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IAS 36 'Impairment of Assets' prescribes theaccounting for impairment reviews. While the guidance in this areahas not changed in recent years, it still remains a challengingarea to apply by preparers of financial statements.
The articles in our 'Insights into IAS 36'series have been written to assist preparers of financialstatements and those charged with the governance of reportingentities understand the requirements set out in IAS 36, and revisitsome areas where confusion has been seen in practice.
The next three articles our 'Insights into IAS 36'series are all about cash-generating units (CGUs). In this articlewe discuss how to identify them, and in our following articles howto allocate assets to them and also then to allocate goodwill tothem.
Identifying CGUs is a critical step in the impairment review andcan have a significant impact on its results. That said, theidentification of CGUs requires judgement. The identified CGUs mayalso change due to changes in an entity's operations and theway it conducts them.
A CGU is defined as follows:
The smallest identifiable group of assets that generates cashinflows that are largely independent of the cash inflows from otherassets or groups of assets
Roles of the cash-generating unit in the impairment review
A CGU serves two primary roles in the impairment review. Itfacilitates the testing of:
- assets for which the recoverable amount cannot be determinedindividually, and
- goodwill and corporate assets for impairment
Goodwill and corporate assets by definition do not generate cashinflows on their own and therefore, must be allocated to a CGU orgroups of CGUs for impairment testing purposes. The allocation ofgoodwill and corporate assets is discussed in our articles'Insights into IAS 36 – Allocating assets tocash-generating units' and 'Insights into IAS 36 –Allocating goodwill to cash-generating units'.
Identifying cash-generating units
The objective of identifying CGUs is to identify the smallestidentifiable group of assets that generates largely independentcash inflows. CGUs are identified at the lowest level to minimisethe possibility that impairments of one asset or group will bemasked by a high-performing asset.
To identify a CGU, an entity asks two questions:
- Does a group of assets generate largely independent cashinflows?
- Is there an active market for the output?
Does a group of assets generate independent cashinflows?
Put simply, identifying CGUs involves dividing the entity intoclearly identifiable components. Because the CGU definition isbased on cash inflows, the division process should focus on anentity's sources of revenue and how assets are utilised ingenerating those revenues. Management will need to consider variousfactors including how it monitors the entity's operations (suchas by product lines, businesses, individual locations, districts orregional areas) or how management makes decisions about continuingor disposing of the entity's assets and operations.
Practical insight – Operational structure overlegal structure
It may be the case that the design and management of anentity's operations does not reflect the legal structure of thegroup. Depending on the circ*mstances, a CGU might correspond to alegal entity, a division, product line, geographic region, physicallocation (such as a hotel or retail store) or collection ofassets.
The following examples illustrate the identification of thelowest aggregation of assets that generate largely independent cashinflows in different circ*mstances.
Example 1 – Identifying the CGU: lowest level of largelyindependent cash inflows
A bus company provides services under contract with amunicipality that requires minimum service on each of five separateroutes. Assets devoted to each route and the cash flows from eachroute can be identified separately. One of the routes operates at asignificant loss.
Analysis
Because the entity does not have the option to curtail any ofthose bus routes, the lowest level of identifiable cash inflowsthat are largely independent of the cash inflows from other assetsor groups of assets is the cash inflows generated by the fiveroutes together. The CGU is the bus company as a whole.
Example 2 – Identifying the CGU: supermarketchain
Entity A owns and operates 10 supermarkets in a major city (CityB), each store residing in a different suburb throughout City B.Each supermarket in City B purchases its inventory through EntityA's purchasing centre. Pricing, marketing, advertising andhuman resources policies (except for the hiring of eachsupermarket's local staff) are decided by Entity A. Entity Aalso operates 50 other supermarkets in other major cities acrossthe country.
Analysis
The supermarkets in City B probably have different customerbases as they reside in different suburbs. Accordingly, althoughoperations are managed at a corporate level by Entity A, eachsupermarket generates cash inflows that are largely independent ofthose of other supermarkets. Therefore, it is likely eachsupermarket in City B is a separate CGU.
In making its judgement about whether each supermarket is aseparate CGU, Entity A might also consider if:
- management reporting monitors revenues on asupermarket-by-supermarket basis in City B, and
- how management makes decisions about continuing or closing itssupermarkets (eg on a store-by-store or on a region/citybasis).
The IFRS Interpretations Committee (IFRIC) was asked to developan Interpretation on whether a CGU could combine more than oneindividual store location. The submitter developed possibleconsiderations including shared infrastructures, marketing andpricing policies, and human resources. The IFRIC noted IAS 36requires identification of CGUs on the basis of independent cashinflows rather than independent net cash flows and so outflows suchas shared infrastructure and marketing costs are not considered. Inits March 2007 agenda decision, the IFRIC took the view developingguidance beyond that already given in IAS 36 on whether cashinflows are largely independent would be more in the nature ofapplication guidance and therefore decided not to take this itemonto its agenda.
Is there an active market for the output?
When management has identified a group of assets that generatean output, but those assets do not generate largely independentcash inflows, it needs to consider if there is an active market forthe output.
For the purposes of applying IAS 36, even if part or all of theoutput produced by an asset (or a group of assets) is used by otherunits of the entity (ie products at an intermediate stage of aproduction process), this asset (or group of assets) represents aCGU if the entity could sell the output on an active market. Thisis because the asset (or group of assets) could generate cashinflows that would be largely independent of the cash inflows fromother assets (or groups of assets).
Practical insight – Vertically integratedbusinesses and an active market for output
This is a common issue for vertically integrated businesseswhereby some groups of assets do not generate independent cashinflows, only because each operation's output is usedinternally, rather than being sold externally. IAS 36 addressesthis issue by clarifying that even if part or all of the outputproduced by an asset (or a group of assets) is used by other unitsof the entity, this asset (or group of assets) forms a separate CGUif the entity could sell the output on an active market. An activemarket is defined in IFRS 13 'Fair Value Measurement' as'a market in which transactions for the asset or liability takeplace with sufficient frequency and volume to provide pricinginformation on an ongoing basis'. This may be the case forcertain commodities such as oil or gold.
Example 3 – Identifying the CGU: active market forthe output
Entity X produces a single product (widgets) and owns productionplants 1, 2 and 3. Each plant is located in a different region ofthe world. Plant 1 produces a component of the widgets that isassembled in either plant 2 or plant 3 and sold worldwide fromeither plant 2 or plant 3. Neither plant 2 nor plant 3 is operatingat full capacity.
The utilisation levels depend on the allocation of orderfulfillment between the two locations of order fulfillment betweenthe two locations.
Scenario 1: There is an active market for plant1's component.
Scenario 2: There is no active market for plant1's component.
Analysis
Scenario 1: It is likely plant 1 is a separateCGU because there is an active market for its output. As cashinflows for plants 2 and 3 depend on the allocation of productionacross the two locations, it is unlikely the future cash inflowsfor plants 2 and 3 can be determined individually so they wouldprobably be combined into a single CGU.
Scenario 2: It is likely the three plants (1, 2and 3) are a single CGU because:
- there is no active market for plant 1's output and its cashinflows depend on sales of the final product by plants 2 and 3
- cash inflows for plants 2 and 3 depend on the allocation ofproduction across the two locations. It is unlikely the future cashinflows for plants 2 and 3 can be determined individually.
Where the cash inflows generated by an asset or CGU are affectedby internal transfer pricing, an entity uses management's bestestimate of future prices that could be achieved in an arm'slength transaction in estimating:
- the future cash inflows used to determine the asset's orCGU's value in use (VIU), and
- the future cash outflows used to determine the VIU of any otherassets or CGUs that are affected by the internal transferpricing.
Example 3 continued – Identifying the CGU: activemarket for the output
In Scenario 1, in determining the VIU of plants 1, 2 and 3,Entity X will adjust its financial budgets/forecasts to reflect itsbest estimate of future prices that could be achieved in arm'slength transactions for plant 1's output while alsoincorporating future cash outflows used to determine the VIU ofother assets impacted by the internal transfer pricing.
When the group of assets does not generate cash inflows that arelargely independent and there is no active market for its output(even if used internally), the group is not a CGU. Management thenhas to combine these assets with others that contribute to the samerevenue stream until a CGU is identified.
Changes in identified cash-generating units
Unless a change is justified, CGUs are identified consistentlyfrom period to period for the same asset or types of assets. If achange in CGUs is justified (eg an asset belongs to a different CGUthan in previous periods or previously recognised CGUs are combinedor subdivided), and an impairment loss is recognised or reversedfor the CGU, the entity should disclose additional information.
Practical insight – Triggers for a change in CGUstructure
IAS 36 does not provide examples of events or circ*mstances thatwould justify a change in CGUs. Such a change would generally beappropriate only if there has been a change in the entity'soperations – ie different revenue-generating activities ordifferent utilisation of assets in undertaking those activities.Typical triggers for a change might include:
- business combinations or divestments
- restructurings
- introduction or withdrawal of products or services, or
- entry to or exit from new markets or regions.
Practical insight – A change in CGU structure overtime
The factors that justify a change in CGU structure sometimesdevelop over time rather than being driven by a specific event. Forexample, an entity might gradually change the way it allocatesorder intake across its production facilities or how it utilisesassets to generate a revenue stream. In our view, the change in CGUstructure is justified if an asset's cash inflows become, orcease to be, independent even if this cannot be attributed to aspecific event. One practical suggestion for determining theeffective date of the change is to consider when management beganreviewing or assessing the CGUs differently (eg when managementreporting changed).
The content of this article is intended to provide a generalguide to the subject matter. Specialist advice should be soughtabout your specific circ*mstances.
