Goodwill is an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually recognized and separately identified.
It is recorded and recognizes in the balance sheet as long-term assets when a company purchases another company and owning more than 50% of shares.
How to perform an impairment test for goodwill?
The examination of goodwill impairment involves the following steps:
Assess qualitative factors such as increased costs, deterioration of macroeconomic conditions, declining cash flows, change in management, possible bankruptcy. Such factors help to review if further impairment testing is needed to be carried out.
Compare the fair value of the unit to it carrying amount and include goodwill in the carrying amount as well. If the fair value is greater than the carrying amount, then there is no impairment loss.
Calculate impairment loss as to the difference of carrying amount is greater than the fair value but limited to the value of carrying amount of goodwill.
Stage 1: Preliminary qualitative assessment:
The company must ensure whether the goodwill reflecting in the books would exceed its fair market value. It is to be checked on the basis of macroeconomic developments, political and legal changes, the existence of current competitors, management, and the structure of the company.
If this assessment shows that the goodwill in the balance sheet will not exceed its fair market value, then no further testing is required. But if it exceeds, then the preliminary qualitative assessment is required.
Stage 2: Quantitative assessment:
It consists of calculating the fair value of the reporting unit on which goodwill is based and then comparing the fair value with the book value of goodwill shown in the balance sheet. The company must calculate the relative impact of all factors that may materially affect the value of goodwill.
If this assessment reveals goodwill does not exceed the fair value, then the company must proceed to the next stage of the quantitative assessment.
Stage3: Quantitative assessment:
The company checks the value of individual assets and liabilities of the entity to find its fair value. On the basis of this analysis, if the company determines the goodwill to exceed the fair value, then excess goodwill is treated as an impairment to goodwill. This value is ultimately shown as an impairment loss in the books of accounts.
Journal entry for impairment of goodwill:
Goodwill impairment expense (P&L)
Proportionate goodwill and impairment review:
When goodwill has been calculated on a proportionate basis, it is necessary to gross up goodwill to carry the impairment test. Any impairment loss that arises is first allocated against the recognized and unrecognized goodwill in the normal proportion that the parent and its non-controlled entity share profits and losses.
Any amount which has been written off against the goodwill in the books will not affect the consolidated financial statements and the branch entity.
If the total impairment loss is more than the amount allocated against recognized and goodwill of books, the excess goodwill be allocated against any other assets on a pro-rata basis. This loss will be shared between the parent and non-controlling entity in the normal proportion of their usual sharing of profits and losses.
Gross goodwill and impairment review:
When goodwill has been calculated in gross, any impairment loss will be allocated between the parent and NCI in the normal proportion of their profit and loss sharing ratio.
Example of impairment review of proportionate goodwill:
The year-end impairment review is being conducted on a 65% owned subsidiary. At the date of the review, the carrying amount of assets of the subsidiary was 200 million, and goodwill attributable to the parent was 250 million, and the recovery amount of the subsidiary was 400 million.
Now it is necessary to gross up the goodwill so
Gross goodwill= 250*100/65=384.62 million
Now for the purpose of impairment review, the goodwill of 384.62 million and net assets of 200 million form the carrying amount of cash-generating unit.
Carrying amount of:
The impairment loss, in this case, is less than the total of recognized and unrecognized goodwill, so in this case, goodwill is only impaired, not other assets.
Only the parent’s share of goodwill impairment loss will be recorded, i.e.65% of 184.62 million=120.003 million.
Impairment review of gross goodwill:
At the year-end impairment, a review is conducted on a 70% owned subsidiary. The carrying amount of net assets was 600 million and gross goodwill of 450 million out of which (60 million allocated to NCI) and the recoverable value of the subsidiary as 700 million.
The impairment review of goodwill is actually the impairment review of goodwill and net assets of NCI as a Cash generating unit for which we can calculate the recoverable value.
This impairment loss will be used to write down the value of goodwill so that goodwill will appear in books at 450-350=100 million
In the PL statement, an impairment loss of 350 million will be charged as an extra-operating expense.
How to perform an impairment test for goodwill?
Start impair testing early. Goodwill can be tested earlier at the beginning. If any impairment indicator arises between the testing date and balance sheet date, the impairment assessment should be updated.
Comply with the disclosure requirements such as
Key assumptions on which management bases its cash flow projections
The period over which cash flows have been projected
The growth rate used to extrapolate cash flow projections beyond the period covered by budgets.
Allocate goodwill to the appropriate Cash generating units: Goodwill doesn’t generate cash flow independently, so the recoverable value can’t be independently measured. So, goodwill acquired in the acquisition is allocated from the acquisition date to each of the Cash generating units that are expected to take advantage of the synergy.
Make sure that the cash flows are consistent with the assets being tested. They must match with each other.
Reconcile the final result by comparing it with the external market data and check whether the economic assumptions made earlier still make sense.
Pay attention to market capitalization. If the market capitalization is lower than the value in use, then the assumptions made about the market environment can be challenged.
Cash flows used in the impairment calculations should be reasonable: Forecasts made in the previous months need to be rechecked and reassessed. Forecasts should be made on the latest management budgets. Greater weightage should be given to evidence sourced from outside.
The impairment test is the testing procedures that perform by the companies on the assets that they have to find out if the assets are impaired that make the carrying value of assets in the reporting date less than the recoverable value of assets.
For example, the company performs the impairment test on the computers that it has as of 31 December 2020 with the carrying value amounting to USD500,000 to see if there any impairment on the computers.
The impairment test is done to find out if the carrying amount of the asset exceeds the recoverable value. The carrying amount of assets means the value of an asset less accumulated depreciation.
At the time of the acquisition, the carrying amount of an asset equals its original cost price.
The company must conduct tests at each balance sheet date that if the asset is impaired. If such a situation persists, the firm must estimate the recoverable value of an asset.
The following indicators show the impairment of assets:
The carrying amount of an asset is more than the market capitalization
The proof of its external damage or obsolescence is present
A significant decline in operating profit or net cash flows from the asset
Increase in market interest rates
Negative changes in technology, economic situation, laws, or political situation
How to determine the recoverable value?
If we can’t determine the fair value fewer costs of disposal then the recoverable amount can be taken as its value in use
The recoverable value of the disposable asset is higher than fair value minus the costs of its disposal and value in use
Value in use:
It represents the present value of future expected cash flows from the continuous use of an asset and its disposal discounted to reflect the underlying risk and time value of money.
If the recoverable amount is less than the carrying amount, the carrying amount is reduced to its recoverable amount. This reduction is the impairment loss.
Impairment loss of revalued assets should be recognized as an expense immediately. However, for a revalued asset, an impairment loss is recognized against any revaluation surplus to the extent that such loss doesn’t exceed the revaluation surplus.
If the impairment loss is greater than the carrying amount, then the company must recognize it as liability.
In measuring value in use:
The cash flow projections must be based on the most recent approved financial budgets/projects
Cash flow projections beyond the covered period must be estimated by extrapolation of projects based on forecasts using the declining rate for subsequent periods or a steady rate. This growth rate must not exceed the long-term average growth rate of the product or industry.
Example of impairment of assets:
Company C purchased Company D ltd. and paid USD 1,000,000. The book value of assets was USD 700,000. The extra USD300,000 paid by Company C Ltd. above the book value of assets of D is to be recorded as goodwill.
Over the year after purchase, the fair market value of Company D Ltd. fell from USD700,000 to USD400,000.
As a rule, the company is required to test for impairment of assets every year. So, after a year Company C ltd will compare the carrying amount of its assets with the fair value of Company D Ltd, and with the differential amount, the goodwill will be reduced. So, the goodwill, in this case, is the impaired asset. The journal entry for recording impairment loss is:
Journal entry for revaluation:
How to test the impairment?
The measurement of amount of loss involved in impairment involves following steps:
Perform the recoverability test: It involves evaluating whether the future value of asset undiscounted cash flows is less than the book value of the asset. If the cash flow is less then, the impairment loss is calculated.
Measurement of impairment loss: It is calculated by finding the difference between book value and market value of the asset.
The use of undiscounted cash flows in this process assumes that the cash flows are definite and risk-free and the timing of the cash flow is not taken into account.
6 Tips for impairment test:
Cash flows in the impairment calculations should be reasonable. Forecasted statements in the prior periods may need to be revisited. It must be based on the latest management reports or budgets or estimates. It must be backed by reasonable assumptions that should represent management’s best estimate of economic situations that will remain over the remaining lives of the asset. Greater weight should be given to external evidence.
Value in use should comply with the standard: Future cash flows should be estimated for assets in the present situation. The major problems that might occur in making assumptions about the value in use relate to future restructuring and capital expenditures on investment. Where management has approved the restructuring plans, the approved budget is likely to include the costs and benefits of the restructuring.
Focus on market capitalization: Market capitalization below net asset value is an indicator of the impairment test. If the market capitalization is less than the value in use then the impairment test is carried out. The fall in the market value of an asset is the indicator of impairment. A lower market value acts as a trigger but it doesn’t necessarily mean so. However, when management determines the recoverable value above the market value then the assumptions of market conditions should be checked in the light of available external evidence.
Check the discount rate: Many companies follow the capital asset pricing method to determine the discount rate. The factors like cost of capital, corporate loan rates, and risks associated with the cash flows are to be taken into account since these may result in an increase in the discount rate.
Reconcile the conclusion with the external market data: The current economic assumptions made a year ago might not be reasonable in the current scenario. Consumer expenditure is falling due to the economic situations hence cash flow growth assumptions must be reviewed carefully. The analyst reports should be obtained to support growth assumptions.
Compare the assets being tested for impairment with the cash flows coming from that asset: It is to be ascertained that the cash flows being tested are consistent with the assets being tested. IAS 36 states that cash flows related to assets that generate cash flow independently should not be included in the cash flow forecasts. Cash flows should exclude cash related to financing.
In the accounting world, the asset is defined as an owned resource from which future economic benefits are expected. On the balance sheet of any organization, be it a not-for-profit or for-profit, the carrying amount of all assets is reported.
All such assets are divided into two categories on the balance sheet based on how quickly they can be turned into cash; current assets and non-current assets (also known as fixed assets).
Current assets are resources that are used up within one year, whereas fixed assets or non-current assets have a useful life of more than one year.
In this article, we will discuss how fixed assets are reported on the balance sheet of a not-for-profit organization.
Recognition of Fixed Assets:
As per the generally accepted accounting principles (GAAP) used around the world, every organization should determine a capitalization policy for its assets.
A capitalization policy for each organization defines a certain threshold amount over which any expenditure incurred would be qualified as a capital expenditure and hence, will be reported on the balance sheet.
On the other hand, any expense incurred under the threshold would be categorized as revenue expenditure and hence, expensed out on the income statement. For small non-profit organizations, the capitalization criterion usually ranges between $500 and $1,000.
The other criterion that an asset has to meet to be recognized as a fixed asset is having a useful life of more than one year.
In other words, the asset should be able to provide benefits throughout the period in which it is used, and the specified period must be of more than one year.
Once an asset is classified as a fixed asset, it is recorded in the books of accounts in the year of purchase.
Cost of Asset:
The fixed asset is recognized at cost plus any expenses incurred to bring it to its current condition of use.
However, if the tangible asset is a contribution, then it must be recognized at its fair value on the date of donation except when the fair value cannot be reasonably determined when it is recorded at a nominal amount.
The following entry is recorded in the accounting journals if the fixed asset is purchased through cash:
DR Fixed Asset xx
CR Cash xx
On the other hand, if the fixed asset is a contribution, then the following journal entry is reported:
DR Fixed Asset xx
CR Contribution Revenue xx
Calculation of Depreciation:
The fixed asset after being recorded is depreciated every period it is used. Non-profit organizations usually use a straight-line method to depreciate their assets.
In other words, the cost of assets less salvage value is evenly distributed throughout the asset’s useful life. The formula to calculate depreciation is:
Depreciation = (Cost – Salvage Value) / Useful Life
Depreciation is expensed out each year as a non-cash expense on the statement of activities also known as the statement of operations.
The accumulated depreciation i.e. the sum of depreciation expense up to the reporting date is reported under the amount of the fixed asset on the statement of financial position of the non-profit organization.
Accounting depreciation is the use and tear and wears of tangible assets allocated by the company over the useful life of assets generally governed by corporate laws and accounting standards.
The recognition of accounting depreciation is driven by accounting principles and standards such as US GAAP or IFRS or the country’s financial reporting standard.
Depreciation is a non-cash item and does not represent actual cash movements. Despite being a non-cash item, it appears on the income statement and ultimately in balance sheet getting accumulated to compute written down value of the asset.
So, this non-cash item is ought to be reported by the company. Accounting depreciation is also popularly called book depreciation.
Accounting depreciation is computed using different methods such as:
The most popular method is the straight-line method of depreciation. It distributes depreciation equally over all the periods of asset’s useful lives.
Other methods are accelerated methods allowing for higher depreciation in the earlier years and lower in the subsequent years.
For example, the double-declining method allows for twice the rate of straight-line depreciation in the earlier years.
Example of accounting depreciation
Majestic Inc purchases equipment worth $100,000 with a salvage value of $10,000 and a useful life of 10 years.
In this case, the straight-line method of depreciation is used meaning equal depreciation over the useful life of assets.
Depreciation = (purchase price- salvage)/Useful life = (100,000-10,000)/10 = $ 9000 per year
Tax depreciation is depreciation computed as per tax laws and to be reported on the tax return. It is subject to a tax deduction as per jurisdiction. BY deducting depreciation, tax authorities allow individuals and businesses to reduce taxable income.
However, the taxpayer cannot claim depreciation for all the assets. The conditions are specified in tax laws in order to be eligible for depreciation.
The regulations are country-specific and if countries have several tax jurisdictions like the US, it can be jurisdiction-specific.
The tax laws publish specifications of assets’ class, the period in which they are placed to use and the applicable depreciation allowed for such assets.
In the United States, the Internal Revenue Service is handed the responsibility to publish materials on depreciation.
Example of tax depreciation
Majestic Inc purchases equipment worth $100,000 with a salvage value of $10,000 and a useful life of 10 years.
Now, tax depreciation is as per IRS. IRS may require the equipment to be depreciated over the 7-year property as an accelerated method.
This will result in higher depreciation in the earlier years. The rate keeps changing with conditions. For example, if the equipment is placed in the third quarter of the year, there will be a separate rate for such equipment.
In a nutshell, following are differences between accounting and tax depreciation can be summarized as under:
Depreciation is prepared as per accounting purposes and complies company laws
Depreciation is prepared to comply with tax laws.
The company has a choice in depreciation methods, rates, and useful life.
The company has to use the depreciation rate and method as per tax law.
It is based on accounting principles, governed by accounting principles and accounting board.
Installation of fixed assets requires sincere work and incurs certain charges called commissioning costs for setting up and making a modification to the landscape for erecting the asset.
Similarly, the decommissioning cost is the cost incurred by the companies to reverse modifications that were made in setting up in the landscape.
This means the asset is used up and set for sale or salvage. Decommissioning costs are also popularly called asset retirement costs.
In this article, we will discuss detail on how to account for decommissioning costs
Industries where decommissioning is done.
The asset heavy industries such as metal industries and oil and other companies requiring large asset to be set for manufacturing incurs decommissioning cost.
These costs are usually very high in oil industries due to the nature of functioning. They have to keep and put drilling instruction in use so as to not let harmful gases leakage to earth.
Standards for Decommissioning costs
Decommissioning costs may require a provision in certain industries as per the prudent approach. IAS 37 on Provisions, contingent liabilities, and Contingent Assets require the creation of provision.
Similarly, IAS 16 Property, Plant and Equipment require including the initial estimate of the costs of dismantling and removing the item and restoring the site into the cost of an asset.
Further, IFRS has developed IFRIC 1 Changes in Existing Decommissioning, Restoration and Similar Liabilities to account for such decommissioning costs.
Computation of decommissioning costs
Since, these costs are future costs and likely, time value concept loops into the computation of decommissioning costs. The following are the steps in the calculation of the cost:
Compute decommissioning present cost using the time value of the asset assuming no improvement in decommissioning procedure.
Take into account the expected inflation to the time of actual decommissioning of the asset.
Use the discount rate and compute decommissioning liabilities or provisions to be included in the cost of the asset.
Unwind the discount on decommissioning assets that equal the opening balance of the decommissioning obligation. This will result in the period end balance of decommissioning liability.
Accounting treatment for decommissioning costs
Initial Recognition and Measurement
The retirement of production assets may be required by operating licenses or past practices. As per IAS 37, this ought to create an obligation and thus a liability.
Further, a corresponding asset is created as per IAS 16 on Property, Plant, and Equipment, which defines cost as an initial estimate of dismantling and removing the asset and restoring the site on which it is located.
The required accounting treatment in this scenario would be
Property, Plant and equipment
Provisioning for decommission
Such provisions are calculated by using present value concept
Subsequent Recognition and Measurement
When the asset is used up, unwind the discount and charge the interest on provisions to build up the required provisions over the life of the asset. This discount has to be recognized as a finance cost in the income statement.
Provisioning for decommission
Further, this cost of provision has to be depreciated over the useful life of fixed asset.
If changes to provision relate to removal of asset, then there is the case of decrease in value of asset as:
Provisioning for decommission
Property, Plant and Equipment
However, the asset cannot go below zero and neither can go above its recoverable amount . If the decrease in provision exceeds the carrying amount of the asset, the excess is recognized immediately in profit or loss.
At the end of useful life of asset, the company decommissions the asset and restores the site to required condition and all the expenses are charged against the provision. The entry to be made here is :
Exploration costs mean the cost incurred for the search of mineral resources including minerals, oils, natural gas, and other similar non-regenerative resources after the entity has obtained the rights to explore in specific areas by determining technical feasibility and commercial viability of extracting the mineral resource. (adapted from IFRS 6).
IFRS 6 allows the company to develop accounting policy for recognition of exploration and evaluation expenditures without adhering to much of the policy requirements of IAS 8 on Policies, changes in Accounting estimates, and errors. The evaluation phase is after the exploration but is dealt with likewise as one in IFRS.
Elements of cost of exploration and evaluation
After recognizing exploration cost as per IFRS 6, the following are the components that form part of the cost:
Acquisition of rights to explore.
Cost of exploratory drilling
Trenching and sampling
Cost of study towards topography and geology
Cost of activities related to technical feasibility and commercial viability of extracting mineral
However, expenditure related to the development of mineral resources shall not be recognized as exploration and evaluation costs. These are dealt in as per IAS 38 on intangible assets as development costs.
Accounting for exploration and evaluation.
An entity may have a past practice of deferring all exploration and evaluation expenditure as an asset even if the outcome is highly uncertain. Other entities may have a past practice of expensing all exploration and evaluation expenditure until the technical feasibility and commercial viability of extracting a mineral resource have been established.
An entity can change its accounting policy for E&E only if the change results in an accounting policy that is closer to the principles of the Framework.
The entity should determine the unit to which exploration and evaluation cost will be allocated. The common method is to allocate between areas of interest.
This should involve determining areas to examine and track separately the costs incurred for each area. The area of interest contracts over time as work progresses.
Subsequent measurement of exploration and evaluation
There are two methods to determine the cost of exploration and evaluation. These methods are cost method and the revaluation method.
Whichever method is applied, it shall be consistent with the classification of the costs/assets. Depreciation and amortization of E&E assets usually do not commence until the assets are placed in service.
The revaluation method is applied to intangible assets only if there is an active market in relevant intangible assets.
However, such criteria are seldom met and cost method is used then. The ‘fair value as deemed cost’ exemption in IFRS only applies to tangible fixed assets and thus is not available for intangible assets.
Reclassification of Exploration and evaluation assets.
Exploration and evaluation assets are reclassified procedures that have been completed to recognize as such.
Those expenditures which are commercially viable have to reclassified to development cost viz. as development assets. The exploration and evaluation assets shall also be tested for impairment.
Impairment of Exploration and evaluation assets
There are various indicators to determine the impairment of exploration and evaluation assets as :
The right to explore in the geographical area has expired or about to expire with no option to renew.
Further exploration and evaluation are not planned.
There is sufficient data to conclude that exploration and evaluation will be discontinued due to a lack of commercial reserves.
The disclosure requirements of exploration and evaluation assets generally include:
The accounting policy used for allocating exploration and evaluation assets cash-generating units for impairment purposes
The amount recognized in financial statement w.r.t. exploration and evaluation activities including the disclosure in operating cash flows and investing cash flows
Last but not least the reconciliation statement of amounts carried forward as exploration and evaluation assets at the beginning and closing of the accounting period. The reconciliation statement includes transfers to development, amounts written off, and impairments.