Harlow Industrial Group: impairment of a cash-generating unit with allocated goodwill (IAS 36)
Harlow Industrial Group tests its coatings division for impairment at 31 December 20X4. The division is the smallest identifiable group of assets generating largely independent cash inflows and is therefore a cash-generating unit. Its carrying amount comprises goodwill of £4.0m (from a past acquisition and allocated to the division), property, plant and equipment of £18.0m, a customer-relationship intangible of £3.0m with a remaining life of six years, inventory of £2.0m and net trade receivables of £0.0m after payables - £27.0m in total. Demand from the division's two largest customers fell 25% during the year and the main plant ran at 60% of capacity. Management's value-in-use calculation used pre-tax cash flows of £2.5m, £2.8m, £2.9m, £2.8m and £2.6m for the next five years, a terminal value reflecting a 2% annual decline, and a pre-tax discount rate of 10%. A competitor has offered £23.0m for the division, with £0.5m of fees payable on sale. The value-in-use calculation includes £0.4m of redundancy costs that would only arise if the division were closed.
1. Compute the recoverable amount and the impairment loss, and show how the loss is allocated.
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Recoverable amount is the higher of value in use and fair value less costs of disposal.
Value in use (discounting at 10%):
| Year | Cash flow £m | Factor at 10% | PV £m |
|---|---|---|---|
| 1 | 2.5 | 0.909 | 2.273 |
| 2 | 2.8 | 0.826 | 2.314 |
| 3 | 2.9 | 0.751 | 2.179 |
| 4 | 2.8 | 0.683 | 1.912 |
| 5 | 2.6 | 0.621 | 1.614 |
| Terminal value* | 21.233 | 0.621 | 13.184 |
| Total | 23.476 |
*Terminal value = 2.6 × 0.98 ÷ (0.10 + 0.02) = £21.233m, i.e. a perpetuity growing at −2%, discounted from the end of year 5.
Fair value less costs of disposal = 23.0 − 0.5 = £22.5m. Recoverable amount is therefore the value in use of approximately £23.5m.
Impairment loss = 27.0 − 23.5 = £3.5m. The loss is allocated first to the goodwill allocated to the CGU, so goodwill is written down from £4.0m to £0.5m and no other asset is touched. Because the loss does not exceed the goodwill, there is no need to apply the pro-rata rule across PPE and the customer relationship. Note that the £0.4m of closure-related redundancy costs should be stripped out of the value-in-use cash flows (no restructuring provision exists at the year end); doing so raises value in use by roughly £0.36m, which would reduce the impairment to about £3.1m but leaves the conclusion and the allocation unchanged.
2. Critically evaluate the inputs management used in the value-in-use calculation.
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Several inputs need challenge before the number is relied on:
- Redundancy costs. IAS 36 permits only incremental cash flows. Costs of a future restructuring are included only where the entity is demonstrably committed and a provision has been recognised. Here it is a contingent closure cost, so it should be removed – which increases value in use by about £0.36m. Excluding it is the more defensible position.
- Projection period. Five years is the maximum without strong justification. A capital-intensive coatings plant with a 25-year asset life may need a longer explicit period, supported by evidence about the order book; otherwise a short period plus a terminal value does the heavy lifting.
- Terminal growth. A −2% perpetuity is aggressive pessimism. IAS 36 caps growth at the long-term average for the markets in which the unit operates and requires a stated basis; a decline rate must be entity-specific and evidenced (product obsolescence, contractual loss), not simply extrapolated from a bad year.
- Discount rate. It must be pre-tax if the cash flows are pre-tax, reflect the current market assessment of time value and the unit's specific risks, and not double-count risks already built into the cash flows (such as the demand fall).
- Consistency. Cash flows must exclude financing, tax and general overhead allocations not directly attributable to the unit, and must be in the currency of the discount rate.
- Fair value less costs of disposal. £23.0m is a non-binding offer; costs of disposal should include the legal and redundancy costs necessarily incurred to complete, not just the stated £0.5m fee.
The choice of higher of the two amounts is correct, but because the two are close (£23.5m vs £22.5m) the impairment is highly sensitive; disclosure of the discount rate, growth rate and the period used, and of the sensitivity, is required.
3. Following the impairment, demand recovers sharply in 20X6. Explain how much, if any, of the loss can be reversed, and how the answer would change if the goodwill had been allocated across three cash-generating units.
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Reversal rules. An impairment loss recognised for goodwill can never be reversed. Reversals of losses on other assets are permitted, but only where there has been a change in the estimates used to determine the recoverable amount since the last impairment test – a genuine recovery in demand qualifies, but a mere passage of time does not.
On the facts, the entire £3.5m was absorbed by goodwill, so there is nothing to reverse: the goodwill carrying amount of £0.5m stays at £0.5m and is not written back up.
If part of the loss had fallen on PPE or the customer relationship, a reversal would be recognised immediately in profit or loss and would be capped at the carrying amount that would have existed had no impairment been recognised, net of the depreciation or amortisation that would have been charged in the meantime. For example, if £2m of the loss had hit plant with a 10-year life, the reversal would be limited to the notional cumulative depreciation catch-up.
Allocation across three CGUs. If the £4m of goodwill had been allocated as, say, £2m, £1.2m and £0.8m, the test would be performed at the level of each CGU (or group of CGUs) to which the goodwill is allocated, not at division level. Some units might be loss-making while others are not, so the loss would be recognised only where recoverable amount is below carrying amount; spreading the goodwill does not reduce the total but it changes both the amount and the timing of recognition. Reversal of the non-goodwill element could then occur in a unit whose assets were written down, still subject to the notional carrying amount cap.