During poor economic times, management of various companies may be under pressure to produce good results, and may use various means to justify the fair value of goodwill and indefinite life intangible assets. In these circumstances, the auditor should proceed with skepticism and caution when reviewing the impairment tests prepared by management for these elements of the financial statements.

Things to look out for
Due to the very subjective and somewhat complex nature of all things intangible, management is able to adopt different strategies in classifying an asset so as to enhance the overall profitability of the company. For example, during the purchase price allocation of a business combination, management may regard intangible assets as having an indefinite rather than a finite life, since the latter classification would require an annual charge through the statement of profit and loss that may not attract a corresponding tax deduction.

Discount Rate:
Another trick auditors should be aware of is the principles used by management in determining the discount rate. The lower the discount rate used in a discounted cash flow calculation, the higher the net present value result and, therefore, the lower the chances of impairing the goodwill. For example, where a company is faced with different levels of debt, management may suddenly prefer to use the current very low prime interest rate as the overall cost of debt to the company, resulting in a higher valuation. This is because weighting the different costs of debt, which they would have done previously, would be likely to produce a higher number. The auditor should ensure that consistency is maintained in the method of arriving at the discount rate.

Cash Flow Projections:
The cash flow projections prepared by management are perhaps the area where auditors need the most vigilance when reviewing the impairment tests. For example, management may have two different budgets, one presented to the auditor for purposes of reviewing the impairment tests and evaluating going concern, and an entirely different one may be used for internal management. This would be the case where it is difficult for management to produce a single forecast that is low enough to be achieved so as to impress their superiors, but high enough to be used in a cash flow calculation that escapes an impairment charge. Management should use a single realistic forecast for all purposes. The auditor should ensure that the cash flow calculation used for the impairment tests is the same one that has been approved by the Board or highest level of management.

Allocation of Goodwill:
IAS 36 states that goodwill should be allocated to cash generating unit(s) that represent the lowest level at which goodwill is monitored for internal management, and not larger than an operating segment. The auditor should be aware of schemes where management attempts to reallocate goodwill in a manner that lumps struggling units with those that are still profitable during a recession. To avoid such manipulation of the impairment testing process, the auditor should insist on separate discounted cash flow calculations for each cash generating unit, particularly for those that have indications of impairment.

Why take the high road
It is mandatory for an auditor to know the business of the client well enough to have an indication of whether or not the cash flow projections are too ambitious given the current macro-economic environment. This is due to the requirements of the International Standards of Auditing, in particular ISA 315, which requires an auditor to understand the entity and its environment, including the objectives, strategies and the related business risks that may result in a material misstatement of the financial statements. One way for the auditor to achieve this, is to review the management accounts of the entity after year end and to document the entity’s performance to corroborate the assumptions used in the impairment test calculations.

It is also in the best interests of management to be as accurate as possible when performing impairment tests. An inaccurate impairment test could easily be argued to constitute fraudulent financial reporting, which is currently an offence. In addition, the new Companies Act prescribes extremely high fines and a jail term of up to ten years for all persons that are party to the preparation of financial statements that are materially false or misleading.

Both the auditor and management would be short-sighted in accepting an impairment test calculation that is flawed. In ensuing financial years, if the entity fails to meet the cash flow projections, higher impairment charges will be recognised in subsequent financial statements as opposed to the systematic expensing of the impairment. Worse still, in terms of IAS 8, it may be more accurate to recognise a prior year error for the value of goodwill previously reported in the financial statements. This statement defines an error as a misstatement arising from a failure to use reliable information that was available at the time and could reasonably be expected to have been taken into account.

Small and medium enterprises
The IASB has recently issued the Statement “IFRS for Small and Medium Enterprises (SMEs)”. The statement applies to entities that have no public accountability. Such SMEs are in many instances owner managed, which reduces the incentive to skew results. However, the need to show profitable results may still exist such as where the SME requires external financing. Whereas this new statement requires the amortisation of goodwill, it should not be forgotten that it also stipulates that goodwill must be tested for impairment where there are indications that it might be impaired. The auditor and management should be careful to look out for such indications of impairment, particularly in these difficult times.

When businesses are doing well, the performance of an impairment test usually takes the form of a routine exercise, which concludes that goodwill and indefinite life intangible assets should remain at their current balance sheet levels. During a global economic slow-down however, this process needs to be looked at with greater scrutiny by both auditors and management using the guidance provided in the auditing and accounting standards. These standards were prepared after extensive deliberation and will therefore be useful in producing reliable financial statements that reflect a fair and reasonable value of all intangible assets.

KC Rottok CA(SA), MCSD, is the Manager: Technical & Advisory, RSM Betty & Dickson.