An impairment loss is recognised when the acquisition cost of an asset exceeds its recoverable amount.

It’s no secret that many acquisitions made by Indian corporates in the past are turning out to be expensive now in hindsight either because the acquisition price was overpaid or because the expected synergies are not getting realised. This situation will arise typically when the Indian company has paid significant premium over the book value of net assets acquired, which has been recognised as goodwill.

Accounting Standard 28 (AS 28) issued by the Institute of Chartered Accountants of India requires Indian companies to assess at each balance-sheet date (typically March 31) whether or not there is impairment loss on goodwill arising on acquisition. This is likely to have an impact on Indian enterprises based on the following facts:

Market capitalisation of companies globally has reduced significantly due to the global recession.

Recently we have seen a significant fall in property prices.

This assessment has not been done rigorously so far, primarily because there were no impairment indicators as things were going well. There was no reason earlier to believe that the value of assets/companies (owned or acquired) could have come down. But now the situation is different; and this would be the first time that impairment is being considered since there are impairment indicators.

An impairment loss is recognised when the carrying amount of an asset (that is, acquisition cost) exceeds its “recoverable amount” (either its “net selling price” or its “value in use”, whichever is higher).

Since goodwill does not generate cash flows independently, the recoverable amount of goodwill is determined for the cash-generating unit to which the goodwill belongs. Computing recoverable amount for a cash-generating unit (that is, net selling price or value in use of an asset) is by no means an easy task.

Net selling price

If impairment testing is done at the entity level and the acquired entity is listed, then net selling price can be computed with reference to market price of its equity shares. If the acquired entity is unlisted then its value as computed using Comparable Companies’ Multiples (CCM) method, which is one of the acceptable methods for valuation, can be considered as proxy for its net selling price.

In the CCM method, the value of a company is computed with reference to benchmark valuations of other listed companies operating in the similar industry and having similar value drivers as the acquired entity.

For example, an Indian software company acquired another software company in the US, which is unlisted. If other similar software companies operating in the US are trading at an average of, say, 10 x current PAT (profit after tax), then value of this acquired software company under the CCM method can be considered at 10 x its current PAT.

Further, if the acquired entity has more than one cash-generating unit (CGU), then each such CGU should be valued accordingly.

Value in use

Estimating value in use involves computing present value of future net cash flows arising from that asset. Since projecting future cash flows can be subjective, AS 28 requires the management to estimate cash flows based on reasonable assumptions.

Greater weight should be placed on external evidence and the cash flows should be projected based on the management’s best estimate of expected economic conditions. The management can consider synergies and other acquisition benefits that can reasonably be estimated. These cash flows should be prepared on pre-tax basis and discounted to present value using appropriate pre-tax discount rate.

The discount rate should consider current market assessment of time value of money and riskiness of the asset’s cash flows.

Having computed net selling price and value in use of the acquired company or each such CGU (if the acquired company has more than one CGU), the management should evaluate whether the acquisition cost is lower than either of them.

If yes, then there is no impairment loss that needs to be recognised in profit and loss account. Else, a loss for goodwill that has got impaired needs to be recognised. If the parent company is reporting standalone financials, then Accounting Standard 13 (AS 13) requires parent company to assess at each balance-sheet date (typically March 31) whether or not there is diminution, other than temporary, in value of equity investments made by parent company to acquire equity stake of subsidiary company.

A loss is recognised if the value of these investments is less than the acquisition cost and such diminution in value is not temporary. To assess diminution in value (other than temporary), the management may consider valuing subsidiary company using CCM or discounted cash flow method as explained above.

Rules for reversal

AS 28 (and also AS 13) prescribes certain rules for the management to reverse an impairment loss on certain conditions being met (example, improvement in future market conditions). Losses recognised under AS 13 or AS 28 will have impact on distributable profits for dividend declaration, calculation of EPS, determination of profits for senior management remuneration and payment of MAT (minimum alternate tax).

In the ultimate analysis, the Accounting Standard’s objective is to ensure that assets are not overstated in the balance sheet and managements should keep this in mind and comply with the same so that the financial statements are well appreciated by all stakeholders.

Article by Sanjiv Agrawal  & Mihir Gada The authors are Partner and Associate Director, respectively, Transaction Advisory Services, Ernst & Young