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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. |
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:
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:
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.
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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 |
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 useVIU model does not include cash outflows required to get an asset ready for use. |
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To avoid double-counting, estimates of future cash flows do not include:
AASB 136, paragraph 43
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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.
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.
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:
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 capitalDouble 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.
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 liabilitiesDeducting deferred revenue liabilities from CGU assets when determining carrying amount of CGU assets tested for impairment. |
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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:
AASB 136, paragraph 44Because future cash flows are estimated for the asset in its current condition, value in use does not reflect:
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.
Publisher A has two operating segments:
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 - RestructuringIncluding 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.
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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 |
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 15Including 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. |
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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 |
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.
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 16Not including future cash flows necessary to maintain the level of economic benefits expected to arise from the asset in its current condition. |
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Estimates of future cash flows shall not include:
AASB 136, paragraph 50Estimated 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
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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.
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 17Including cash inflows or outflows from financing activities in the VIU model. |
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.
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.
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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) |
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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).
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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 18Including income tax receipts or payments in the VIU model. |
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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 |
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 |
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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 19Not 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
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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:
AASB 136, paragraph 53
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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.
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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 |
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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).
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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 |
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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 20Incorrectly 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. |
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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 |
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.
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2017 |
2018 |
2019 |
2020 |
2021 |
|
|
$'000 |
$'000 |
$'000 |
$'000 |
$'000 |
|
|
Sale proceeds in USD |
2,700 |
2,700 |
2,700 |
2,700 |
2,700 |
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Exchange rate |
0.70 |
0.65 |
0.60 |
0.58 |
0.57 |
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Sale proceeds converted to AUD |
3,857 |
4,154 |
4,500 |
4,655 |
4,737 |
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Costs in AUD |
(1,200) |
(1,200) |
(1,200) |
(1,200) |
(1,200) |
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Net cash flows |
2,657 |
2,954 |
3,300 |
3,455 |
3,537 |
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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) |
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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 21An entity translates foreign currency cash flows at a rate other than the prevailing spot rate. |
In next month’s article (Part 2c) we will look at errors in determining the discount rate.