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Under Canadian GAAP, management is required to test long-lived assets for impairment whenever circumstances indicate that their carrying amount may not be recoverable. The decline in the current economic environment, including reduced market prices for assets, may result in such a circumstance. With the decline in the economic environment, there is an increased risk of material misstatement in financial statement items involving significant judgment and estimation by management. Investors are scrutinizing the value of assets presented in a company’s financial statements more than ever, making it critical for management to consider the effect of the changing economic environment on their estimates and assumptions associated with long-lived asset valuation.
How does the current economic environment affect management’s estimates? All assumptions used in calculating a long-lived asset’s fair value should be reasonable, and reflect the changes in market conditions. Management will be required to incorporate the changing environment through means such as evaluation of the sensitivity of an asset’s value to the significant market-driven factors. For example, a junior oil and gas exploration and production company’s recovery of an asset’s value is affected by the forecasted price of oil or natural gas. As these commodity prices fluctuate, the entity must determine whether there has been a change in the forecasted commodity prices used in its calculation of expected undiscounted cash flows, and what effect this has on the future economic recoverability of their asset’s carrying value. This has the potential to result in significant impairment of an asset’s value.
What if I write-down the value of an asset and the prices increase again? Under Canadian GAAP, a write down of a company’s asset cannot be reversed despite whether the fair value of the asset subsequently recovers. However, under the upcoming IFRS standards, management will be able to reverse the impairment loss recognized to the extent of the original write down, i.e. what the carrying value would have been if the impairment had not been recognized. This gives management more flexibility in terms of being able to measure their balance sheet at the market value.
Where do we go from here? Most importantly, management must be able to support the assumptions made with regard to the valuation of the company’s long-lived assets and recognize the need to inform financial statement users of the actual economic benefit expected to arise from the use and disposal of such assets. As well, management shall clearly disclose within the financial statements and in their Management’s Discussion and Analysis that the current economic situation increases the uncertainty of management’s estimates and assumptions. This ensures that users are aware that management recognizes the increased risk and is factoring it into its financial reporting.
For more information, please contact me or your local MNP advisor.
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