During the useful lives of fixed assets, situations may arise when the residual value of an asset no longer corresponds to the value that the asset is capable of generating for the entity or the amount it could be sold for.

In such cases, the impairment of the asset should be quantified and recognised. Companies may have experienced this situation more often during the last few years, which have been quite turbulent in the world. The unprecedented situation related to the covid-19 pandemic and the subsequent economic shock due to the conflict in Ukraine have greatly complicated many companies’ existing plans and forecasts for the coming years and often changed the real value of their assets. To maintain a true and fair view of the accounting and financial position, entities should recognise the identified impairment in the form of valuation allowances.

Testing the impairment of an asset

In order to assess the need for a valuation allowance for non-current assets (hereinafter also “NA”), it is necessary to test the assets for impairment. For this purpose, it is possible to use the procedure set out in Interpretation “NAC-45 – Impairment of Tangible and Intangible Fixed Assets – Testing and Reporting” issued by the National Accounting Council. According to NAC I-45, if there is a presumption of impairment of an asset (e.g., change in market value, damage to the item, etc.), it should be tested for impairment.

In case of impairment of an asset, it is necessary to determine the “recoverable amount”, which is defined as the higher of the values:

• “the asset’s fair value less costs to sell,
• value in use, which represents the discounted net operating cash flows that the asset or group of assets generates.”

This comparison of values shall be made regardless of whether the entity intends to retain or sell the asset.

The first test option states that if, for example, the price of a particular asset falls in the market, its recoverable amount can be determined from the current market value less the costs associated with a notional sale at that point in time. If this recoverable amount is lower than the residual value, it is appropriate to include the difference in the valuation allowance. However, if the opposite situation occurs – the asset appreciates in value and the recoverable amount exceeds the accounting value, a valuation allowance created in the past can be reversed. If an accounting entity reduces the accounting value of an asset through a valuation allowance, it is also appropriate for the entity to adjust the depreciation schedule that might not otherwise reflect that reduced value.

The second option can be applied when the market situation changes and the company is forced to change its management plan. At that time, it is also necessary to determine the recoverable amount of the asset updated for these new facts. This can be done using the net cash flow discounting method. This method calculates the cash flows that the asset is expected to generate in future periods. Based on this test, it is possible to compare the accounting value with the recoverable amount and decide on a valuation allowance according to the result. For the discounting method, information on the market situation and, as far as possible, an accurate estimate of the company’s performance in the following periods are essential. By the same token, the discount rate must be assessed as best as possible.

Assets that do not in themselves generate any cash flows for the company may be tested for impairment. In this case, they can be aggregated into so-called “money-creating units”. This is the smallest group of assets that generates cash flows sufficiently independent of other cash-generating units. If that group of assets is impaired, the identified impairment loss shall be allocated to the individual assets that comprise the cash-generating unit as follows:

1. a) the first loss is allocated to a specific impaired asset if that asset is clearly identifiable;
2. b) subsequently, the loss is allocated to positive goodwill or a positive valuation difference up to its current residual value; if the loss is identified at the consolidated level, it is first allocated to a positive consolidation difference up to its current residual value;
3. c) the remainder of the loss is allocated to the other assets of the cash-generating unit in proportion to their residual accounting values;
4. d) after the attribution of loss, the value of any asset of a cash-generating unit must not fall below its individual recoverable amount, if determinable.

At the present time, when a significant number of companies are affected by large market fluctuations, accounting for valuation allowances is very topical. In practice, one can encounter situations, where sudden international changes cause significant losses in the value of a company’s assets, or, conversely, situations, where the market allows firms to achieve very interesting appreciation for assets.

Author: Jiří Anděl