In 2011, the world economic crisis entered a new phase with increasing uncertainty about the creditworthiness of some sovereign states and recessionary trends in the US and the UK. The current market conditions mean that asset values are likely to be under scrutiny, increasing the likelihood of an impairment charge being recorded in financial statements.

An impairment is recorded when an asset's carrying amount exceeds its recoverable amount (of higher value in use and net selling price). The method of performing impairment testing is not new or unique; however, the current market environment has re-emphasised its importance. Historical assumptions of profitability, discount rate, etc., may no longer be supportable.

The effect of declining market conditions on the reporting entity's future revenue, earnings and expected cash-flows will have to be factored into the impairment calculations. Re-assessment may have to be done on traditionally stable discount-rate input variables such as equity risk premium, company-specific risk, gearing level and cost of debt. Since the discount rate should reflect a return that investors expect for a specific set of risk-adjusted cash flows, the same should not be adjusted for risks already considered in projecting cash-flows.

Given the uncertainties in the current market, ‘double-counting' may happen if both cash-flows and the discount rate are overly conservative. An appropriate discount rate for cash-generating units (CGUs) operating in various economic environments should be determined, as the country risk, currency risk, price risk and cash flow risk may vary for each CGU in these uncertain times.

Measuring recoverables

At a time of falling markets, it is critical for preparers to reassess the recoverability of intangible and goodwill balances, if any. Disclosure of the basis on which recoverable amount has been measured — that is, value-in-use or fair value, less the costs to sell — and the key assumptions used to determine that value must be spelt out in sufficient detail.

Entities are also exposed to declining values of financial assets, both directly, as a result of having invested in such assets, and indirectly, through exposures to employee benefit plans that invested in these assets. In India, we have not yet fully adopted the fair value or the marked-to-market requirements as available in the international standards for investments.

The challenges

The current Indian standard does not provide further guidance on what constitutes ‘a decline, other than temporary'. For unquoted investments, obtaining a fair value may prove a greater challenge as there may be limited sources from where information would be available to establish values and the assumptions used for the valuation may be subjective.

Though valuation concepts have not changed, the risks surrounding the application have. Judgment will have to be exercised when placing emphasis on one valuation approach over another as methodologies and tools to determine asset values during the economic upswing may now be rendered redundant and new valuation techniques may have to be developed.

Significant increases in provisioning for receivables and advances may be required. This may be particularly relevant for entities with customers in countries experiencing financial difficulty or for receivables from government-related entities in those countries.

This crisis has further highlighted the need for asset valuation techniques and impairment review processes to be robust, transparent and well documented in order for investors to have confidence in reported asset values.

(Kartikeya Raval is Director, and Shernaz Dadachanji is Senior Manager, Deloitte Haskins & Sells. The views are personal.)

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