Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA) (for more background see here); this is from their 13th edition:

• “The issuer recognised in its statement of financial position a significant amount of goodwill exceeding 100% of its equity. For the purposes of the impairment test of goodwill, the issuer identified six CGUs.
• The recoverable amount of each CGU was determined based on its value in use by applying the discounted cash flow method. When determining the cash flow estimates for the CGUs, costs related directly to the CGUs and a portion of issuer’s sales, general and administration costs (i.e. indirect corporate costs) were included. The cash flows did not include the following in the indirect corporate costs: the Costs of Sales Director, Human Resources Director, Chief Financial Officer and Chief Information Officer. The issuer believed that these costs of corporate officers should not be allocated to the CGUs. This is on the basis that the independency of cash flows was an important criterion when determining the cash inflows and outflows of a CGU, and these cash flows benefited the company as a whole rather than the individual CGUs.
• The unallocated corporate costs represented costs that were needed for corporate level optimization but not to improve the performance of the individual CGUs. For example, if a CGU was sold, the costs of these corporate officers would not be taken into account when determining the sale price but would remain with the issuer after the sale.”

The enforcer (as ESMA likes to term it) disagreed with excluding the described cash flows, concluding that “the corporate costs were cash outflows that, according to IAS 36 paragraph 39(b), were necessarily incurred to generate the cash inflows from continuing use of the assets and could be allocated on a reasonable and consistent basis to the asset. In addition, in its internal management reports, the issuer had allocated all costs (including the costs of corporate officers) to CGUs.” It goes on: “As the goodwill and other intangible and tangible assets were fully allocated to CGUs, and all estimated cash inflows were included in the cash flows projections, it was not reasonable to exclude from the CGU’s estimated cash flows any corporate level costs.”

It’s very easy, in applying IAS 36, to get tangled up in the mechanics of slicing and dicing into CGIs and allocating cash flows and so forth, and to lose sight of what we like to call the “big picture.” Indeed, the standard often seems to be written in a way that encourages nothing less. IAS 36.102 addresses how corporate assets are tested for impairment by being allocated to cash-generating units or (if that’s not possible on a reasonable and consistent basis) to groups of CGUs. IAS 36.101 specifies that corporate assets don’t generate separate cash inflows. It doesn’t acknowledge though that they might generate separate cash outflows, and when it talks about adjusting the carrying amount of groups of CGUs to include allocated portions of carrying amounts of corporate assets, it pointedly requires comparing that adjusted carrying amount only “with the recoverable amount of the group of units” – that is, without adjusting the recoverable amount to include any outflows from the corporate assets. This seems to acknowledge that certain cash outflows might never be taken into account in the impairment testing model. Because this exclusion could easily undermine the aggregate effectiveness of the process, it appears it should be confined to outflows that indeed can’t be allocated to CGUs on any kind of reasonable and consistent basis. Plainly, this didn’t apply to the various salaries cited in the ESMA example, as a basis always exists for allocating salaries to the units which benefit from those individuals, and indeed, the issuer was already doing that for its internal purposes.

Of course, this is only one of the many areas in which detailed examination of IAS 36 procedures might find problems; among others, the Canadian Public Accountability Board has commented on this area in the context of its reviews of audit quality. In its 2012 report, CPAB said it found “a number of instances where the auditor did not apply appropriate professional skepticism to management’s estimates. In one case, the impairment analysis of a long-lived asset included overly optimistic and unrealistic revenue forecasts that had been reviewed by the firm’s own valuation experts.” It also stated: “firms of all sizes do not sufficiently analyze whether (cash flow) projections are based on reasonable and supportable assumptions and discount rates. Firms need to exercise a high degree of professional skepticism when analyzing projections prepared by management, as CPAB has seen instances where they were overly optimistic.” It’s especially hard, one might think, to counter a bias toward optimism in this area, as the optimism is presumably often a direct expression of management’s vision for the business…

The opinions expressed are solely those of the author