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Impairment of Assets � Exposure Draft 23

Comments from ACCA
January 2004

Executive Summary

The Association of Chartered Certified Accountants (ACCA) is pleased to have this opportunity to provide comments to the IFAC Public Sector Committee on its Exposure Draft on Impairment of Assets (the Exposure Draft). These comments have been developed with our Public Sector Technical Issues Committee, a group of experienced accountants who work in the public sector. We have also consulted a range of our public sector members across the globe.

We recognise that the transfer of concepts, definitions and approaches developed for financial reporting in the private sector is difficult to apply in the public sector setting. This is especially problematic where assets are not expected to be a source of revenue for the entity which controls them and may indeed be associated with obligations for the assets to be maintained. As a result, controlling a public sector asset may result in a financial outflow of resources from the entity; a marked contrast to the position in the private sector.

Some public sector entities have the objective of making a commercial rate of return on their assets, while other entities do not. We believe that this distinction can usually only be made at the level of the entity rather than, as the Exposure Draft does, at the level of the particular assets which are controlled.

For most public sector entities which hold assets to fulfil their obligation to provide a public service, it is the expected extent of this service potential which should indicate whether or not an impairment has taken place. Similarly, it is the level of service expected to be provided and the estimated length of the useful life of an asset (or its available alternative) which will be central to the calculation of the degree of impairment.

The authors of the Exposure Draft do not appear to have considered the implications of changes to the assets� useful life if they are to be replaced or restored. The Exposure Draft does not consider the need for planned maintenance which has not actually been undertaken, to be recognised as an expense in the statement of financial performance. We believe that this would provide valuable information on the quality of the entity�s management of its assets for users of general purpose financial reports.

Detailed Comments

INTRODUCTION

1. The main problems we have with this Exposure Draft arise from the attempt to apply in the public sector concepts, definitions and approaches developed for the private sector. Unfortunately, we believe that the transfer of these concepts to the very different financial environment of the public sector may not in reality be practical. As a minimum, this transfer requires more thought and clarification than is provided in the Exposure Draft.
   
   

   THE DEFINITION OF AN ASSET

2. The Exposure Draft builds on the definition of assets which the IFAC Public Sector Committee has previously developed. This extends the definition of an asset used by the International Accounting Standards Board (IASB), so that in addition to assets being resources "from which future economic benefits are expected to flow to the entity", the alternative of "service potential" which is "expected to flow to the entity" is added.
   
   
3. This extension of the definition of an asset appears to have at least two problems. Estimating the service potential which may flow to the entity is far less objective than estimating the future economic benefits which may flow to it. In addition, it is not clear that the future service potential will actually flow to the entity. The direct beneficiaries will be those who are in receipt of the services provided by the entity. The entity will only benefit indirectly through the achievement of its objectives. This is recognised at paragraph 16 of the Exposure Draft.
   
   
4. The financial implications of controlling assets in the public sector may, however, be conceived to be the opposite of the implications of controlling assets by a private sector entity or other entities, whose main objective is to generate a commercial rate of return. In the private sector the control of an asset brings with it the expectation of a future income stream from the asset. This is what is meant by "future economic benefits". In contrast, in the public sector, the control of an asset may often bring with it the obligation to undertake future expenditure without the practical possibility that the asset can be sold. For example, we may take the case of a hospital building in a country where there is a strong tradition of health services being provided free at the point of use. The control of this asset will lead to the obligation to maintain the building without the realistic option of being able to sell it. Thus, for the entity which controls this asset, the asset represents a future expenditure stream, in cash flow terms at least; the opposite of "future economic benefits".
   
   
   RECOVERABLE SERVICE AMOUNT
   
   
5. The phrase "recoverable service amount" should be replaced throughout the Exposure Draft with the phrase "service potential". The current phrase is suggestive of economic resources or cash that the entity may gain as a result of its control of the asset.
   
   

   
   

   THE OBJECTIVE OF AN ASSET
   

6. The Exposure Draft states that if assets are held with the objective of generating a commercial rate of return then the methods outlined in International Accounting Standard (IAS) 36 should be used for determining any impairment. The methods outlined in the Exposure Draft should be used for other assets. ACCA, however, considers this distinction may not always be amenable to a clear objective decision. Thus, we consider that the distinction between Government Business Enterprises (GBEs) and other public sector entities is to be preferred.
   
   
7. We believe that there is a clear and objective distinction between GBEs and other public sector organisations which has a significant effect on the purposes of their financial statements. For GBEs the key objective of their financial statements is to report the surplus (or deficit) for the period. In contrast, the objective of the financial statements of other public sector organisations is to report the cost of the service which has been provided. In the latter case the allocation of the historic cost of the asset should take precedence for the valuation of an asset. The market value will usually not be relevant, as selling the asset will not be considered as a significant option. In addition, value in use for such an asset is difficult to estimate with any degree of precision or confidence.
   
   
8. We believe that there are significant problems if the accounting treatment of an asset is determined on the basis of the objective for which the particular asset is held rather than the objective of the reporting entity. In general, in the public sector, assets are held to provide a service rather than to generate cash flows or a commercial rate of return.
   
   
9. The definition of a cash-generating asset is one held "to generate a commercial rate of return". In paragraph C13 this definition is relaxed for licences and other intangible assets, with the suggestion that these "often arise in a cash-generating context". We believe that the distinction can usually be made more easily between those entities whose objectives include that of making a commercial rate of return on their assets and those which do not. This would ensure that a clear distinction was made between assets used "to generate a commercial rate of return" and those which do not, but may give rise to cash income. An exception to this would apply, however, if an entity had a unit or section with control of clearly defined assets, if this unit or section had an objective of making a commercial rate of return.
   
   
   THE NATURE OF CASH FLOWS
   
   
10. In many cases any cash flow may be more in the nature of taxation, rather than a charge for a service. Changes in the level of future cash flows can be made on the basis of policy rather than demand for the service. Thus for example, in the UK, television licenses and charges for medicines prescribed by a doctor are more in the nature of a tax rather than a charge for the service and are set on the basis of Government policy.
    
    
11. We also consider that there is a complete spectrum of practice between assets with no associated cash flow, which are provided at cost, and those assets with an estimated future cash flow, which will more than cover their historic cost and any associated maintenance and staff costs. The point at which an asset may be considered to be held with the objective of generating net cash flows will usually be hard to define and may be largely arbitrary.
    
    
12. In addition, some assets will have multiple uses, with separate future cash flows associated with each use. Some of these uses may be cash generating, others may have little or no expected future cash flows associated with them. With these assets allocating costs between the uses may be difficult and will increase the subjectivity of the accounts (and the potential for manipulation).

    
    DEFINITION OF A GOVERNMENT BUSINESS ENTERPRISE

13. The definition of a GBE should depend on the objective of the entity rather than the financial outcome of its activities. Thus section (d) of the definition (paragraph 13 of the Exposure Draft) should be deleted and a new characteristic (a) should be added as follows:
    
    "(a) the objective of the entity includes that of generating a commercial rate of return on its assets".
    
    
    

    IDENTIFYING AN ASSET WHICH MAY BE IMPAIRED
    

14. The black letter writing in paragraphs 19 and 20 is not particularly clear or easy to understand. We believe that a public sector asset will be impaired if its service potential over the course of its expected useful life is significantly reduced. This may occur due to:
    
    
    
    • a significant reduction in the expected level of service which the asset is utilised to provide (arising from social, political, policy, technological, environmental or regulatory changes)
      
      
    • a significant reduction in the useful life of the asset which results in an associated reduction in the total level of service which the asset is utilised to provide over its expected useful life
      
      
    • physical damage to the asset which results in a significant reduction in its ability to contribute to the provision of the service for which it is being utilised
      
      and/or
      
      
    • changes in technology which mean that the service potential of the asset can be provided significantly more economically by other more advanced assets.
      
      
15. In the public sector, services are not necessarily produced as a result of public demand or, indeed, need (paragraph 20(a)). The level of service provided by an entity to which the asset contributes is determined largely by political decisions, whose impact is often transmitted by the level of budgetary support provided to the entity. An asset may be considered to be impaired if the level of service provided by the entity is significantly reduced as well as if the service is ceased.
    
    
16. Paragraphs 20(b), 20(d) and 22 of the Exposure Draft should make clear that the "adverse effect on the entity" is one that will result in a significant long-term reduction in the level of service provided by the entity. The result of this will be an impairment to the assets which the entity uses to provide this service. There may be other changes which have an "adverse effect on the entity" and its financial circumstances which do not, however, have a detrimental effect on the level of service provided by the entity through using the asset.
    
    
17. The suggestion in paragraph 21(a) that a significant decline in the market value of an asset may be an indicator of impairment is not consistent with the view at the end of paragraph 30 that the selling price of a public sector asset is not a good estimate of its value in use.
    
    
18. The Exposure Draft should provide an example of the timescales which are indicated by the terms "long-term" (paragraph 22) and "near future" (paragraph 23). Presumably "long-term" in this context means over the expected life of an asset. We are not sure that the condition "in the near future" adds anything to the meaning of paragraph 23. The question should rather be whether the construction should be resumed, not whether this is expected to be "in the near future" or at a later date.
    
    
19. One indicator of impairment could be that alternative assets are now available which are significantly less expensive, but are able to contribute to the same quality of service. The first example in Appendix B suggests that this would be appropriate with a computer that costs a tenth of the original assets, but in this case this is linked to a reduced demand for the computer. The Exposure Draft does not explain whether a significant decline in the replacement cost of an asset (which is particularly common with computer technology) would by itself be considered an indicator of impairment.
    

    ESTIMATING THE IMPAIRMENT OF AN ASSET
    

20. In the private sector, the estimation of the impairment of an asset is relatively straightforward. It clearly depends on an adjustment to the estimate of the value of the future cash flow which will flow to the enterprise as a result of its control of the asset.
    
    
21. In the public sector, any impairment loss is much more difficult to quantify in financial terms. The decline in the utility of an asset to the entity has to be based on the future services the provision to which the assets will contribute. As a result, the Exposure Draft has to use an estimate of the current cost of the service potential of the asset as a proxy for its value in use or, as the Exposure Draft puts it "the present value of the asset�s remaining service potential" (paragraph 36). Unlike in the private sector, the market value of the asset cannot be used as an estimate of its value in use as this "is likely to be greater than its net selling price" (paragraph 30).
    
    
22. The Exposure Draft defines the value in use of a non-cash-generating asset as "the present value of the asset�s remaining service potential" (paragraph 13). Three methods of estimating this value are provided in the Exposure Draft, which all relate to the current cost of obtaining the asset (paragraphs 37-41). The problem is that if the selling price of an asset is not likely to be a reasonable estimate of its value in use then there is equally no reason why the cost price of an asset should provide a more accurate estimate of its value to the entity.
    
    
    

    DEPRECIATED REPLACEMENT COST
    

23. The methodology for calculating the depreciated replacement cost of an asset (paragraphs 38-39 and Appendix B examples 1-3) appears to ignore the fact that the existing useful life of an asset may not be the same as the life of its replacement. This difference in asset lives may be taken into account by a two-stage process described below.
    
    
24. The annual value of the service potential of an asset may be estimated by dividing an estimate of its replacement cost by an estimate of the useful life of the replaced asset (although note the problem of equating the value in use of an asset with its cost in paragraph 22).
    
    
25. An estimate of the value in use of the original asset can then be calculated by multiplying this annual value of the service potential of the asset by the expected remaining life of the original asset.
    
    
26. In example 4, on the restoration cost approach, the Exposure Draft includes the assumption that the "restoration will not affect the useful life of the asset". This assumption is not re-stated in the explanation for example 5. No allowance is however, made for any effect the restoration may have on the useful life of the asset within the calculation of impairment in this example. In addition, in example 5, the assumption is made that "all the restoration costs are capitalizable". The reason for this assumption and its implications are not explained in the Exposure Draft.
    
    
27. The problem of the replacement or restoration of an asset changing its useful life is not taken into consideration in either of the two examples of the service units approach provided in the Exposure Draft.
    
    
    

    RECOGNITION OF AN IMPAIRMENT LOSS
    

28. The Exposure Draft indicates that an impairment loss (or its reversal � paragraph 62) "should be recognised as an expense in the statement of financial performance immediately" (paragraph 47). No explanation is provided, however, for the adoption of this approach. Depending on the circumstances, it may be more appropriate to take this adjustment direct to the balance sheet.
    
    
    REDUCTION IN SERVICE POTENTIAL
    
    
29. Appendix A to the Exposure Draft provides examples of reduction in use of an asset due to a fall in demand (example (e)) and increased maintenance costs (example (h)). There may also be circumstances where the service potential of an asset is reduced and these two circumstances do not apply, for example, where the estimate of the useful life of the asset or the level of service it is capable of providing is less than the original expectations.
    
    
    

    PROVISIONS FOR PLANNED MAINTENANCE NOT UNDERTAKEN
    

30. The importance attached to maintaining public sector capital assets has increased in recent years, at least in the UK. This is because there was a failure to maintain adequately the public sector infrastructure. This has resulted in a significant backlog of maintenance expenditure. There are also current or developing problems with funding the necessary investment in the infrastructure for rail travel, water services and waste disposal. This backlog maintenance was not identified despite the use of private sector-style accrual based financial reporting in local government and the health service.
    
    
31. This suggests that governments need to be clearly held to account for this aspect of the management of public services, and that public sector financial statements should clearly show the value of any work not undertaken, or which has been postponed, which may be considered necessary to maintain adequately the asset base of the organisation. Thus provisions should be included in the accounts for any maintenance which has not been undertaken as planned (certainly in the case of impaired assets in need of repair or maintenance). These provisions should be charged as an expense in the statement of financial performance of the entity concerned.
    
    
    

    EXCLUSION OF SOME ASSETS MEASURED AT FAIR VALUE
    

32. The exclusion of non-cash-generating property, plant and equipment measured at fair value from the scope of the proposed standard would result in the majority of UK public sector assets being excluded from its scope.  The statement made in paragraph 7 of the Exposure Draft that the regularity of valuation compensates for the lack of an applicable impairment standard could be equally made in respect of cash-generating assets held at fair value, yet both IAS 36 (and Financial Reporting Standard (FRS) 11 in the UK) require all fixed assets to be tested for impairment, irrespective of how they are valued. Clearly, therefore, the IASB and the UK Accounting Standards Board (ASB) do not view the revaluation process as negating the need for impairment testing.  Although the valuation process may ensure that the carrying value does not exceed the recoverable amount of the asset, it will not be possible to distinguish between impairments due to consumption of economic benefits and impairments due to changing prices. This will decide whether the impairment will be recognised in the income statement or the balance sheet.
    

    Answers to �Questions for Respondents�

    (a) The proposal to include in the scope of the proposed Standard, agricultural assets, goodwill and all other identifiable intangible assets not explicitly excluded in paragraph 1 of the Exposure Draft.

33. ACCA has reservations about the extension of the scope of the Exposure Draft to identifiable intangible assets. We believe that the treatment of such assets (for example the right to tax and natural resources) requires further consideration and will depend in part on the outcome of the IFAC Public Sector Committee�s project to develop International Public Sector Accounting Standard(IPSAS) on non-exchange revenue.

    (b) The proposal to define cash-generating assets as assets held by:

    (i) Government Business Enterprises (GBEs); and
    (ii) public sector entities other than GBEs to generate a commercial rate of return (paragraph 13).

34. ACCA considers that whether or not assets are considered to be cash generating should be determined by the objectives of the entity which controls them. The Exposure Draft considers that all assets controlled by a GBE are cash generating, even if the entity concerned does not have as its prime objective the generation of a commercial rate of return. In addition, the nature of other public sector assets is to be determined by the objective of holding the asset rather than by the objective of the asset. We have commented further on this aspect in paragraphs 6 � 9 above.
    

    (c) The proposal to assess at each reporting date whether there is an indicator that an asset may be impaired. Paragraph 20 identifies a minimum set of indicators, but the list is not exhaustive.

35. The proposal to require entities to assess whether any of their assets have been impaired should be restricted to significant assets whose impairment is likely to have a material effect on the overall financial performance of the entity or at least a segment, the financial results of which are separately reported. This should ensure that this proposal is cost effective.
    

    (d)The proposal to estimate an asset�s recoverable service amount when an indicator of impairment is present at the reporting date (paragraph 19).

36. Subject to the above comment, we consider that this proposal is reasonable. We do have a number of criticisms of the methods described in the Exposure Draft to undertake this task; these are included in the main body of our response.
    

    (e)The proposal to exclude the decline in market value from the list of minimum indicators set out in black letter in paragraph 20, but to indicate in commentary that it may be an indicator (paragraph 21).

37. We agree with this proposal and support the view that market values are usually a poor indicator of the value in use of a public sector asset.
    

    (f) Whether the Standard should include:

    
    (i) a reduction (other than cessation) in demand or need for services provided by the asset as an indicator of impairment in the minimum set of indicators identified by paragraph 20; and
    
    (ii) an increase in demand or in need for services provided by the asset from a previously reduced (but positive) level as an indicator of the reversal of impairment loss in the minimum set of indicators identified by paragraph 53.

38. We consider that a significant reduction in the level of use of an asset (for whatever reason) over the expected useful life of the asset should be included as an indicator of impairment of an asset (and similarly for a significant increase in use of an asset).
    

    (g) The proposal to measure the value in use of a non-cash-generating asset using the depreciated replacement cost, restoration cost or service units approaches as appropriate (paragraph 36).

39. We have commented in the main body of our response on our criticisms of the methods outlined in the Exposure Draft to calculate the value in use of an asset.
    

    (h) Whether the three approaches to determination of value in use set out in paragraphs 37 to 41 are separate approaches as in the Exposure Draft, or whether the depreciated replacement cost approach is a broader approach that encompasses the other two approaches.

40. We do not consider that the implications of these alternative views are significant.

     

    (i) The proposal to recognise an impairment loss and reduce the carrying amount of the asset to its recoverable service amount, when the asset�s recoverable service amount is less than its carrying amount (paragraphs 45 and 47).

41. We believe that the cause of the impairment should affect the way that an impairment loss is recognised. Thus it will not always be appropriate to recognise the whole of the loss in the statement of financial performance for the current period. See also paragraph 28 above in our main response.
    

    (j) The proposal to assess at each reporting date whether there is an indicator that an impairment loss recognised for an asset in prior years may no longer exist or may have decreased. Paragraph 53 identifies a minimum set of indicators, but the list is not exhaustive.

42. Our concerns over this paragraph correspond to those we have for paragraph 20 of the Exposure Draft, which are outlined in our response to question (c) above and in paragraph 14 of the main body of our response.

    (k) The proposal to estimate an asset�s recoverable service amount when annual assessments indicate that a previous loss no longer exists or has decreased (paragraph 52).

43. Our concerns over this paragraph correspond to those we have for paragraph 19 of the Exposure Draft, which are outlined in paragraph 14 of the main body of our response.
    

    (l) The proposal to recognise a reversal of an impairment loss if, and only if, there has been a change in estimates used to determine the asset�s recoverable service amount since the last impairment loss was recognised, and increase the asset�s carrying amount to its recoverable service amount subject to the ceiling set in paragraph 61 (paragraphs 58, 61 and 62).

44. We agree with this proposal.
    

    (m) The proposal to make disclosures as set out in paragraphs 65 and 68�70.

45. Subject to our previous comments, we agree with the disclosure proposals included in the Exposure Draft.

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