by John Hughes

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 15^th edition:

• “The issuer is in the retail industry and has a significant network of branches of merchants and retailers. In its financial statements, the issuer determined its CGUs for the impairment testing at the level of each branded business under which it operated, rather than at each individual branch. At December 31 2011 the net book value of the issuer’s property, plant and equipment was CU 560 million and its net assets were CU 4,200 million.
• The determination of CGUs was based on the fact that each of its individual branches did not operate on a standalone basis as some income, such as volume rebates, and costs were dependent on the whole branded business rather than on individual branches. The issuer considered that cash inflows and outflows for individual branches did not provide an accurate assessment of the actual cash generated by those branches Volume rebate income was approximately CU 70 million compared with gross revenue of approximately CU 1,000 million.
• However, the issuer has daily sales information and monthly income statements produced for each individual branch and this information was used to make decisions about continuing to operate individual branches.”

The enforcer (as ESMA likes to term it) disagreed with the issuer’s determination, concluding it should have identified each branch as a separate CGU. Referring back to the basic definition of a CGU as “the smallest identifiable group of assets generating cash inflows that are largely independent of the cash inflows from other assets or groups of assets,” ESMA notes that how management monitors the entity’s operations is relevant to making the determination, and that in this case much of this monitoring appears to focus on the individual branches. It concludes: “each branch should be identified as a separate CGU because rebate income was insignificant compared to gross revenues and because the issuer monitored and made decisions about its assets and operations at the individual branch level.”

In applying the IAS 36 concept of cash-generating units, I’ve found it’s easy to become swept up in the technicalities, and to forget the underlying purpose of the exercise. The key question in any given situation, I suppose, is essentially this: if it’s clear that the carrying value of certain assets won’t be recovered, when is it necessary and appropriate to recognize an impairment loss based on those facts, rather than regarding the loss on those assets merely as reducing future profits from other assets, and therefore as not needing to be recognized? As with other aspects of IFRS, management’s view of these matters may not always be entirely aligned with the requirements of the standards. For example, management might regard the assets of a particular loss making entity as a strategic investment to build name recognition and market presence, as valuable to its overall direction as the assets attached to its individual profitable businesses. Even so, if that entity meets the definition of a CGU, such an analysis won’t be sufficient to prevent recognizing any resulting impairment loss.

This might be all the more frustrating because (as ESMA acknowledges) it’s clear in the wording of IAS 36 that the determination of CGUs, and therefore of whether or not to recognize an impairment loss in a specific situation, differs to some extent based on internal factors, entailing some variation between different entities. Actually it might be a lot of variation, if you take this passage from the literature of one of the accounting firms, focusing on the retail industry: “For the majority of modern multi-site retailers, some level of aggregation of sites is normally appropriate. A larger grouping can be treated as a cash-generating unit or each site can be taken to be a cash-generating unit, though in the latter case a pragmatic view of aggregation may be taken on grounds of materiality…In some circumstances, it may be impractical (or at least costly) to prepare detailed cash flow forecasts for each individual site. Furthermore, forecasts may, to some extent, be based on macro-assumptions about factors that affect larger groupings in a similar way.” Although no doubt intended to be helpful, it seems to me this discussion might be suggesting a degree of flexibility and practicality that auditors (including auditors from that same firm) might not be as willing to apply in practice.

Anyway, it’s no doubt for the greater good that compared (for instance) to old Canadian GAAP, IFRS reduces the ability to avoid recognizing the consequences of loss-making assets by applying some fuzzy claim about (say) management regarding those assets as belonging with other (profitable, but entirely unrelated) assets within a single operating division. But at the same time that IFRS brings such losses out into the open, it may also force out other write-downs that don’t represent losses at all, within management’s way of looking at things. Of course, many entities choose to focus the attention of their users on key performance indicators that exclude these impairment write-downs (among other things), and they can explain the surrounding circumstances in their MD&A. And the best way to do that is to talk in real-world terms about what the losses actually mean, and what they don’t mean, taking the technical determination of CGUs as just the starting point for the conversation.

The opinions expressed are solely those of the author