How to amend impairment models for right-of-use assets under IFRS 16

The new leases standard, IFRS 16 Leases, applies to annual periods beginning on or after 1 January 2018, so would impact financial statements for years ending 31 December 2019 and 30 June 2020. While many entities (lessees in particular) are still grappling with the mechanics of lease accounting under IFRS 16, a lesser known, and often overlooked effect, is that lease accounting, and the consequential recognition of right-of-use (ROU) assets and lease liabilities on the balance sheet, impacts your impairment testing model under IAS 36 Impairment of Assets.

This article explores and explains these impacts. It does not elaborate fully on all aspects of the requirements of the IAS 36 impairment test, or the mechanics thereof. Please refer to our IFRS in Practicefor a more in-depth discussion on the reporting requirements of IAS 36.

ROU assets to be tested for impairment

ROU assets are non-financial assets, and impairment is therefore considered in the context of IAS 36. If using the ‘cost model’ to measure ROU assets subsequent to initial recognition, IFRS 16, paragraph 33, specifically requires lessees to apply IAS 36 in order to determine whether the ROU asset is impaired, and then to account for any resulting impairment loss.

Impairment losses arise where the asset’s carrying amount exceeds its recoverable amount.

Recoverable amount is the higher of:

Value in use (VIU), and
Fair value less costs of disposal (FVLCD).

Because of the significant uncertainty in the current COVID-19 environment, FVLCD may not be a reliable measure for recoverable amount because the range of possibilities could be extremely broad, or asset prices could be depressed. As such, VIU is probably the more appropriate measure for recoverable amount at the moment.

When to test ROU assets for impairment

At the end of each reporting period, lessees must assess whether there is any indication that an asset may be impaired, and if so, determine the recoverable amount, and any resulting impairment loss (IAS 36, paragraph 9).

It is important to note that an ‘impairment test’ (i.e. determining recoverable amount) is only necessary for an individual asset where impairment indicators exist at the end of the reporting period.

COVID-19 is likely to be an impairment indicator for most assets of most entities.

At what level are ROU assets tested for impairment?

Individual asset level

If the recoverable amount of the ROU assets can be estimated for the individual asset, then individual ROU assets are tested for impairment on a stand-alone basis. This would only occur if the ROU asset generates cash flows in its own right, i.e. the cash flows generated are largely independent of those generated from other assets.

CGU level

If it is not possible to estimate the recoverable amount of the individual ROU asset, lessees will need to determine the recoverable amount of the cash-generating unit (CGU) to which the ROU asset belongs. Typically ROU assets do not generate their own independent cash flows, except in limited cases, such as ROU assets that comprise investment properties which generate rental income. ROU assets are usually used as part of the lessee’s main operating activities, and therefore tested for impairment as part of a CGU, for example, leased premises, photocopiers, etc.

IFRS 16 may also result in the recognition of more corporate ROU assets, e.g. leased corporate head office, which must be allocated appropriately to CGUs for impairment testing purposes.

Timing of impairment tests

Impairment tests (i.e. determining recoverable amount), is performed in the time frames indicated in the table below.

Individual asset

Part of a CGU with NO goodwill and/or indefinite useful life intangible assets

Part of a CGU containing goodwill and/or indefinite useful life intangible assets

At the end of each reporting period, but only if there are indicators of impairment

IAS 36, paragraph 9

At the end of each reporting period, but only if there are indicators of impairment

IAS 36, paragraph 9

At least annually, at the same time each year

IAS 36, paragraph 10(a) & 90

AND

Whenever there is an indicator of impairment if outside of normal annual impairment testing cycle

IAS 36, paragraph 90

Example:

Entity ABC has a CGU containing goodwill and a 30 June 2020 year-end. It performs its annual impairment test in December each year.

Due to the overriding requirement in IAS 36, paragraph 9, to assess impairment indicators at reporting date, and given impairment indicators at 30 June 2020 due to COVID-19, ABC will need to perform another impairment test at 30 June 2020.

VIU applying IAS 17

Under IAS 17, operating lease expenses, both fixed and variable lease payments are:

Presented in the cash flow statement as cash outflows from ‘operating activities’ and
Deducted in determining VIU (i.e. NPV of future cash flows).

Although no detailed background information has been provided, the example VIU model below is a snapshot of an impairment test to illustrate how all rent charges until the end of the lease in 2024 are deducted to determine VIU, i.e. based (fixed rent), supplement (variable payments such as turnover rentals), and outgoings. Even though the lease finishes in 2024, we need to assume that the existing ROU asset will have to be replaced. Therefore cash flow assumptions for 2025 and the terminal value include cash outflows for new capital investment which is required to replace the current lease.

VIU applying IAS 17

Assuming the following carrying amounts of CGU assets, no impairment write-down is required because the recoverable amount of $987 exceeds the carrying amount of the CGU assets of $950 by $37, i.e. there is ‘head room’ of $37:

	$
Brand names PPE Other assets	500 350 100
	950

VIU applying IFRS 16

Under IFRS 16, lessees:

Recognise a ROU asset and lease liability on the balance sheet
Present the principal amount of the lease payments in the cash flow statement as outflows from financing activities, and
Present the interest portion of lease payments in the cash flow statement as outflows from either operating, investing or financing activities as permitted by IAS 7 Statement of Cash Flows.

IAS 36, paragraph 50 requires that estimates of future cash flows do not include cash outflows from financing activities. Because lease liabilities are now part of the entity’s recognised borrowings, they are part of the lessee’s financing activities, and all payments associated with these lease liabilities (principal and interest) must be excluded from the cash flows used to determine VIU.

‘Adding back’ lease payments to VIU cash flows will result in an increase in the recoverable amount of a CGU. However, the carrying amount of the CGU will also increase, because ROU assets must be included with the carrying amount of all other assets making up the CGU (such as goodwill, intangibles, PPE, etc.).

Using a similar VIU model as demonstrated for IAS 17 above (no detailed background information provided), the example VIU model below illustrates how the calculation is adapted under IFRS 16:

Budget and forecast cash flows for the remainder of the lease no longer include base rent changes as these are now considered outflows for financing activities.
Cash outflows still include variable lease charges for turnover rent, as well as outgoings, and
Consistent with VIU calculations under IAS 17, we assume that the existing ROU asset will have to be replaced at the end of the lease (see cash outflows for base rent (CAPEX) during 2025 and the terminal value).

VIU applying IFRS 16

Assuming the following carrying amounts of CGU assets, an impairment write-down of $17 is now required ($1,361 less $1,378):

	$
Brand names PPE ROU asset – premises for Store X (using modified retrospective method #1) ROU asset – head office premises - allocation of corporate asset using modified retrospective method #1) Other assets	500 350 423 5 100
	1,378

Theoretically this change in VIU methodology should not result in CGU impairment because economically the entity is leasing the same asset. However, there are two reasons why an impairment write-down is required under IFRS 16:

The discounted ‘cost savings’ in fixed lease payments are likely to be less than the additional ROU assets added to the CGU. This discrepancy arises because the incremental borrowing rate used to discount lease liabilities (which is the starting point for the ROU asset – assume 8%) is less than the rate used to discount cash flows for VIU (14%), and
The transition method selected to determine the ROU asset can also make a difference. For example, entities using modified retrospective method #1 to determine the ROU asset will include higher values for ROU assets in the carrying amount of the CGU because the ROU asset equals the lease liability on transition date. If modified retrospective method #2 is used, ROU assets on transition date are likely to be lower due to straight-line depreciation being applied from the commencement of the lease.

The discount rate

Also note that the discount rate used in our example above is lower at 14% than the 15% used under IAS 17. This is because the weighted average cost of capital should incorporate the capital cost of lease liabilities, which is expected to be lower because lease liabilities are secured borrowings. If you require assistance with determining the discount rate for VIU models applying IFRS 16, please contact BDO’s Corporate Finance team.

Are lease liabilities deducted from the carrying amount of the CGU?

When using VIU to determine recoverable amount, the general rule is that liabilities are not deducted from the carrying amount of the CGU. IAS 36, paragraph 78 only requires liabilities to be deducted where the disposal of the CGU would require the buyer to assume the liability (for example, a buyer would be required to assume lease liabilities). In such cases, the carrying amount of lease liabilities would be deducted off both the carrying amount of the CGU, and the recoverable amount of the CGU determined as VIU (i.e. comparing ‘apples with apples’).

On disposal of CGU…	Carrying amount of CGU	VIU recoverable amount
Buyer would not assume lease liabilities	No reduction for lease liabilities	No reduction for lease liabilities
Buyer would assume lease liabilities	Deduct from carrying amount of CGU	Deduct from VIU recoverable amount

Deducting the lease liabilities from the VIU recoverable amount calculation in these circumstances ensures that the VIU is a comparable measure to FVLCD, where a buyer would offer a lower price because of its assumption of lease liabilities.

It is important to note that the inclusion/exclusion of lease liabilities from the carrying amount of the CGU and VIU has a neutral effect, and therefore no impact on the amount of impairment losses recognised. In practice, even if lease liabilities would be assumed by a buyer, they can be ignored where there is a reasonable amount of ‘headroom’ in the VIU calculation (i.e. VIU exceeds carrying amount of the CGU by a reasonable amount). However, if there is insufficient ‘headroom’ in VIU, then FVLCD must be determined because recoverable amount is the ‘higher of’ FVLCD and VIU. FVLCD assumes deduction of lease liabilities, therefore, in order to compare FVLCD and VIU, lease liabilities must also be deducted from VIU.

Need assistance?

As demonstrated above, developing assumptions and inputs for VIU models under IAS 36 is complex, particularly given adjustments required to incorporate ROU assets into impairment models, and the added uncertainties around impacts of COVID-19. Please contact our IFRS Advisory Team if you require assistance. Our April 2020 webinar, Impairment testing after the implementation of IFRS 16 also includes additional information on this topic.