3 July 2000

The Chairman
Australian Accounting Standards Board
530 Collins Street (Level 3)
MELBOURNE VIC 3000

Dear Sir

ED 99 Impairment of Assets

The Group of 100 has reviewed ED 99 Impairment of Assets and is pleased to make the following comments. The Group of 100 supports the proposals that discounting be mandatory when assessing impairment on the basis of anticipated future cash flows. The Group of 100 strongly disagrees with many of the proposed changes to the assessment of impairment and with the definition of recoverable amount. The Group of 100 supports the approach adopted in IAS 36 Impairment of Assets and believes that Australia should harmonise with these requirements. The approach involving impairment indicators and the application of the definition of recoverable amount may result in entities undertaking a less thorough process than presently occurs. Our comments are detailed below:

a. Scope Issues

We have no issues with the scope of the proposed standard.

b. Indicators of Impairment

The Group of 100 agrees with the proposal that recoverable amount need not be measured where there is no indication that an asset's carrying amount may exceed its recoverable amount, and is broadly in agreement with the indicators listed in paragraph 5.2. However, we disagree with the requirement that recoverable amount of an asset must be measured where any of those indicators are present and then limiting that requirement in associated commentary by reference to materiality considerations.

If, for example, interest rates increase as is currently occurring in most developed countries, paragraphs 5.1 and 5.2(d) require the recoverable amount of all of the entity’s assets to be measured. This is an onerous requirement and the "materiality" factors outlined in the commentary which overrides the bold print requirement should be given equal status in bold print.

The Group of 100 also opposes the requirement to take into account variances from internal budgets (refer paragraph 5.2.4) or variances from "expectations" (paragraph 5.2(h). This should only apply to expectations that were factored into previous recoverable amount assessments. Assessments of recoverable amounts are usually conducted separately from budget and forecast processes.

For example, some companies have adopted recent theories that promote the abandonment of the budgeting process in favour of more regular forecasts. These internal management tools should not impact formal recoverability assessments required by an Accounting Standard, and we do not believe that there is precedent for their use in any other Australian Accounting Standard.

c. Definition of Recoverable Amount

We strongly oppose a number of the aspects of the proposed definition of recoverable amount.

Firstly, we strongly favour the definition adopted in IAS 36. The IAS 36 definition, being the higher of value in use and net selling price more closely aligns with business and commercial practice, and generally accepted historic practice, than the arguably more narrow and constrained definition that is being proposed.

The proposal basically recommends against the IAS 36 definition on the basis that recoverable amount calculations would be too easily manipulated by management and that the current system lacks the "checks and balances" to avoid such manipulation. This position is contrary to the legal and professional duties of directors when approving accounts and the legal and professional duties of auditors when forming and expressing an opinion on those accounts. We believe that a more appropriate definition of recoverable amount combined with the existing requirements for directors and auditors is preferable to the proposed definition of recoverable amount.

In our opinion, the main areas of deficiency of the proposed definition are that:

Given that most assets or groups of assets for which a recoverable amount will need to be determined are neither listed assets nor homogenous or commodity-type assets, the determination of the maximum amount a theoretical entity would rationally be prepared to pay for those assets is highly subjective and speculative. As is regularly seen in asset transactions, some entities are prepared to pay considerably more than other entities for the same asset, and, in some cases, considerably more than an independent expert who is not familiar with the circumstances of the purchaser would nominate as a reasonable maximum price. Such "price premiums" can be attributed to factors including strategic benefits, synergies with existing assets, differing perceptions of future benefits which an informed industry participant may be aware of, preparedness to pay for "blue sky" (e.g. consider some recent e-commerce related transactions) or simply availability of resources. These "price premiums" are also becoming increasingly prevalent as global markets become more concentrated and industry participants engage in and respond to takeover activity.

As a further demonstration of this point, in industries with one or two dominant participants (which describes many Australian industries) the range of potential purchasers for many assets is extremely limited. In our opinion this requirement to consider theoretical transaction possibilities rather than the benefits likely to be generated by the current owners through use of assets is inappropriate. What is relevant to shareholders and other interest holders are benefits an entity expects to derive from the use of its assets rather than what it may be able to sell them for, despite the fact it has no intention to sell them.

As a further issue, the market buying price of previously purchased individual assets is commercially irrelevant. If assets are recorded at their actual cost, the recoverable amount issue should be whether the entity can generate sufficient cash flow from use of those assets to justify the carrying amount. Market buying prices can rise or fall due to progression through the technology cycle (ie new technology becoming cheaper), commodity price movements, exchange rate movements (eg for imported assets), supplier market demand and supply factors, tax changes, general inflationary pressures and for a range of other reasons.

The fact that any of these factors cause increases or reductions in the "replacement cost" of assets should be irrelevant to the question of whether the costs actually incurred are recoverable.

This issue is demonstrated as it relates to goodwill. Assume that a company acquires a business for $130m, being the NPV of management’s expected future cash flows from the business and that the consideration represents $100m of net tangible assets at fair value and $30m of goodwill. If, at the following balance date, the fair value of the business remains at $130m (based on the NPV of future cash flows) but the market buying prices of the net tangible assets (assume the same assets) has increased to $130m because those assets are mainly imported equipment and the Australian dollar has devalued significantly, under paragraph 6.4 of ED 99 the goodwill would have to be written off, resulting in a $30m charge to profit (ignoring amortisation).

Note that it is the same business with the same assets, the same expected future cash flows and the same value, and under the current impairment test no writedown would be required, however it would be necessary to write off the goodwill under the proposed impairment methodology. That impairment would not be reversed if, in the following year, the Australian dollar appreciated and the market buying price of the net tangible assets again returned to $100m. It could also be argued that in this case the reduction in the value of goodwill is offset by an increase in the value of the tangible assets. However, if the company was using actual or deemed cost (per AASB 1041) to measure those assets it could not recognise that increase, and even if it adopted fair value the increase would be credited to Asset Revaluation Reserve and, therefore, would not offset the profit impact. This demonstrates the unsound principles underlying the proposals and the criticisms that are likely to arise as directors are asked to approve and explain financial accounts.

We also note that many entities use highly specialised assets for which market buying prices are not readily available. Obtaining estimates of market buying prices for these assets would be a significant administrative burden which is required for no other purpose and would be expensive, time consuming and onerous.

As is stated on page 8 of ED 99, "the purpose of an impairment test is to ensure that the carrying amounts of assets are recoverable from the future economic benefits they are expected to generate, and that any losses of future economic benefits are properly recognised in a timely manner". As explained above, we believe that the impairment methodology proposed in ED 99 is inconsistent with this statement of principle.

We suggest that the above statement of principle is consistent with the going concern basis that is generally required by AASB 1001 "Accounting Policies", whereas the proposed recoverable amount definition is more consistent with the liquidation basis, which is generally inappropriate when preparing accounts.

While mention is made in ED 99 of whether a physically damaged asset that is part of a cash generating group of assets should be individually assessed for impairment, we believe that such a requirement for individual assessment could easily and practically be introduced in conjunction with the IAS 36 impairment definition.

If the Board retains the proposed definition an issue which arises is whether transaction/incidental costs which are capitalised when assets are purchased will pass the impairment test. Given the proposed definition and guidance, it appears that such incidental costs would have to be expensed immediately. This anomaly requires correction or clarification. A further issue is that the Standard should clearly state, with respect to an "asset’s quoted market price in an active and liquid market", that, in the case of subsidiaries and associates any quoted market price is presumed to not be relevant as there would not be an active and liquid market for holdings of the size required to achieve subsidiary or associate status.

Our final point is that the compliance costs associated with these proposals will be excessive, as there will be ongoing pressure for independent valuations and assessments regarding the potential sale proceeds should an entity decide to sell businesses/assets which it currently has no intention of selling. While this would be welcomed by investment bankers and other corporate advisors, the cost of engaging such experts to provide such valuations on a regular basis would be excessive and disproportionate to any benefits that result. When added to the cost of obtaining and documenting market buying prices, which are needed for no other reason, we believe compliance costs will be excessive.

d. Requirements and Guidance

Given that we fundamentally disagree with the proposed definition of recoverable amount, the main guidance in relation to that definition (eg regarding market buying prices) and numerous other aspects of ED 99, we offer no comments on the proposed guidance.

e. f. Reversal of Impairment Losses

We agree with the proposed treatment of impairment loss reversals. However, we believe that, consistent with IAS 36 entities should also be able to reverse an impairment loss for goodwill where it is clear that the effect of the specific external event giving rise to that impairment loss has been reversed.

To illustrate this point, assume an entity acquires a business in another country and the price paid results in the recognition of goodwill. Assume that the government of that country then nationalises the acquired business without compensation, resulting in all of the assets, including goodwill, becoming impaired and written down. One year later that government is overthrown and the new government reinstates the entity’s ownership and control of the business. All assets can have the impairment loss reversed. However, under the proposals goodwill could not be reinstated because it is deemed that the goodwill would be "indistinguishable from an increase in internally generated goodwill". This is clearly inconsistent and inappropriate. Directors and auditors would be quite capable in many instances to differentiate internally generated goodwill from reversal of specific external events. While the above scenario may appear to be extreme, it is possible that it and similar issues could arise due to changes and subsequent reversals of government policy (e.g. tax, licencing, import duties etc), excessive price competition new competitor who within months is liquidated due to lack of profitability or numerous similar scenarios.

g. Impairment Losses and Reversals as Expenses and Revenues

We agree with this aspect of ED 99.

h. Disclosure Requirements

We broadly agree with the proposed disclosure requirements, with the exception that we do not support specific disclosure of discount rates as proposed in paragraph 9.3(f). Discount rates are commercially sensitive and impact on numerous transactions and negotiations, particularly where the estimated weighted average cost of capital is used. Given that no specific guidance is offered in ED99 regarding selection of a discount rate, provided directors and auditors are satisfied that an appropriate discount rate is used there should be no requirement for further disclosure.

We also note that the asset disclosure treatment of the impairment write-down has not been prescribed, ie whether it should be treated as a provision, an accumulation etc and how it should be formatted with respect to accumulated depreciation. We believe this should be clarified.

As explained above, we believe ED 99 is fundamentally flawed and has major and serious disagreement with many of its proposals. We would welcome the opportunity to make presentations to the Board to further explain our concerns about these proposals.

Yours sincerely


Bryce JH Denison
National President

 

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