Why impairment testing matters

Today’s heightened regulatory environment means that impairment testing is no longer a box-ticking exercise - it’s a critical process that can significantly impact an organisation’s financial reporting credibility. For boards of directors, Chief Financial Officers (CFOs), and audit committees of ASX-listed companies, it’s vital to ensure that asset values on the balance sheet are supportable.

Engaging a valuation specialist in a company’s impairment review can provide the accuracy and objectivity needed to get this right. In our article series, ‘Valuation requirements in impairment testing: A strategic perspective’, we outline key impairment testing considerations from a valuation and accounting perspective, highlighting why specialist expertise is important for management, directors and auditors alike.

In part one of our series, we discuss the focus of the regulator, the importance of impairment testing and the implications when it can go wrong. Throughout our series, we discuss how engaging a valuation specialist can help management avoid common pitfalls and confidently withstand scrutiny from auditors and the regulator.

Source: ASIC’s oversight of financial reporting and audit 2023-24 Report 799 (October 2024)

In today’s volatile market conditions, asset values can swing rapidly. IAS 36/AASB 136 Impairment of Assets requires companies to assess at each reporting date whether there are indications that certain non-current assets may be impaired. For certain assets, such as goodwill and indefinite-life intangibles, an annual impairment test is mandatory regardless of indicators. The goal is simple in concept: ensure that no non-current asset within the scope of IAS 36/AASB 136 is carried on the balance sheet for more than its recoverable amount (the higher of fair value less costs of disposal and value in use).

Achieving that goal, however, is complex in practice. It demands robust valuation techniques, sound judgement in forecasting cash flows, appropriate discount rates, and consistency in how assets are grouped and tested. Mistakes in impairment testing can lead to financial overstatements, regulatory intervention, and damage to corporate reputation. This is why many forward-thinking companies engage independent valuation specialists to assist with impairment reviews. A valuation expert brings deep technical knowledge and an objective viewpoint to challenge assumptions, adding credibility to the process that both auditors and regulators (such as the Australian Securities and Investments Commission (ASIC)) increasingly expect to see for high-risk areas.

Focus of the regulator: ASIC’s expectations and consequences

In Australia, ASIC has been prominent in communicating the importance of proper impairment testing. It conducts regular surveillance of financial reports of listed entities, and impairment of non-financial assets is constantly on its radar as a focus area. Company directors and auditors should be acutely aware of ASIC’s guidance and the possible repercussions of getting impairment wrong.

ASIC has published an information sheet (INFO 203) specifically for directors on impairment of non-financial assets, underscoring directors’ responsibilities in this area.

The key takeaways from this information sheet are:

• Directors must challenge assumptions: Don’t just accept forecasts at face value. Ensure the cash flow assumptions and growth projections used in impairment tests are reasonable and supportable in light of historical performance and external conditions. For example, if sales have been flat for three years, assuming 10 per cent annual growth without strong supporting evidence is an area for concern
• Ensure robust processes: ASIC expects companies to have a systematic process for assessing impairment indicators and performing tests where required. This process should be well-documented. The board (or audit committee) should be reviewing the outcomes. If management is not itself expert in valuations, involving external specialists is seen as a prudent way to cover off on this requirement
• Consistency with market information: ASIC often compares what companies say in their Operating and Financial Reviews (OFR) and market updates with what they assume in their impairment calculations. Inconsistencies (e.g. telling investors the outlook is challenging but assuming successful scenarios in the impairment model) are a red flag.

The consequences of insufficient impairment assessments have been evident in ASIC’s actions, including:

• Public corrections and write-downs: ASIC often challenges the bases on which companies conclude impairments are not required, which can lead companies to restate results or recognise impairments. Such outcomes not only impact the financial statements but can also attract negative media coverage and affect investor sentiment
• Restrictions on capital raising: ASIC has restricted a company from issuing a prospectus for a period of time because the company did not comply with impairment testing requirements. This shows that if you haven’t adequately assessed impairment, it can impede your ability to raise capital
• Audit file inspections and enforcement: ASIC’s inspections of audit firms have frequently found that impairment of assets is an area where auditors fail to obtain sufficient appropriate audit evidence or adequately challenge management’s assumptions around impairment. Audit teams have faced findings for accepting management’s impairment calculations without adequate scrutiny. This environment means auditors are now especially careful with impairment - they may ask more questions, seek more audit evidence, and suggest involving independent experts if they’re not comfortable. If auditors get it wrong, ASIC has acted against individual auditors, including fines and suspensions. So, auditors have a vested interest in their clients doing a thorough job (usually with an external valuation report) before the audit even begins.

All of this points to a clear trend: regulators expect high-quality impairment analyses. Directors can be held accountable if they sign off on accounts with assets carried at unrealistic values. In extreme cases, ASIC can pursue legal action against directors for permitting the publication of misleading financial statements, which could involve hefty penalties.

ASIC’s guidance suggests that where valuations are complex, an independent review is recommended. In some cases, auditors will use their own valuation specialists to interrogate the impairment valuation and assumptions. However, it’s often better for the company to have its own specialist from the start, so that issues can be dealt with ahead of time rather than in the small window allocated to your company by the audit firm.

The importance of impairment testing

Under AASB 136 (IAS 36), companies must not carry certain non-current assets at more than their recoverable amount. Impairment testing is the process to ensure this, by comparing carrying values to recoverable values. It’s especially relevant for assets that do not have obvious market prices (e.g. goodwill arising from acquisitions, intangible assets, or specialised plant and equipment).

Why it matters:

• Regulators and investors pay close attention to impairments as signals of management’s forecasting accuracy and the health of the business. Surprises (like a sudden large write-off) can shake investor confidence, whereas well-timed, transparently explained impairments can demonstrate prudent governance
• Carrying an asset above its recoverable amount sets up problems for later. The business will either have to write it down or accept that it won’t deliver the expected returns. This distorts performance, as future earnings will inevitably be hit when the correction comes. Timely recognition of impairment avoids overstating today’s results, protects future earnings from sudden shocks, and supports the credibility of financial reporting.

Importantly, impairment testing requires significant judgement, and that’s where valuation expertise is invaluable. Determining recoverable amount involves either estimating fair value (as if selling the asset/Cash-Generating Units (CGU) in an orderly transaction) or calculating value in use (present value of future cash flows from continued use). Both approaches require valuation skills. Assumptions around cash flow projections, growth rates, discount rates and market multiples need to be determined using a reasonable basis.

Conclusion

Impairment testing sits at the intersection of finance, accounting, and valuation. It requires forward-looking analysis tempered by objectivity and compliance with accounting standards. Management and directors of ASX-listed companies are expected to actively engage with this process, not just sign off on what the model spits out. Auditors will probe the assumptions, and regulators can and do challenge the outcomes.

BDO’s valuation team bring technical expertise, market data, and independent judgement that can greatly enhance the quality of an impairment review. Engaging a valuation specialist is an investment in getting it right. For auditors, the involvement of an external expert provides an additional layer of comfort that the assumptions and methodologies have been vetted. For the company, it can mean the difference between a smooth audit versus last-minute audit adjustments, and between a quiet disclosure versus a negative headline. Contact a member of the team to discuss your needs.

The next instalment of our three-part article series, 'Valuation requirements in impairment testing: A strategic perspective’ advises on how to get the impairment testing methodology right.