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Recent volatility in markets could lead to impairment charges this year

Bowling

Posted on December 18, 2015

Volatility in the Canadian and global economic environment can have a significant impact on the financial position and financial performance of entities. Generally speaking, across all accounting frameworks, impairment testing is required whenever events or circumstances indicate that an individual asset or group of assets will not be able to generate a sufficient level of future economic benefit to support its carrying amount. While the specific details of impairment tests do, in fact, vary by framework, entities need to consider whether existing internal or external factors will reduce the entity’s ability to generate future cash flows from its asset(s).

In 2015, we have seen some significant adverse changes in the market environment in which many Canadian entities operate. They range from fluctuations in commodity prices to a declining Canadian dollar and both actual and anticipated changes to interest rates. These factors, among many others, are potential indicators of impairment and may trigger an assessment as to whether the underlying value of an entity’s assets is recoverable. The outcome of such tests may result in an impairment loss being recorded in an entity’s financial statements. Conversely, favourable economic changes help support the carrying value of an entity’s assets. Lower interest rates may result in calculations of higher recoverable amounts. Commodity prices, foreign exchange rates and interest rates are often significant inputs into valuation models used to assess whether an asset or groups of assets are impaired.

Assets subject to impairment testing generally include inventories, property, plant and equipment, intangible assets, financial assets (other than those measured at fair value through profit or loss) and, of course, goodwill. So, given that year-end reviews for indicators of impairment and/or annual impairment testing are already underway, we have compiled a list of some economic trends for your consideration.

Fluctuating commodity prices

In the last 12 months, we have seen various peaks and valleys in many commodity prices. For example, the price of crude oil has dropped from approximately US$70/barrel to less than US$40/barrel1, and other commodities that have experienced significant price swings in the same period include natural gas, gold, silver, and copper. Many of you may be thinking, “I’m not a commodity producer, so do I really need to monitor commodity prices?”

Well, the answer is yes! Volatile commodity prices have a direct impact on entities producing commodities, but can also have a significant impact on entities whose activities are dependent on those commodities as a key input in their cost structure. Certainly, the movement in commodity prices may have a positive impact on your financial performance in one reporting period, but what about three months from now? Entities need to understand the significant inputs used in their valuation models, including those tied to commodity prices, and how changes in those inputs may result in an impairment of the underlying value of their assets. Monitoring is key.

Declining Canadian dollar

Another key input we have all witnessed in Canada is the continued depreciation of the Canadian dollar. In the past year, the 12-month average U.S.-Canadian dollar exchange rate declined from US$0.914 in November 2014 to US$0.797 in November 20152 – that is, a 13% devaluation! I expect that this decline will result in some significant foreign currency gains and/or losses for many entities. As a reminder, a decline in the local currency relative to one’s functional currency is a potential indicator of impairment under the various frameworks, so when this sort of market change occurs, further analysis is often required.

To the extent that underlying cash inflows and outflows are denominated in a foreign currency, management will need to determine their impact on their valuation calculations.

Changing interest rates

In an effort to balance slower growth and the depreciation of the Canadian dollar with inflation targets, the Bank of Canada revised its target for the overnight rate to 0.5% (July 2015)3. Conversely, our friends to the south at the U.S. Federal Reserve are expected to increase U.S. interest rates as a result of improved employment statistics4.

So what does this mean? First, entities using the risk-free interest rate as a basis for developing their discount rate for impairment purposes need to ensure that they have captured the above changes. And second, anyone with variable interest-bearing assets and/or borrowings should continue to monitor whether subsequent changes to interest rates result in new and/or increased interest rate risk exposure and how any such changes might impact impairment calculations.

Income taxes

The recording of an impairment may result in the recognition of a deferred tax asset or a reduction in a deferred tax liability, depending on the tax base of the asset. Management is reminded that deferred tax balances are measured using the tax rates that are expected to apply when the temporary differences reverse, based on tax rates enacted or substantively enacted at the end of the reporting period. Recent losses and changes in economic conditions are just some of the criteria that need to be assessed prior to the recognition of deferred tax assets, including those arising from impairment. In addition, an assessment should be made, at each subsequent reporting period, as to whether an entity will be able to generate sufficient future taxable profit such that its recognized deferred tax assets remain recoverable. Tax assets should be reduced to the extent that recoverability is no longer probable.

Disclosure and other considerations  

If you have identified an indicator of impairment as a result of the changes in the economic environment in which you operate, regardless of whether an impairment needs to be recognized, your financial reporting disclosures may need updating to reflect current facts and circumstances faced by your entity, including, but not limited to, your impairment test methodology and key inputs applied. Refer to disclosure requirements as set out in your respective accounting frameworks. Remember that the basis on which the recoverable and carrying amount of assets is determined is a matter of judgment and, as such, your accounting policy and significant judgment disclosures should reflect these considerations.

Entities may also need to update their financial statement disclosures when market changes occur in order to identify any new and/or increased risks associated with such exposures. In addition, consider disclosures in your other communications. For example, continuous disclosure documents such as your Management Discussion and Analysis will need updating to describe how your financial performance was impacted by changes in the economic environment and your exposure to such financial risks, including any changes to your risk management strategy. Disclosures need to be entity-specific and should contain relevant information for financial statement users.

A number of entities have entered into hedges to mitigate their exposure to currency, interest rate and/or pricing fluctuations. It is also important to understand how the accounting for your risk mitigation strategy may impact your impairment tests and vice versa.

Other considerations with regards to how economic volatility may impact your financial reporting include a reassessment of your methodology and the basis on which assets are depreciated or amortized, and how economic trends may impact the fair value measurement of assets acquired in a business combination.

Final thoughts

The key, as noted above, is monitoring and disclosure. When markets are changing, preparers of financial statements need to be well versed on how economic fluctuations can impact their financial reporting and, in turn, ensure that their disclosures reflect how the entity was affected and how it has responded to those fluctuations.

As always, please don’t hesitate to reach out to your Deloitte Business Advisor to discuss this article further or for more information.

1 http://www.nasdaq.com/markets/crude-oil.aspx?timeframe=1y
2 http://www.bankofcanada.ca/rates/exchange/10-year-lookup/
3 http://www.bankofcanada.ca/2015/07/fad-press-release-2015-07-15/
4 http://www.federalreserve.gov/newsevents/testimony/yellen20151203a.htm

Alexia Donoghue, Senior Manager | National Accounting and Securities Services
Alexia is responsible for monitoring quality standards for Deloitte’s public company client filings.  Alexia also provides consultative advice to attest and non-attest clients on general securities filings and financial reporting matters.
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