Blind Freddy – Common errors in accounting for impairment – Part 3 - Errors when determining ‘fair value less costs of disposal’
The ‘Blind Freddy’ proposition is a term used by Justice Middleton in the case of ASIC v Healey & Ors  (Centro case) to describe glaringly obvious mistakes.
In this month’s Blind Freddy article, we continue our series on errors that can be made in applying the requirements of AASB 136 Impairment of Assets, focusing on errors that can be made by not applying the requirements of AASB 136 and AASB 13 Fair Value Measurement when determining an asset’s recoverable amount using ‘fair value less cost of disposal’ (FVLCD).
Basic requirements of AASB 136
The recoverable amount of an asset or a cash-generating unit is the higher of its fair value less costs of disposal and its value in use.
Definition of ‘recoverable amount’ in AASB 136, paragraph 6
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. (See AASB 13 Fair Value Measurement.)
Definition of ‘fair value’ in AASB 136, paragraph 6
AASB 136 contains 25 paragraphs on how to calculate value in use (VIU), setting out very detailed guidance on the:
- Basis for estimating future cash flows
- Composition of estimates of future cash flows
- Foreign currency future cash flows, and
- Discount rate.
At the same time, AASB 136 only contains two paragraphs on the fair value method. These discuss what should be regarded as a ‘cost of disposal’ and the treatment of liabilities to be assumed by the buyer, rather than containing any detailed guidance on how to determine fair value. However, it would be wrong for preparers to conclude that determining fair value less costs of disposal (FVLCD) is not subject to the application of very strict principles, which if not applied correctly, could lead to ‘Blind Freddy’ errors.
Fundamentally, the determination of FVLCD is something far more sophisticated than a discounted cash flow model which contains wildly optimistic forecasts and is back-engineered to show that there is no impairment charge. FVLCD is not a means of circumventing the strict rules around preparing discounted cash flow models for VIU calculations.
Can FVLCD be reliably measured?
We should not underestimate the difficulties in determining fair value where there are no observable inputs into the valuation model. AASB 136 acknowledges that in some circumstances, it may not be possible to determine FVLCD, in which case the VIU model must be used.
It may be possible to measure fair value less costs of disposal, even if there is not a quoted price in an active market for an identical asset. However, sometimes it will not be possible to measure fair value less costs of disposal because there is no basis for making a reliable estimate of the price at which an orderly transaction to sell the asset would take place between market participants at the measurement date under current market conditions. In this case, the entity may use the asset’s value in use as its recoverable amount.
AASB 136, paragraph 20
Although the preparer effectively has the choice to determine an asset’s recoverable amount by either determining its VIU or FVLCD, preparers and auditors should be aware of the inherent difficulties in determining FVLCD for an asset where there are no recent observable transactions, or is not being actively marketed for sale.
The use of FVLCD is typically applied to assets that are not actually in use, i.e. mothballed mining assets, or assets that are in the start-up phase, or not fully in production.
What is fair value?
AASB 136 defines fair value as ‘… the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.’
IAS 36 (the international equivalent of AASB 136) was originally issued in 1998 by the International Accounting Committee (IASC), the predecessor to the IASB. It was not until the release of AASB 13 (IFRS 13) in May 2011 that detailed guidance was produced on fair value. Preparers and auditors now need to follow the principles set out in AASB 13 if they are going to use FVLCD as the basis of determining an asset’s recoverable amount.
The majority of the ‘Blind Freddy’ errors highlighted in this article therefore centre on these AASB 13 principles not being applied correctly.
Fair value is a market-based measurement, not an entity-specific measurement
A fundamental principle of AASB 13 is that fair-value is a market-based measurement, not an entity-specific measurement.
Fair value is a market-based measurement, not an entity-specific measurement. For some assets and liabilities, observable market transactions or market information might be available. For other assets and liabilities, observable market transactions and market information might not be available. However, the objective of a fair value measurement in both cases is the same - to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions (i.e. an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability).
AASB 136, paragraph 2
There are therefore two key aspects of this basic principle that impact the application of AASB 136, i.e.:
- Inputs into any cash flow model must be those of a market participant, and
- Any entity-specific savings or costs should be excluded from the model (refer AASB 136, paragraph) 53A
Fair value differs from value in use. Fair value reflects the assumptions market participants would use when pricing the asset. In contrast, value in use reflects the effects of factors that may be specific to the entity and not applicable to entities in general. For example, fair value does not reflect any of the following factors to the extent that they would not be generally available to market participants:
- additional value derived from the grouping of assets (such as the creation of a portfolio of investment properties in different locations)
- synergies between the asset being measured and other assets
- legal rights or legal restrictions that are specific only to the current owner of the asset, and
- tax benefits or tax burdens that are specific to the current owner of the asset.
AASB 136, paragraph 53A
Therefore, if a discounted cash flow model is being used to determine a FVLCD, it must not include costs and savings that would not be achieved by a market participant.
Blind Freddy Error 1
Including entity-specific assumptions for fair value in FVLCD.
Maximise observable inputs and minimise the use of unobservable inputs when calculating FVLCD
In many cases, there are no observable market prices when testing an asset for impairment using FVLCD. AASB 13, paragraph 3 expressly states that any valuation technique used to determine fair value should maximise the use of relevant observable inputs and minimise the use of unobservable inputs.
When a price for an identical asset or liability is not observable, an entity measures fair value using another valuation technique that maximises the use of relevant observable inputs and minimises the use of unobservable inputs. Because fair value is a market-based measurement, it is measured using the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk…
Extract of AASB 13, paragraph 3
This principle is also re-iterated in AASB 13, paragraphs 61 and 67.
An entity shall use valuation techniques that are appropriate in the circumstances and for which sufficient data are available to measure fair value, maximising the use of relevant observable inputs and minimising the use of unobservable inputs.
AASB 13, paragraph 61
Valuation techniques used to measure fair value shall maximise the use of relevant observable inputs and minimise the use of unobservable inputs.
AASB 13, paragraph 67
Observable market inputs would include:
- An entity’s share price
- The share price of similar entities
- The price achieved for similar assets
- The price being asked for similar assets, and
- Inputs into a cash flow model e.g. forward prices on commodities and foreign exchange etc.
With the basic principle of maximising observable market inputs, it is difficult to see how preparers can rely solely on internally generated cash flow forecasts, using inputs that are inconsistent with observable market data.
A simple example is the use of commodity prices and foreign exchange rates in FVLCD models. Although the entity may itself have very good reasons to believe that the consensus pricing on a particular commodity is wrong, or they hold a particular view as to future exchange rates, the inputs into the FVLCD model cannot differ from the market participants’ view.
Blind Freddy Error 2
Not maximising the use of observable inputs such as level 1 or level 2 assumptions, and using level 3 assumptions (internal) instead.
The fair value hierarchy
A fundamental principal of AASB 13 is the application of the ‘fair value hierarchy’ which classifies inputs as observable (level 1), unobservable (level 3) and mixed (level 2) as follows:
- Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.
- Level 2 inputs are inputs, other than quoted prices included within level 1, that are observable for the asset or liability, either directly or indirectly.
- Level 3 inputs are unobservable inputs.
…The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs).
Extract of AASB 13, paragraph 72
This means that entities using level 3 discounted cash flow models to determine FVLCD cannot ignore level 2 or level 1 inputs that may be available. For example, an entity calculating FVLCD for an investment in shares listed on the ASX cannot ignore the level 1 listed share price, and instead use a level 3 discounted cash flow model that uses level 3 inputs.
Similarly, for assets where there are level 2 inputs (i.e. observable price for a similar asset or liability), an entity cannot solely use a level 3 discounted cash flow model to determine FVLCD. The requirement to give highest priority to level 1 inputs, and lowest priority to level 3 inputs, coupled with the requirement to use multiple valuation techniques (refer discussion below), means that level 2 inputs, being observable market prices for similar assets, adjusted for the condition and location of the asset, must be taken into account.
Blind Freddy Error 3
Putting level 3 spreadsheets ahead of level 1 and level 2 inputs that may be available to determine FVLCD.
Market conditions at the measurement date
AASB 13 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date under current market conditions.
AASB 13, paragraph 15
Using the measurement date is reinforced in AASB 13, paragraphs 24 and 62 as follows:
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction in the principal (or most advantageous) market at the measurement date under current market conditions (i.e. an exit price) regardless of whether that price is directly observable or estimated using another valuation technique.
AASB 13, paragraph 24
The objective of using a valuation technique is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions. Three widely used valuation techniques are the market approach, the cost approach and the income approach…
Extract of AASB 13, paragraph 62
In practice, many entities fail to update assumptions used in FVLCD calculations to reflect current circumstances at measurement date. If a preparer finds themselves arguing that ‘this is only a temporary market blip’, or ‘the market was temporarily negatively impacted by xxxx’, or ‘the market overreacted’ to justify why these factors have been excluded from their FVLCD model, they have fundamentally misunderstood that the FVLCD is determined using market conditions at the measurement date.
Blind Freddy Error 4
Not updating FVLCD models to reflect assumptions current at measurement date, or justifying why market conditions at measurement date are not valid.
Using overly optimistic assumptions in the cash flow models
AASB 136 contains detailed guidance on cash flows to be used in VIU models. It requires that they be realistic, in line with past performance and realistic budgets, and generally be restricted to five years because forecasting beyond five years is generally not considered to be reliable.
Prima facie this guidance does not apply to the FVLCD model, however, FVLCD is driven by the principle that using FVLCD simply does not allow for the use of bullish optimism in terms of growth, profitability, etc. The growth rates and the associated risks of not achieving growth should be that of market participants, not that of management.
Blind Freddy Error 5
Using overly optimistic assumptions in cash models that are not substantiated by market participant assessments.
Use of multiple valuation techniques
Under the fair value hierarchy contained within AASB 13, the ideal fair value model is an observable market price for an asset. In reality, this is very unlikely to be achieved in impairment testing under AASB 136, and there is therefore a tendency to resort solely to discounted cash flow models to determine FVLCD. AASB 13, paragraph 63 expressly states that when an observable market is not available, e.g. when valuing a cash-generating unit (CGU), multiple valuation techniques will be appropriate.
In some cases a single valuation technique will be appropriate (e.g. when valuing an asset or a liability using quoted prices in an active market for identical assets or liabilities). In other cases, multiple valuation techniques will be appropriate (e.g. that might be the case when valuing a cash-generating unit). If multiple valuation techniques are used to measure fair value, the results (i.e. respective indications of fair value) shall be evaluated considering the reasonableness of the range of values indicated by those results. A fair value measurement is the point within that range that is most representative of fair value in the circumstances.
AASB 13, paragraph 63
Paragraph 63 also states that in such cases, the fair value is then ‘the point within that range that is most representative of fair value in the circumstances’. Many preparers simply use a single valuation method, usually based on a DCF, ignoring the market approach and the cost approach.
Blind Freddy Error 6
Using one valuation technique only (failing to use multiple techniques).
Incorrect development of level 3 models
If FVLCD needs to be determined using level 3 inputs (i.e. there are no level 2 or level 1 inputs), then the preparer must still aim to determine a fair value that represents ‘...an exit price at the measurement date from the perspective of a market participant that holds the asset..’.
This exit price must be produced using risk assumptions that a market participant would use.
…unobservable inputs shall reflect the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk…
Extract of AASB 13, paragraph 87
...A measurement that does not include an adjustment for risk would not represent a fair value measurement if market participants would include one when pricing the asset or liability…
Extract of AASB 13, paragraph 88
…In developing unobservable inputs, an entity may begin with its own data, but it shall adjust those data if reasonably available information indicates that other market participants would use different data or there is something particular to the entity that is not available to other market participants (e.g. an entity-specific synergy)…
Extract of AASB 13, paragraph 89
The AASB 136 guidance on VIU models allows the uncertainty for the amount and timing of cash flows to be dealt with by either probability adjusting the cash flows, or by adjusting the discount rate. The same applies when building level 3 FVLCD models, but it is a requirement of AASB 13 that these uncertainties are that of market participants, and therefore does not represent overly optimistic internal entity-specific views.
Blind Freddy Error 7
Not applying a market participant’s risk profile when developing level 3 FVLCD models.
Fair value less costs of disposal
AASB 136 requires recoverable amount of an asset to be its FVLCD, rather than just its fair value.
Costs of disposal, other than those that have been recognised as liabilities, are deducted in measuring fair value less costs of disposal. Examples of such costs are legal costs, stamp duty and similar transaction taxes, costs of removing the asset, and direct incremental costs to bring an asset into condition for its sale. However, termination benefits (as defined in AASB 119) and costs associated with reducing or reorganising a business following the disposal of an asset are not direct incremental costs to dispose of the asset.
AASB 136, paragraph 28
Some entities ‘forget’ to deduct costs of disposal to arrive at the recoverable amount. This means that recoverable amount is overstated, and therefore any impairment charge is understated.
Blind Freddy Error 8
Not deducting costs of disposal from the asset’s fair value.
Other entities could incorrectly deduct too many costs of disposal, and therefore potentially understate recoverable amount, and overstate the impairment charge. This may occur, for example, when termination costs associated with reorganisations of a business post disposal are treated as a cost of disposal.
Blind Freddy Error 9
Deducting termination costs of reorganising a business following its disposal as costs of disposal.
Accounting for liabilities associated with an asset or group of assets
Sometimes, the disposal of an asset would require the buyer to assume a liability and only a single fair value less costs of disposal is available for both the asset and the liability. This could occur, for example, where a purchaser of a mine also takes over the restoration obligation. In such cases, the liability needs to be deducted from the carrying amount of the CGU assets, otherwise the impairment charge will be overstated.
It may be necessary to consider some recognised liabilities to determine the recoverable amount of a cash-generating unit. This may occur if the disposal of a cash-generating unit would require the buyer to assume the liability. In this case, the fair value less costs of disposal (or the estimated cash flow from ultimate disposal) of the cash-generating unit is the price to sell the assets of the cash-generating unit and the liability together, less the costs of disposal. To perform a meaningful comparison between the carrying amount of the cash-generating unit and its recoverable amount, the carrying amount of the liability is deducted in determining both the cash-generating unit’s value in use and its carrying amount.
AASB 136, paragraph 78
Blind Freddy Error 10
Not deducting liabilities from both FVLCD and the carrying amount of CGU assets when they buyer is to assume the liability.
In next month’s article we look at common errors made because impairment is not tested at the correct unit of account.