Impairment of Assets at Newcrest Mining Ltd (NCM)

When should companies undertake an impairment test?

In order to determine whether its assets are impaired or not, a company should carry out an impairment test. This test ensures that the impairment of assets of the company is carried out at no more than their recoverable amount. Impairment test is carried out at the end of every financial reporting period, e.g. annually, quarterly, or semi-annually. Companies test all assets including goodwill and intangible assets at the end of every reporting period to determine whether the assets show any indication of impairment (Ernst and Young, 2013). Circumstances may change in relation to assets between the time of impairment test and the next financial reporting period; hence impairment test may be carried out more than once in a financial year.

An impairment test needs to be undertaken under three circumstances. First, assets are tested for impairment when there is an indication that the asset may be impaired. At the end of every accounting period, companies are required to consider whether there is any indicator of impairment on their assets. Secondly, the time in which companies should test for impairment is annually if the asset is an intangible asset that is not already available for use or has an indefinite useful life. Companies should also test these intangible assets for impairment when there is a sign of potential impairment. Lastly, an impairment test may be carried out annually when goodwill acquired in the past has been allocated to a Cash Generating Unit. The exception of this requirement is when the company fails to allocate the goodwill completely to the Cash Generating Unit (CGU) for the purpose of impairment test before the current financial period ends (IFRS, 2014). IAS 36 does not allow companies to allocate goodwill provisionally and carry out an impairment test based on this provisional allocation. However, companies should ascertain that they are not really able to allocate the goodwill completely when there is an indication of impairment. Therefore, it is clear that it may be prudent and right to carry out a reasonable allocation of the goodwill and test it for impairment.

IAS 36 provides that if an impairment test should be carried out on intangible assets and goodwill annually, it may be done at any time during the financial year (IFRS, 2012). However, it should be done at the same time each year. In this case, different Cash Generating Units or groups of Cash Generating Units may be tested for impairment at different times of the year. If an indicator of impairment arises after an annual impairment test, goodwill may be tested for impairment again in an interim period.

Cause of impairment in NCM

Causes of impairment can either be operational or financial, or at times both types of impairment may occur on one asset or groups of assets. Operational causes of asset impairment are those causes related to the operational activities of the company including poor management of activities, technological innovations, production activities, distribution activities, customer service operations and other operations that are aimed at improving the value of products in the company. On the other hand, financial causes of asset impairment include all financial activities such as capital expenditure, financing through long term and short term debt, financing through equity, purchase of assets, and other activities related to finances.

The cause of asset impairment in Newcrest Mining Ltd (NCM) was both financial and operational. Maiden (2014) suggests that the impairment that was recently announced by the company was probably caused by the Lihir goldmine in Papua New Guinea which was acquired by the company in 2010. Following the acquisition, shares of the company were trading at $40. The takeover value was $10.5 billion. The book value was cut to $7.6 billion indicating a write-down of $3 billion on the Lihir acquisition. Since the acquisition is involved a financial investment, the cause of the $3 billion impairment is therefore considered to be financial. The amount of money invested in the assets of the takeover was higher than their book value because the takeover was overvalued. This impairment is therefore financial in nature.

The same cause of writedown in 2013 is the main cause of writedown this year as the company expects to writedown an impairment of $2.5 billion; Lihir being the centre of the impairment. Original financial allocation for Lihir has caused the impairment down to 2014. Discounting of cash flows is also another financial cause of impairment of assets. Ernst and Young (2013) suggests that metal and commodity prices should match the life profile of the mine. Companies should consider time value of money and inflation when determining the value of an asset. However, NCM acquired Lihir in 2010 basing its decision on the high profits, market value and share price of the company at that time. This is a financial management blunder which led to the impairment of the company’s assets. The high debt ratio of Newcrest rising up to 30% also shows a weakness in financial management, which resulted in the impairment of assets (Ker, 2014).

In terms of operational causes of asset impairment, NCM experienced operational costs which led to the impairment of its assets, especially in Lihir. Maiden (2014) says that Lihir is a multimillion investment of Newcrest with a lot of costs. In June quarter Lihir produced 174,601 ounces of gold using a total cost of $1,225 per ounce yet an ounce of gold fetched only $72.51. This is reflected in the overall world cost of mining costs. Ernst and Young (2013) claims that there has been an inflation of mining costs in the world as mining become more challenging. There has also been an increasing demand of services from contractors, mining equipments, and workforce. This has also caused cost inflation which leads to impairment of assets because the value of assets will be low in terms of the output it produces.

What effect will the impairment have on the cash flows, balance sheet and financial performance of a company? Why is it NCM Ltd.’s preference to have a debt ratio of 15%? Explain.

The impairment will affect the cash flow, balance sheet and financial performance of the company. Impairment reduces the cash flows of the company. Ker (2014) suggests that Newcrest barely achieved a cash flow of $100 million. A good cash flow enables the company to meet its operational costs and manage its assets efficiently and effectively. Since asset impairment represents a decrease in the income generated from the asset, the company’s balance sheet and income statement will show diminished cash flows (Lister, 2014). In the long run, the company’s statements will run out of cash and the company may not be able to meet its financial obligations.

An impairment loss is recorded as an expense in the company’s accounting records. This will lead to a decrease in net profit of the company. In the balance sheet, the carrying amount of the assets will be recorded after deducting the accumulated depreciation and impairment (Ernst and Young, 2011). This means that the balance sheet value of the assets will be low. This means that the financial performances of the company will be poor – given the weak balance sheet and the decrease in net profit of the company.

NCM prefers to have a debt ratio of 15%, a reduction from the current 30% because a higher debt ratio means that the company operates with more debt than equity (Ker, 2014). Therefore, it will not be able to meet its financial obligations. 15% debt ratio means that the company finances its assets with long term and short term debt, and 85% with equity. On the other hand, 30% means that the company finances its assets with 30% of debt and 70% of equity. Therefore, 15% of debt ratio is more preferable because it requires less debt to finance assets which are already decreasing in value due to impairment.

How does the impairment of assets affect the strategic decision making of NCM Ltd?

Impairment of assets has critical consequences on the strategic decision making of NCM, especially because IFRS requires companies to disclose their impairment of assets based on IAS 36. Failure to disclose its impairment of assets in 2013 led NCM to be charged a fine of $1.2 billion (Maiden, 2014). The reason why a company may choose not to disclose its asset impairment value is because impairment of assets has great negative impact on its strategic decision. Investors wouldn’t want to invest in a company with low valued assets or rather impaired assets because this would mean that they are investing in a poorly performing company in terms of asset utilization which is the key aspect in any investment. The company has to utilize its assets well as a fundamental requirement for it to make sound strategic decisions.

If the company had a strategy of expansion or globalisation, it may be affected by the impairment. So it may be forced to focus on cost minimization strategy to utilize its decreasing cash flows. Strategic decisions also require financing in order to be implemented successfully. Due to impairment of assets, cash flows and profits of the company will decrease; hence the company will lack funds to implement its decision making. Since decision making of an organisation involves the time value of money and discounted cash flows, an impairment of an asset will affect decision making negatively because it reduces the discounted cash flows of assets in the future. Instead of focusing on strategic decisions to improve its performance, the company will start focusing on how to utilize its assets to minimize costs and increase the value of its assets.

NCM Ltd is under pressure from investors and other stakeholders to conduct a capital raising in order to increase the cash flow used to finance the company’s activities in order to improve the value of its assets.

Is the impairment material? How do you know? Discuss any additional disclosure requirements NCM Ltd should make with respect to the impairment of assets.

The impairment is material because the carrying amounts of the assets are less than the fair market values of the assets and the assets are not able to recover the undiscounted cash flows of the company (Lister, 2014). In the recognition of impairment of assets based on the AASB 136, the carrying amount and the impairment loss are the main elements that will be recognised by the company. The carrying amount will be recorded in the accounting records as the higher of the asset’s fair value less costs of sell (IFRS, 2012). The impairment loss is recognised if it is improbable that the future economic benefits of the assets will be greater than 50%. This is the case with NCM.

The materiality of the asset impairment is indicated by the disclosures of the company in its June quarter. The company warned that it would write down up to $2.5 billion which is the impairment loss of the company. This disclosure is in line with the requirements of AASB which suggests that if an asset’s recoverable amount is less than its carrying amount, it needs to be reduced to its recoverable amount. This reduction which represents an impairment loss should be recognized in profit or loss of the company. Although the calculations on the book value are not complete, the company’s review indicates that the impairment of the carrying value is something between $1.5 billion and $2.5 billion after tax. This is material because it is an official announcement of the company based on the review on the book value of its assets.

Another disclosure that the company needs to consider is the reason why the recoverable amount is more or less than the market capitalization. The company should disclose the possible reasons why the impairment occurred including the cost inflation, exchange rates, etc. Pre-tax rate is also another disclosure requirement (IFRS, 2012). IAS 36 and AASB 101 require that the pre-tax rate should be disclosed by companies because the rate may vary due to assumptions about taxation. The discount rate for impairment should also be explicitly disclosed.

 

References list

Ernst and Young. (2011). IAS 36 Impairment testing: practical issues. Ernst and Young.

Ernst and Young (2013). Expensive Acquisitions? Cost Overruns? Implications for Impairment Testing. Ernst and Young.

IFRS (2012). IAS 36 Impairment of Assets. IFRS.

Ker, P. (2014). Newcrest Warns of $2.5b in write-downs. Accessed July 31, 2014 from             http://www.smh.com.au/business/markets/newcrest-warns-of-25b-in-writedowns-20140724-zw8x4.html.

Ker, P. (2014). Newcrest CEO facing tough questions in his first big outing. Sydney Morning       Herald, Accessed July 31, 2014 from http://www.smh.com.au/business/newcrest-ceo-facing-tough-questions-in-his-first-big-outing-20140723-3cfwa.html.

Lister, J. (2014). Impairment of an Asset in Cash Flow. The Sydney Moring Herald, Accessed July 31, 2014 from http://smallbusiness.chron.com/impairment-asset-cash-flow-37386.html.

Maiden, M. (2014). All that glitters is not gold at Newcrest’s Lihir. The Sydney Morning Herald, Accessed July 31, 2014 from http://www.smh.com.au/business/all-that-glitters-is-not-gold-at-newcrests-lihir-20140724-zw97y.html.

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