Judgment in Asset Impairment (IAS 36 / ASC 350 and 360)
Impairment of non-financial assets – such as goodwill, other intangibles, and plant or equipment – is a domain where accounting standards deliberately require management to apply reasoned estimates and judgment to ensure assets are not carried above their recoverable amounts. Under IFRS, IAS 36 Impairment of Assets provides a principles-based approach: at each reporting date, entities must assess whether there are any indicators an asset may be impaired. Certain assets (goodwill and indefinite-life intangibles) must be tested at least annually regardless of indicators. When an impairment test is required, the standard says to determine the asset’s recoverable amount, defined as the higher of (a) fair value less costs of disposal, and (b) value in use (present value of future cash flows from the asset or cash-generating unit). Any excess of carrying amount over recoverable amount is an impairment loss. While the definition sounds straightforward, each element – identifying the cash-generating unit (CGU), estimating future cash flows and an appropriate discount rate for value in use, or determining fair value if used – involves substantial judgment and estimation.
Defining cash-generating units (CGUs): IFRS requires that assets be grouped into the smallest identifiable group that generates cash inflows largely independent of other assets. This often means defining at what level goodwill is monitored internally or how assets interplay. For example, is a factory a CGU by itself, or is it part of a larger CGU that includes a whole product line or region? The judgment here can influence impairment outcomes. Companies have some latitude: one might treat each store as a CGU, another might group stores by region (if cash flows aren’t independent store by store). Goodwill must be allocated to CGUs or groups of CGUs for testing, which can be complex post-merger when synergies blur the lines. A lot of judgment and sometimes negotiation with auditors goes into CGU determination because it affects how easily an impairment might be triggered. A broader CGU grouping can allow strong parts to offset weak parts, potentially delaying an impairment, whereas a narrow grouping might isolate a struggling unit and show impairment earlier. IFRS (and GAAP similarly under its reporting unit concept for goodwill) put some constraints (for instance, a CGU for goodwill cannot be larger than an operating segment before aggregation), but there is still variability in practice. Transparent companies disclose what their CGUs are and how goodwill is allocated, giving users insight into this judgment.
Estimating value in use (VIU): When performing an impairment test, most companies default to the value in use method because they often plan to continue using the asset rather than sell it. Value in use is essentially a discounted cash flow (DCF) calculation. Here, management must project future cash inflows and outflows from the asset/CGU and then discount them to present value using a rate that reflects the market’s assessment of the time value of money and the risks specific to the asset’s cash flows. This involves numerous judgments:
- Forecast period: Many use a 5-year explicit forecast and then a terminal value (assuming a stable long-term growth). But if an asset has a shorter useful life, maybe a shorter period is used; for long-life mines, perhaps longer.
- Cash flow projections: These come from budgets and strategic plans. Management’s optimism or conservatism here directly impacts impairment. For example, if a division has had declining results but management forecasts a rebound and strong growth, the VIU will be much higher than if one assumed flat or further declining cash flows. Auditors will check these forecasts against historical accuracy and external evidence. Yet, management often has better insight into potential improvements or new contracts that might justify optimistic forecasts. The standard asks that cash flow projections be reasonable and supportable and based on the asset in its current condition (exclude future restructurings or upgrades not committed) – but within that, there’s a wide range of credible estimates.
- Terminal growth rate: The perpetual growth rate assumed beyond the forecast horizon is another judgment. It should not exceed long-term average growth for the industry or country typically, but even a 0% vs 2% terminal growth difference can swing values significantly.
- Discount rate: Choosing the discount rate (often a WACC – weighted average cost of capital – or some variant for the CGU) is highly technical and judgmental. Small changes in the rate (e.g. 8% vs 9%) can flip an impairment conclusion. Companies sometimes use an outside appraisal or benchmarking to justify the rate, but ultimately it’s management’s call to select a rate reflecting the risk of the asset. IFRS expects that factors like country risk, currency, and asset-specific risks are considered. If using a pre-tax rate vs post-tax consistency with cash flows must be managed.
Given all these inputs, it’s no surprise that impairment testing is labeled a “critical accounting estimate” in many financial reports. A minor difference in judgment or estimation can lead to a materially different outcome – whether an impairment is recognized or not, and if yes, how big. This is why IAS 36 (and ASC 350/360) also require disclosure of key assumptions and sensitivity analysis for goodwill impairments at least. Companies often disclose, for instance, the discount rate and growth rate used and how much headroom (excess of recoverable over carrying) exists, and they might say “if the discount rate were 1% higher, or growth 1% lower, we would have an impairment of X”. This gives readers a sense of how tight the call may be.
Impairment indicators themselves involve judgment. IAS 36 lists examples: market value declines, adverse changes in markets or regulations, internal evidence of obsolescence or worse performance, etc. Management must assess each reporting date if any trigger exists requiring a formal test. In practice, many companies have checklists – e.g. has our market share declined significantly? Is there evidence of a significant drop in market price for our assets? Did we have worse results than expected? In times of economic stress, triggers are more common. Judging what is a “significant” decline or an adverse change can be qualitative. Some companies interpret triggers narrowly (only test when obvious), others test more frequently to be safe. Accounting regulators often admonish companies after the fact if an impairment seemed apparent (say from external info like industry downturn) but the company didn’t act – implying they perhaps used judgment to delay recognition. Good practice leans towards erring on the side of testing if in doubt, since performing an impairment test is not harmful if it finds no loss, whereas not testing when you should can lead to an error.
Goodwill impairment is a special category under these standards. Goodwill arises in acquisitions and must be allocated to CGUs and tested at least annually. It cannot be amortized (under IFRS and current US GAAP), so the only way it leaves the balance sheet is via impairment. This places considerable pressure on the annual goodwill impairment test as a checkpoint. The judgments in goodwill impairment are similar (CGU grouping, cash flow forecasts, discount) but often at a higher aggregation (like divisions or reporting units). Goodwill impairments can be huge and are often seen by the market as admissions that an acquisition hasn’t panned out. Companies sometimes resist taking them prematurely – hoping performance will bounce back – which is why enforcement authorities scrutinize this area. There is a tension: you don’t want to write off goodwill at the first sign of trouble if recovery is reasonably expected, but you also shouldn’t hold it at full value if evidence strongly indicates it’s impaired. This requires judgment calls about future recoverability of the business. For example, if an oil & gas company acquired a firm at peak oil prices (with high goodwill) and then oil prices collapse, is that goodwill impaired? If management expects the drop is long-term due to structural change, yes. If they believe it’s a cycle and prices will rebound, they might justify no impairment (or a partial one). Their VIU model will reflect their view. If they’re wrong, eventually an impairment becomes unavoidable. Investors are wary of late recognition, so many prefer a bias toward earlier impairment (more conservative). Standard-setters have debated if goodwill accounting should be more rule-based (e.g. amortization or triggers) to reduce reliance on judgment; so far IFRS continues to rely on annual tests and full judgment.
Fair value less costs of disposal (the other measure of recoverable amount) introduces different judgments, typically when an asset could be sold or is planned to be sold. Fair value might be gauged by market prices (if available), or by valuation techniques (like multiples or DCF from a market participant perspective). Often companies use VIU because fair value info isn’t readily available, but sometimes for a cash-generating unit that’s up for sale, fair value can be estimated (with uncertainty). Fair value assessments themselves require judgment in choosing comparables, adjusting for control premiums, etc. The standard asks for whichever is higher of VIU or FV less costs to sell – effectively giving the asset the benefit of the doubt. In practice, many don’t calculate both unless they have reason to believe fair value is higher (like interest from buyers).
Reversals of impairment are another area of difference: IFRS allows that if circumstances change, impairments on assets (except goodwill) can be reversed to a degree (not above what carrying would have been). This means management must also judge if an asset’s value has rebounded. US GAAP generally prohibits reversal of impairments (except for certain assets held for sale). The IFRS approach is principle-based (if the reason for impairment is gone, why keep a write-down?) but opens another judgment: determining that previous estimates were too pessimistic or conditions improved. Companies rarely reverse impairments except in clear cases (like when commodity prices recover and previously impaired mines clearly regain value), but it’s allowed and does happen. Again, transparency is key – IFRS requires disclosure of events leading to reversal.
Global example – Industrial Company: A global manufacturing company that expanded by acquiring a competitor might carry significant goodwill in its regional divisions. Suppose the market then faces a downturn due to new low-cost competitors, and the company’s sales and margins shrink over two years. The company must test goodwill annually. In Year 1, they might avoid impairment by projecting that cost-saving initiatives and new product launches will restore margins in a couple of years, thus in the DCF the dip is temporary. In Year 2, things haven’t improved much; now maybe they temper the forecast – but still no impairment if their model shows recovery in Year 3, maintaining headroom. By Year 3, if recovery hasn’t materialized and outlook is adjusted down significantly, an impairment is finally recognized. This scenario (sadly common) illustrates how judgment can delay an impairment – perhaps justifiably if the initial assumptions were reasonable, or perhaps too optimistically if with hindsight the signs were evident earlier. Enforcement bodies sometimes review such cases: was it really reasonable in Year 1 and 2 to assume a full rebound? Or should impairment have been taken sooner? There is no easy answer because at the time, management may have had plans or evidence supporting their optimism. It shows the inherent subjectivity in impairment testing.
Global example – Tech Company: A tech firm has capitalized development costs for a new software platform (allowed under IFRS when certain criteria are met). Early adoption is slow, and an established competitor is dominating. The firm considers impairment of the software asset. The value in use depends on projections of future cash flows from the software. If management believes they can still capture market share (perhaps pivoting the product), they may project growing cash flows that justify no impairment or a small one. An outside observer might be skeptical if the competitor is entrenched. If ultimately the product fails, a large impairment might occur later. This kind of scenario shows how impairment tests for technology (or any innovative product) rely on assumptions about market acceptance and growth that are really judgments about business success, not just accounting. Auditors challenge these by asking for evidence – e.g. current user growth, pipeline of sales, etc., to support the forecasts.
Public sector angle (IPSAS): Even in the public sector, where “profit” isn’t the motive, the concept of impairment exists for assets providing services. Judgment is needed in determining value in use sometimes via depreciated replacement cost or service units approaches (since cash flows may not be relevant). The principle remains: don’t carry an asset above its recoverable service value. This can be even more judgmental, as it involves assessing usefulness and replacement cost. We mention this to note that professional judgment in impairment transcends sectors – wherever estimation of value is required, it calls on accountants to be both analytical and objective.
In summary, asset impairment testing is a prime example of applying the principle of “substance over form”: one must ensure assets aren’t overstated just because cost or previous valuations said so; if value has declined, recognize it. But determining that decline with reasonable accuracy is challenging. It requires multidisciplinary input – operational data for forecasts, finance theory for discount rates, market knowledge for values. Professional judgment is the glue that assembles these inputs into a conclusion about recoverable amount. The risks of poor judgment here include delayed recognition of impairments (leading to restatements or sudden large hits that spook investors) or conceivably over-aggressive impairments (writing down assets too much, though that is less common since it usually only hurts the reporting company). In either case, confidence in the financial statements can be undermined. That’s why disclosures around assumptions and sensitivities are crucial: they allow users to see the levers of management’s judgment. For instance, if a company discloses that its goodwill test assumes 5% annual revenue growth, investors can judge whether they find that credible given industry trends. If not, they might anticipate an impairment down the road even if management hasn’t recognized one yet. On the flip side, clear disclosure of prudence (e.g. using a high discount rate or low growth) can reassure users that management has been cautious.
In practice, developing sound judgment in impairment involves learning from past experience (Were last year’s forecasts met? If not, adjust approach), consulting with valuation experts, and sometimes benchmarking against peers or external data (like typical WACC for that industry). Auditors often bring an independent view, possibly constructing their own simplistic DCF to see if management’s outcome is in the right ballpark, and they will push back if assumptions seem outlier. Still, at the end of the day, these impairment decisions highlight that accounting is not just bookkeeping; it is business analysis and forecasting under conditions of uncertainty – which is exactly where professional judgment thrives and is most tested.