows

           420

         700

      2,100

      2,800

      4,200

10%

$381.82

$578.51

$1,577.76

$1,912.44

$2,607.87

The above VIU model should have recorded no impairment charge because without the deductions for tax payments, the recoverable amount would have exceeded $10,000 (refer table below).

2017

2018

2019

2020

2021

$'000

$'000

$'000

$'000

$'000

Profit before tax

           600

      1,000

      3,000

      4,000

      6,000

Cash flows

           600

      1,000

      3,000

      4,000

      6,000

10%

$545.45

$826.45

$2,253.94

$2,732.05

$3,725.53

Blind Freddy Error 18

Including income tax receipts or payments in the VIU model.

Estimating the net cash flows to be received (or paid) for the disposal of an asset at the end of its useful life

The estimate of net cash flows to be received (or paid) for the disposal of an asset at the end of its useful life shall be the amount that an entity expects to obtain from the disposal of the asset in an arm’s length transaction between knowledgeable, willing parties, after deducting the estimated costs of disposal.

AASB 136, paragraph 52

Example 20

Entity M prepares the following VIU model for a CGU with a carrying amount of $10 million.

It determines the recoverable amount to be $9,773,000 and recognises an impairment loss of $227,000.

2017

2018

2019

2020

2021

$'000

$'000

$'000

$'000

$'000

Profit before tax

           600

      1,000

      3,000

      4,000

      5,500

Cash flows

           600

      1,000

      3,000

      4,000

      5,500

10%

$545.45

$826.45

$2,253.94

$2,732.05

$3,415.07

The VIU model incorrectly excluded the forecast scrap value ($500,000) of disposing of all of the assets that should have been included in the VIU model. This resulted in a VIU of $10,083,000, with no impairment write-down.

2017

2018

2019

2020

2021

$'000

$'000

$'000

$'000

$'000

Profit before tax

           600

      1,000

      3,000

      4,000

      5,500

Sale proceeds

      500

Cash flows

           600

      1,000

      3,000

      4,000

      6,000

10%

$545.45

$826.45

$2,253.94

$2,732.05

$3,725.53

Blind Freddy Error 19

Not including the net cash flows to be received (or paid) for the disposal of an asset at the end of its useful life in the VIU model.

Estimating the fair value

The estimate of net cash flows to be received (or paid) for the disposal of an asset at the end of its useful life is determined in a similar way to an asset’s fair value less costs of disposal, except that, in estimating those net cash flows:

  • an entity uses prices prevailing at the date of the estimate for similar assets that have reached the end of their useful life and have operated under conditions similar to those in which the asset will be used.
  • the entity adjusts those prices for the effect of both future price increases due to general inflation and specific future price increases or decreases. However, if estimates of future cash flows from the asset’s continuing use and the discount rate exclude the effect of general inflation, the entity also excludes this effect from the estimate of net cash flows on disposal.

AASB 136, paragraph 53

Example 21

Entity N prepares the following VIU model for a CGU with a carrying amount of $10 million.

It determines the recoverable amount to be $10,083,000, assuming that the scrap value of the equipment, including the impact of inflation, over the next five years of 5% per annum is $500,000.

2017

2018

2019

2020

2021

$'000

$'000

$'000

$'000

$'000

Profit before tax

           600

      1,000

      3,000

      4,000

      5,500

Sale proceeds

      500

Cash flows

           600

      1,000

      3,000

      4,000

      6,000

10%

$545.45

$826.45

$2,253.94

$2,732.05

$3,725.53

The discount rate of 10% excludes inflation. Therefore the estimated fair value the sale value of the asset should not have been adjusted for inflation and should instead have been recorded at $300,000, with an impairment loss of $41,000 (refer table below).

2017

2018

2019

2020

2021

$'000

$'000

$'000

$'000

$'000

Profit before tax

           600

      1,000

      3,000

      4,000

      5,500

Sale proceeds

      300

Cash flows

           600

      1,000

      3,000

      4,000

      5,800

10%

$545.45

$826.45

$2,253.94

$2,732.05

$3,601.34

Blind Freddy Error 20

Incorrectly estimating the net cash flows to be received (or paid) for the disposal of an asset at the end of its useful life in the VIU model.

Foreign currency future cash flows

Future cash flows are estimated in the currency in which they will be generated and then discounted using a discount rate appropriate for that currency. An entity translates the present value using the spot exchange rate at the date of the value in use calculation.

AASB 136, paragraph 54

Example 22

Entity O has an asset with a carrying value of $10 million.

It has cash inflows in USD and translates the forecasted cash flows at the forward rates available for the next two year period, then takes a consensus view with a steady weakening of the Australian dollar. The VIU recoverable amount is calculated as $11,892,000 and Entity O records no impairment loss.

2017

2018

2019

2020

2021

$'000

$'000

$'000

$'000

$'000

Sale proceeds in USD

         2,700

          2,700

          2,700

          2,700

          2,700

Exchange rate

          0.70

            0.65

            0.60

            0.58

            0.57

Sale proceeds converted to AUD

         3,857

          4,154

          4,500

          4,655

          4,737

Costs in AUD

(1,200)

(1,200)

(1,200)

(1,200)

(1,200)

Net cash flows

         2,657

          2,954

          3,300

          3,455

          3,537

10%

$2,415.58

$2,441.20

$2,479.34

$2,359.93

$2,196.10

The spot rate was 0.74 and the VIU impairment model should have been as follows:

2017

2018

2019

2020

2021

$'000

$'000

$'000

$'000

$'000

Sale proceeds in USD

         2,700

          2,700

          2,700

          2,700

          2,700

Exchange rate

          0.74

            0.74

            0.74

            0.74

            0.74

Sale proceeds converted to AUD

         3,649

          3,649

          3,649

          3,649

          3,649

Costs in AUD

       (1,200)

         (1,200)

         (1,200)

         (1,200)

         (1,200)

Net cash flows

         2,449

          2,449

          2,449

          2,449

          2,449

10%

$2,226.04

$2,023.68

$1,839.71

$1,672.46

$1,520.42

This results in a recoverable amount of $9,282,000 and an impairment loss of $718,000.

Blind Freddy Error 21

An entity translates foreign currency cash flows at a rate other than the prevailing spot rate.

Next month

In next month’s article (Part 2c) we will look at errors in determining the discount rate.