Impairment Test according to IFRS: How real estate companies secure portfolio values in volatile markets
Rising interest rates and uncertain markets are forcing real estate companies to rethink the valuation of their portfolios. The impairment test according to IFRS is becoming a critical management tool rather than a routine check. Learn how to conduct the test correctly and turn risks into opportunities.
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The topic briefly and concisely
An impairment test according to IAS 36 is mandatory as soon as internal or external indicators, such as significantly increased interest rates or decreased market values, suggest an impairment.
The recoverable amount is the higher of the fair value less costs of disposal (FVLCS) and the value in use (VIU); if either is above the carrying amount, no write-down is necessary.
A careful documentation of assumptions, particularly when calculating the value in use (cash flows, discount rate), is crucial for audit and legal certainty.
When was the last time you critically examined the carrying amounts of your properties? In a market environment where interest rates have risen by over 4 percentage points since 2022, the impairment test according to IFRS (IAS 36) is more than just an accounting obligation. It is a crucial process to ensure that the value of your real estate assets is not artificially inflated. Incorrect execution can lead to massive, unexpected write-downs, reducing equity by up to 10% or more. This article guides you through the 8 key steps of the process and shows you how to strategically secure the value of your properties.
Understanding the basics of the impairment test according to IAS 36
The impairment test, regulated by IAS 36, is a test of the recoverability of assets. Its aim is to ensure that no asset, such as a property, is valued on the balance sheet higher than its recoverable amount. This amount represents the value the company can realise either through sale or continued use. For real estate companies reporting under the cost model, this test is mandatory when certain indicators are present. An accurate valuation of investment properties is the basis for any valid test.
An impairment exists if the carrying amount exceeds the recoverable amount. The difference must be recognised as an expense in the income statement, which directly affects the result. The standard applies to almost all tangible assets (IAS 16) and investment properties held as a financial investment (IAS 40) that are measured at the cost model. The failure to apply the test when indicators are present is one of the most common errors during DPR audits. Correct application protects against inaccurate financial statements and unexpected corrections.
Identify indicators that trigger a test
An impairment test is not carried out arbitrarily but is triggered by specific events. IAS 36.12 lists a number of external and internal indicators that require an assessment of recoverable amount. Companies must actively assess whether such signs are present at each reporting date. An increase in market interest rates by 2% can already be such an external trigger.
The main indicators for real estate companies include:
External triggers: A significant drop in market values for comparable properties, a sharp rise in capital market interest rates that increases discount rates for cash flow calculations by more than 15%, or negative economic developments in the region of the property.
Internal triggers: Physical damage to a property that reduces expected rental income by more than 20%, the decision to decommission or sell a property, or internal reporting that evidences a permanently poorer economic performance of the property.
Even one of these factors requires determining the recoverable amount. Carefully monitoring these triggers is the first step towards risk minimisation and a key aspect of the IFRS disclosure requirements. This analysis forms the basis for the subsequent valuation steps.
Determine the recoverable amount as a central valuation figure
If it is determined that a test is necessary, IAS 36 requires the comparison of the carrying amount with the recoverable amount. The recoverable amount is defined as the higher of two amounts: the fair value less costs to sell (FVLCS) and the value in use (VIU). Therefore, the company must perform two separate calculations.
A rational acting company would always choose the more advantageous option. If the potential sales proceeds after costs are €1.5 million, but the present value of the future rental income is €1.7 million, the value in use is the relevant recoverable amount. It is sufficient if only one of the two values is above the carrying amount to avoid a write-down. The precise Fair Value property valuation is often the more complex part here. The precise calculation of both values is crucial for financial stability.
Accurately calculate the Fair Value less costs to sell (FVLCS)
The FVLCS is the price that would be achieved in an orderly transaction between market participants for the property, less directly attributable selling costs. The determination of this value is governed by IFRS 13. For properties, this usually means relying on current market prices from comparable transactions (Market Approach). An appraisal by an independent expert is often the most reliable source here.
Selling costs only include directly attributable expenses such as brokerage fees, legal costs, or transaction taxes, which typically make up 2-5% of the sales price. Costs already incurred or general administrative costs should not be deducted. The quality of market data is the crucial factor for a reliable FVLCS assessment. Without an active market for the specific asset, the estimation becomes challenging. A data-driven assessment, like the one offered by Auctoa, can provide the necessary assurance by analyzing over 10 million data points. This leads to the next challenge: determining the utility value.
Determine the value in use as an alternative
If the FVLCS is difficult to determine or is below book value, the focus shifts to the value in use (VIU). The VIU is the present value of expected future cash flows from the continued use of the property and its eventual sale. This method reflects the internal company perspective. The calculation requires careful planning and several assumptions.
The essential steps to calculate the VIU are:
Estimate the future cash flows: This includes expected rental income and operating costs over a period usually ranging from 3 to 5 years.
Consider the residual value: The estimated disposal proceeds of the property at the end of the planning period must be included.
Determine a discount rate: A risk-appropriate pre-tax rate (WACC) should be used, reflecting the specific risks of the object.
Discount the cash flows: The future cash flows are discounted back to today's value to obtain the present value.
The discount rate is the greatest lever and can change the outcome by 15-20%. A thorough understanding of the differences between IFRS and HGB is important, as the HGB does not account for such forward-looking valuations. The complexity of these forecasts makes documentation particularly important.
Record impairment expenses and examine reversals
If the determined recoverable amount is below the carrying amount of the property, the difference must be recognised as an impairment expense. This expense is recorded directly in the income statement and reduces the period's result. The carrying amount of the property is therefore reduced to the recoverable amount. This new, lower value serves as the basis for future scheduled depreciations.
However, IFRS also require a reversal of impairment obligation. If in a subsequent period it becomes clear that the reasons for the impairment no longer exist and the recoverable amount has increased again, a write-up must be made. The reversal is, however, limited to the amount of the carrying amount that would have existed without the original impairment. A reversal beyond the original cost is not allowed under the Cost Model. The only exception to the reversal obligation concerns goodwill, where an impairment once recognised is final.
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A comprehensive documentation is essential for every impairment test and a frequent focus during external audits. Companies must provide detailed information about impairments and reversals conducted in the appendix. IAS 36.126 requires disclosure of the events that led to each significant impairment. Additionally, the amount of the recognized expense and the affected segment must be specified.
If the recoverable amount is determined based on the value in use, the assumptions are particularly critical. The discount rate used and the growth rates for the cash flow forecasts must be disclosed. A sensitivity analysis that shows how changes in these assumptions affect the impairment significantly enhances transparency. Incomplete documentation can lead to objections to the entire financial statement. With the ImmoGPT chat by Auctoa, you can quickly and easily clarify initial questions about valuation and necessary assumptions. This prepares you optimally for the final steps.
Conclusion: Use Impairment Test as a Strategic Tool
Which properties are affected by the impairment test according to IAS 36?
The test under IAS 36 is applicable to tangible assets (IAS 16) and investment properties (IAS 40), provided they are measured using the cost model. Properties measured at fair value are not subject to IAS 36, as changes in their value are already recognised in profit or loss.
What happens if I don't carry out a necessary impairment test?
Failure to conduct a necessary impairment test constitutes a violation of IFRS. This can lead to inaccurate financial statements, which may be challenged by auditors and could require correction, potentially resulting in significant adjustments to the accounts.
How do I determine the fair value of a property without an active market?
If no direct market prices are available (IFRS 13, Level 1), alternative valuation techniques must be employed. These include the analysis of transactions of similar assets in less active markets (Level 2) or DCF models (Discounted Cash Flow) based on unobservable inputs like internal cash flow forecasts (Level 3).
Do I always need to hire an external appraiser for the impairment test?
There is no explicit requirement, but it is strongly recommended, especially for significant property values. An independent appraisal greatly enhances the reliability and transparency of the valuation and strengthens your position with auditors and stakeholders.
What is a cash-generating unit (CGU) in the context of property?
A CGU is the smallest identifiable group of assets that generates largely independent cash inflows. An individual rented property can be a CGU. In certain cases, a portfolio of very similar, regionally clustered properties may also be treated as a single CGU.
How does an impairment affect my bank covenants?
A significant impairment reduces equity and can drive the equity ratio below the minimum threshold agreed in loan covenants. This may lead to a breach of contractual terms and, in the worst case, trigger the immediate repayment of loans. Therefore, proactive management is crucial.
Additional useful links
Rödl & Partner addresses the increasing pressure in conducting impairment tests under IFRS and HGB.
Smart Zebra explains the basics and pitfalls of impairment testing according to IFRS (IAS 36) and HGB.
Universität Regensburg offers a dissertation that provides deeper insights into relevant topics.
KPMG provides a brochure on the audit of real estate under IFRS and HGB.
WTS covers IAS 36 – Asset Impairment in this article.
Haufe offers a contribution on the impairment test under IAS 36.
DRSC (Deutsches Rechnungslegungs Standards Committee) provides a document on the topic of IFRS.
IFRS Foundation offers information on IAS 36 – Asset Impairment on their official site.
KPMG released this Valuation Newsletter.
FAQ
Which properties are subject to the impairment test according to IAS 36?
The test according to IAS 36 applies to property, plant, and equipment (IAS 16) and investment property (IAS 40) held at cost, provided they are measured using the cost model. Real estate measured at fair value is not subject to IAS 36, as changes in their value are already recognised in profit or loss.
What happens if I don't conduct a necessary impairment test?
The failure to perform an indexed impairment test constitutes a violation of IFRS. This can result in a flawed financial statement, which may be challenged by auditors and might need correction, potentially leading to significant accounting adjustments.
How do I determine the fair value of a property without an active market?
If no direct market prices are available (IFRS 13, Level 1), other valuation techniques must be used. These include the analysis of transactions involving similar items in less active markets (Level 2) or DCF models (Discounted Cash Flow), which are based on unobservable inputs such as internal cash flow forecasts (Level 3).
Do I always have to hire an external assessor for the impairment test?
There is no explicit obligation, but it is highly recommended, especially for significant property values. An independent assessment significantly enhances the reliability and traceability of the evaluation and strengthens your position with auditors and stakeholders.
What is a Cash Generating Unit (CGU) in the context of real estate?
A CGU (Cash-Generating Unit) is the smallest identifiable group of assets that generates largely independent cash inflows. A single rented property can be a CGU. A portfolio of very similar, regionally clustered properties could also be treated as a single CGU in certain circumstances.
How does a depreciation affect my bank covenants?
A significant impairment reduces equity and can push the equity ratio below the minimum threshold agreed in loan agreements (covenants). This may lead to a breach of contract terms and, in the worst case, trigger an immediate repayment of loans. Therefore, proactive management is crucial.
