Impairment testing: Avoiding pitfalls and adding strategic value

With increasing regulatory scrutiny, ASX-listed companies must approach impairment testing with diligence and strategic foresight.

In the final instalment of our ‘Valuation requirements in impairment testing: A strategic perspective’ series, our experts explore how impairment testing can go beyond just compliance to deliver strategic value, covering common pitfalls, how to avoid them and the implications of a robust impairment process.

Unit of account and grouping of assets

Related to cash-generating units (CGU) identification, as covered in article two of our three-part series, ‘Getting the methodology right’, is the broader concept of determining the correct unit of account for valuation. Impairment is assessed at the individual asset level, if possible, but often individual assets do not generate independent inflows and must be grouped.

We discussed CGUs as the smallest grouping for cash flow independence. However, here are some additional nuances:

• Lowest level of largely independent inflows: Always aim to test at the lowest level where independent cash flows exist. For example, if a factory makes product X and product Y, but they are sold to the same customers using the same sales force, the factory might be one CGU for both products together (unless the products could be sold or measured separately)
• Avoid arbitrary grouping: Don’t group assets with no necessary financial link, as this could let one asset’s overperformance hide another’s impairment. For instance, two different businesses in different industries shouldn’t be one CGU just because they are under the same subsidiary - unless their cash flows are truly inseparable
• Include all necessary assets in the CGU: If an asset cannot be tested on its own, include it in a CGU where it contributes. We highlighted the example of ROU assets needing to be in a CGU. Another example is corporate assets (like a headquarters building or an enterprise resource planning (ERP) system) that serve the whole company. Often, corporate assets are allocated across CGUs for impairment testing, based on a reasonable allocation (e.g. by usage or headcount), because they don’t generate cash alone but are necessary for each CGU’s operations
• Consider how to allocate the impairment: If multiple assets are included in the CGU and an impairment is required, consider the basis for allocating the impairment. This is where it’s important to use a valuer with accounting expertise to ensure that allocations are made according to accounting standards.

Market capitalisation as an indicator (not a valuation method)

One high-level test often mentioned in practice is comparing a company’s market capitalisation to the book value of its equity (net assets). If a listed company’s market cap is consistently below its net assets on the balance sheet, that’s a strong external indicator that the assets might be overvalued (i.e. an impairment indicator under AASB 136). Directors of ASX-listed companies should always be aware of this relationship as it is readily observable by the Australian Securities and Investments Commission (ASIC).

However, market capitalisation should not be used in isolation to determine the recoverable amount or to perform the actual impairment test for a CGU or group of CGUs. Market capitalisation is influenced by many factors (market sentiment, liquidity of the stock, blue sky prospects etc.). It represents the value of equity in the hands of shareholders trading small parcels, not the price for which the entire business would necessarily sell. In fact, one of ASIC’s media releases (15 March 2023) stated that while market capitalisation is an important indicator, it “will generally not represent an appropriate fair value estimate for the underlying business” on its own.

What should companies do with market cap?

• Use it as a sense-check or calibration tool: If your discounted cash flow (DCF) analysis shows a recoverable amount far above the market cap, ask why. Is the market undervaluing your company? Or could your assumptions be too optimistic? Sometimes markets can undervalue, especially if they are short-term focused and your plans are long-term. However, large gaps are often due to over-optimistic cash flow forecasts or underestimating risk. Conversely, if market cap is higher than carrying net assets, impairment is less likely to be an issue (though not impossible if certain segments are struggling while others thrive)
• Reconcile differences: There can be valid reasons for a gap between market value and book value - e.g. internally generated intangible assets like a strong workforce or software might make the business worth more than book value. Conversely, an excessively high book value might include goodwill from an acquisition that the market no longer believes is justified. Management should be prepared to explain these differences to auditors and regulators, or engage a valuation specialist to assist you in responding to these questions, should they arise.

Aside from market cap, there are other external and internal indicators of impairment that companies should monitor continuously:

• External indicators:
  • Deterioration in market conditions - for example, falling demand for products, the entry of a strong new competitor, declines in commodity prices for mining companies, or adverse regulatory changes (for example, tariff cuts for utilities)
  • Increase in interest rates or discount rates - higher interest rates increase the cost of capital, which can reduce VIU calculations
  • Market transactions - if similar assets or companies have changed hands at prices below the carrying values of your assets, that could be an impairment indicator.
• Internal indicators:
  • Operating underperformance - cash flows or earnings are significantly below forecast for prior years
  • Changes in strategy - decision to restructure or dispose of part of the business can be an indicator (since that part might not recover its carrying value if sold)
  • Physical damage or obsolescence - an asset that’s physically impaired (fire at a facility) or technologically obsolete can trigger impairment
  • Plans to discontinue or idle an asset - if you plan to cease using an asset, its value in use becomes zero and its fair value might be only scrap value, so an impairment is likely.

When indicators are present, companies must perform a formal impairment test

Given the complexity and judgement involved, this is the juncture at which involving a valuation specialist is advisable. In practice, many companies engage valuation experts to assist with the annual goodwill impairment review or when significant indicators arise (such as a market cap drop or sector downturn). This helps get the numbers right and serves as evidence to auditors (and ASIC, if they inquire) that the company sought independent, professional input for an unbiased valuation.

To summarise, market capitalisation is a helpful reference point but is not a substitute for a proper impairment calculation. If you ever find yourself justifying asset values by saying “our market cap is higher than book value, so we’re fine” or vice versa, that’s a sign you need to dig deeper.

Strategic implications of a robust impairment process

When done thoroughly, impairment testing can yield insights far beyond compliance:

• Identifying underperforming assets: Impairment exercises force a hard look at each business unit’s financial prospects. Companies might discover, for instance, that one product line’s forecast cash flows don’t justify the carrying value of the specialised equipment dedicated to it, suggesting either that the equipment is impaired or the product economics need improvement. This can prompt strategic decisions to divest, discontinue, or turn around underperforming parts of the business
• Informing capital allocation: Understanding which assets are generating value and which are eroding value helps management allocate capital more effectively
• Enhancing governance and investor trust: A transparent and well-substantiated impairment review (especially with an independent valuation report or support) can be communicated to the audit committee and even in financial disclosures to build confidence that management is not postponing the inevitable or hiding bad news. Timely impairments reflect a conservative and realistic approach to financial reporting, which investors and analysts often appreciate (relative to large and unexpected impairments)
• Supporting audit and reducing audit adjustments: From the auditor’s perspective, an impairment calculation with solid documentation, logical assumptions, and perhaps even a third-party valuation specialist’s input is far less likely to be challenged. This makes the audit process smoother and reduces the risk that the auditors will force an adjustment. It also helps management avoid protracted discussions with auditors, with optimistic assumptions often a flashpoint. Audit regulators (such as ASIC’s inspection teams) frequently cite auditors failing to challenge these assumptions sufficiently as a key deficiency, so strong documentation ensures the company is well-positioned if the audit file is reviewed.

Conversely, treating the impairment process as a box ticking exercise can have strategic downsides. It can lead to misallocation of resources (continuing to invest in assets that are actually impaired or not as valuable) and expose the company to reputational or regulatory risks down the line. For example, an overinflated asset might also inflate a company’s view of its performance (return on assets (ROA), return on investment (ROI), etc.), leading to complacency. Or a company might keep paying dividends or bonuses based on accounting profits that haven’t factored in an economic loss on the balance sheet.

Conclusion

Impairment testing brings together the disciplines of finance, accounting, and valuation. It requires a forward-looking analysis, balanced by objectivity and compliance with accounting standards. For ASX-listed companies, management and directors are expected to engage with this process actively, not just sign off on what the model may produce. Auditors will scrutinise it, and regulators can challenge it.

Engaging a valuation specialist is a strategic move to ensure accuracy and credibility. For auditors, the involvement of an external expert provides an additional layer of comfort that the assumptions and methodologies have been vetted. It can mean the difference between a smooth audit versus last-minute audit adjustments for the company, and between a quiet disclosure versus a negative headline.

BDO’s valuation experts employ technical expertise, market data, and independent judgement that can greatly enhance the quality of the impairment review.