Associate impairments may not reflect underlying economics

Assets measured at cost are subject to impairment testing and potential write-down if there has been a decline in value. However, unclear impairment indicators, subjective measurement and the ability to use so-called value-in-use may mean that accounting impairments do not equal the change in economic value. 

We discuss the impairment process for investments in associated companies that are subject to equity accounting. In the case of French media company Vivendi’s investment in Telecom Italia, a cumulative impairment loss of 1,974m has been recognised since 2015. However, the 2021 balance sheet value still exceeded the market value of the investment by 812m.

Assets measured in the balance sheet at cost are subject to periodic impairment testing.1Impairment testing is also necessary where cost accounting is applied in profit and loss, even though the asset is reported in the balance sheet at fair value. This applies to debt instruments classified as accounted for at fair value through other comprehensive income (FVOCI). This is to ensure that the carrying value of the asset does not exceed what can be recovered through further use of the asset or through its sale. If the cost of an asset is not considered recoverable, the asset is written down and an expense reported in profit and loss.

Under IFRS, fixed assets, including equity investments in associated companies,2An associated company investment is a holding in the equity of another company which gives the investor significant influence over the investee’s operating and financing policies. The investee is not controlled by the investor (if it were, it would be consolidated); however, it is more than simply a passive minority equity investment. While the existence of significant influence is a matter of judgement, it is assumed to exist if the shareholding is 20% or more of the voting equity. are subject to the rules that are included in IAS 36, where the write-down is to the higher of value-in-use and fair value.  However, this potential write-down only applies if there is an indicator of impairment.

Fundamental problems affect the relevance of impairments for investors

The measurement of fixed asset impairments can be very subjective, particularly when it involves the valuation of a business unit to determine whether assets included in that unit (such as goodwill and intangibles) need to be impaired. But in our view, there are also more fundamental problems that affect the relevance of impairments for investors.

In our article ‘Goodwill impairments may not identify impaired goodwill’ we discuss the challenges of impairment testing for goodwill and the problems caused by shielding. This shielding issue, and the difficulty of identifying and measuring goodwill impairments, are amongst the reasons why we prefer the immediate write-off approach to accounting for goodwill, as we explain in ‘Goodwill accounting – Investors need something different’.

In this article we focus on deficiencies in the impairment process applied to investments in associates and specifically investments in listed associates for which a market determined (level 1) fair value is available. The investment by Vivendi in Telecom Italia is an example of such a situation.

Investments in associates are subject to potential impairment because the investment is not reported at fair value. This contrasts with other minority equity investments which are simply reported at fair value in the balance sheet in accordance with IFRS 9 Financial Instruments.

Impairment testing for associates arises because equity accounting is essentially measurement at cost

Under equity accounting, investments in associates are initially recorded at cost – the purchase price. The investment is regarded as an interest in the underlying net assets3Under equity accounting a purchase price allocation exercise is conducted that is similar to the process applied in full consolidation. This does not change the cost of the investment in the balance sheet for the associate at initial recognition, but it does affect the notional split between underlying net assets and ‘goodwill’. In subsequent periods the notional purchase price allocation adjustments impact the reported net income effect under equity accounting. (shareholders’ equity), plus an amount of ‘goodwill’. However, in the balance sheet it is recorded as a single line investment at cost. In subsequent periods, the investor recognises its share of the associates’ changes in equity and increases or decreases the carrying value of the investment. The share of changes in equity comprises the share of net income (which is included in the income statement), share of other comprehensive income and share of other movements in equity, less any dividends received. In effect (albeit subject to some adjustments) the investment in the associate generally increases by the share of profit retained by the associate.

Although the balance sheet value of an associate is updated, the amount reported in the balance sheet is still fundamentally a cost measurement. The share of profit and other equity movements retained by the associate simply represents further investment (at cost) in the associate because not all profit has been distributed.

It is because the investment is essentially measured at cost that impairment testing for associates is required.

Vivendi investment in Telecom Italia

French media company Vivendi holds about 24% of Telecom Italia voting shares, which represents about 17% of the total share capital, taking into account the additional non-voting shares. Vivendi classifies this investment as an associate because it considers “that it has the power to participate in Telecom Italia’s financial and operating policy decisions” and accordingly has significant influence.  As a result, Vivendi applies the equity accounting method to the investment.

The investment in Telecom Italia was acquired for €3,898m through purchases in 2015 and 2016. In the following years Vivendi recognised their share of the profit generated by Telecom Italia that was retained in the business (plus other changes in equity). In aggregate, this increased its ‘investment’ by a further €287m, bringing the total to €4,185m. Although the fair value of this investment has subsequently declined (which has triggered the impairments we discuss below) it is still a material part of the Vivendi business and relevant to any analysis of the company.

Over the last 6 years the balance sheet amount reported for Telecom Italia has averaged about 20% of Vivendi shareholders’ equity and the (pre-impairment) contribution to profit has been in aggregate 16% of net income or 25% before deducting the equity accounting related intangible amortisation adjustment.4When an associate is acquired a ‘purchase price allocation’ exercise is conducted, similar to that applied for full consolidation. This results in part of the purchase price of the associate being attributed to intangibles that are not recognised in Telecom Italia’s own financial statements. These are amortised over their assumed useful life for the purpose of determining the earnings contribution of Telecom Italia. The result is that the share of net income recognised for the associate in the consolidated financial statements of Vivendi is less than the share of profit actually reported by Telecom Italia. In our view, the reduction in profit recognised due to this intangible amortisation adjustment does not represent an economic loss for the same reason we do not think that ‘replacement-expensed’ intangible amortisation is an economic loss for a consolidated subsidiary.

Telecom Italia contribution to Vivendi consolidated results

Vivendi financial statements 2016-21 and The Footnotes Analyst

The investment in Telecom Italia is not Vivendi’s only associate. Following its demerger of Universal Music Group, Vivendi retained a minority stake that is also an associate and equity accounted. Vivendi now has associates that make up a substantial part of its balance sheet as well as market capitalisation. This makes the accounting for investments in associates and the related impairment process even more relevant.

Recognising the share of Telecom Italia earnings is not the only effect on profit and loss of Vivendi. The investment has also been subject to two impairments in recent years. In 2018, Vivendi impaired the investment in Telecom Italia by €1,066m followed by another €728m impairment in 2021.

Telecom Italia reported in Vivendi’s balance sheet at an amount higher than fair value

It is the combination of the recognition of the share of retained earnings and other equity movements plus the impairment charges that determines the carrying value of the Telecom Italia investment in the Vivendi balance sheet. However, this carrying value has been higher than the fair value (based on the market price of Telecom Italia shares) ever since the investment was acquired.

Balance sheet value versus fair value of the Telecom Italia investment5We define fair value as the listed market price for the investment. As we explain below, it is unclear whether Vivendi takes the same view or whether it has applied other valuation techniques to determine fair value for use in its impairment testing.

*  The Telecom Italia shares were acquired in two purchase transactions in 2015 and 2016. In the ‘2015/16’ column we show the aggregate purchase price. Subsequent data shows the balance sheet and market price amounts at 31st December each year, the annual reporting date, except for 2022 which reflects the interim balance sheet at 30th June 2022.

The question we ask is whether the equity accounting method, and particularly the impairment adjustments, provide useful information for investors. Furthermore, if the fair value is below the balance sheet value, why has the investment not been written down further?

Investors may be surprised to learn that associates are not automatically written down if their value is less than the balance sheet carrying amount under equity accounting. Nor are they necessarily tested for impairment each accounting period. To understand why the investment may be measured at an amount higher than fair value we need to understand the impairment process for equity accounted associates.

Impairment of associates under IFRS

Impairment of associates under IFRS is dealt with initially by IAS 28, the standard that defines associates and explains equity accounting. If IAS 28 indicates a potential impairment is indicated, IAS 36 deals with the actual measurement of the impairment loss.

Impairment process triggered only if there is ‘objective evidence’

The impairment process involves assessing whether there has been an impairment indicator or ‘trigger’. This is described in IAS 28 as “objective evidence of impairment as a result of one or more events that occurred after the initial recognition of the net investment (a ‘loss event’) and that loss event (or events) has an impact on the estimated future cash flows from the net investment that can be reliably estimated”.  The problem is that the application of this requirement is very subjective.

The standard provides some helpful, even if fairly obvious, guidance of such impairment triggers, such as the associate being in “financial difficulties” or “significant adverse changes” to the business. However, the most relevant trigger is usually where there has been a “significant or prolonged decline in the fair value of an investment in an equity instrument below its cost”.6See IAS 28 para 41A to 41C But this requirement is difficult to apply, creates a lack of comparability and in, our view, a lack of impairments. The problem is how to interpret the phrase “significant or prolonged”.

Is a 10% decline in value below cost (or the equity accounting carrying value for associates) significant? What about 25%? And what if the decline below cost, even though not judged significant, has persisted for 6 months, is this prolonged? IFRS standards do not provide answers to these questions; it is up to individual companies to make their own judgement about what is ‘significant’ or ‘prolonged’. You can see how different practices have emerged.

‘Significant or prolonged’ also created confusion in financial instrument accounting ….

It is not just for investments in associates that the phrase ‘significant or prolonged’ has caused problems in financial reporting. Prior to the introduction of IFRS 9 Financial Instruments, the same requirements were applied to other equity investments (minority stakes that do not give significant influence) that were accounted for in the ‘available for sale’ (AFS) category.

Under the old IAS 39 accounting, these investments were measured at fair value in the balance sheet, for which no impairments were necessary. However, the accounting in profit and loss was based on cost measurement, with the difference between these two measurement approaches being shown in other comprehensive income. Impairment was therefore necessary for profit and loss and involved a recycling or reclassification adjustment between OCI and P/L.

Removing the AFS category from IFRS 9 simplified the accounting for equity investments and avoided the need for challenging and subjective impairments. However, this change has not been without its critics. The issue of recycling from OCI continues to be one of the most debated issues in financial reporting. We have previously written about this topic (we do not like recycling) in our article ‘Ignore this recycled profit’.

Accounting for equity investments is currently being discussed by the IASB as part of their ’post implementation review’ of IFRS 9. The standard setter is facing considerable pressure from some constituents (particularly from Europe and European insurers) to reintroduce recycling, and therefore reintroduce impairment testing. We think this would be detrimental for investors.

Recoverable amount

If there is deemed to be objective evidence of an impairment, the second step is to calculate the recoverable amount of the asset. If this is less than the carrying value, the asset is written down with the expense reported in profit and loss.

Recoverable amount is defined as the higher of fair value (less costs to sell) and value-in-use. In most cases, and particularly for listed investments, the ‘costs to sell’ deduction from fair value is unlikely to be material, therefore we just refer to fair value below.

  • Fair value: Fair value is a well understood concept for investors – it is the price that would be achieved for the sale of the asset. Fair value measurement takes a ‘market participant’ view of value. If an equity instrument is quoted in an active market, fair value is the quoted price (a level 1 fair value). If the investment is not quoted, companies must use other valuation techniques to estimate what the asset would sell for (a level 2 and 3 fair value). For equities, a multiple based valuation is usually regarded as a level 2 fair value, whereas a valuation based on DCF is regarded as level 3.
  • Value-in-use (VIU): Value-in-use takes an entity specific rather than market participant view of value and is usually based on a DCF approach. The cash flows in the DCF valuation are what the investor expects rather than the flows a market participant might expect. A further difference is that value-in-use is constrained such that it only reflects the value of current business activities. IAS 36 does not permit taking into account future changes in the business through restructuring or new investment. However, the discount rate is market based and should therefore be the same as in the calculation of fair value.

Value-in-use can be higher or lower than fair value. It may be higher if the investor can get more out of its investment than other potential owners or simply disagrees with the market’s assessment of cash flows. On the other hand, the constraints on the cash flow forecasts in VIU may result in a lower value. This is particularly the case where part of the fair value is what the market would pay for future growth opportunities, including real options, as these cannot be included in VIU.

Dropping value-in-use would improve the relevance of impairment testing

In our view, financial reporting would improve if value-in-use were no longer used and that all current value measurement, including that used for impairment testing, is fair value. We think that value-in-use is incomplete and lacks the added discipline of the market participant view. We believe it is all too easy for management to argue that an investment is worth more to them than the market price, simply by producing credible (as far as the auditors are concerned) entity specific cash flow forecasts.

We have previously expressed the same view about preferring fair value to VIU in our article ‘Goodwill impairments may not identify impaired goodwill’.

We also note that US GAAP does not use value-in-use as a measurement basis and all impairments (apart from debt instruments subject to credit losses) involve a write-down to fair value.

Impairment of Telecom Italia

Vivendi recognised impairment losses for its investment in Telecom Italia of €1,066m in 2018 and €728m in 2021. But how did Vivendi decide whether to impair the asset in any given period and how did it determine the amount to which the investment is written down? Clearly the reduction in the market value of the investment is a key factor in determining those impairments, but the impairments have not matched that reduction in market value.

The disclosures about the impairment test in 2020 and 2021 and the write-down in 2021 are shown below.

Vivendi’s impairment disclosure 2020 and 2021


Vivendi financial statements 2020 and 2021

Impairment trigger

In 2021 Vivendi does not disclose what triggering event determined the write-down of the investment.  We assume that the loss of value is evidenced by the significant and prolonged decline in fair value – the pre-impairment carrying value of the investment at the end of 2021 was €0.851 per share at a time when the stock price was only €0.434.

However, in 2020, when there was no impairment, the company states that “there were no triggering events that would indicate a decrease in the value of its interest”. Management considered the decrease in stock market price as “not permanent given Telecom Italia’s long-term valuation outlook”. The Telecom Italia stock price at the end of 2020 was €0.377, which was lower than a year later. We assume that the confidence management expressed in the recovery of the Telecom Italia stock price at the end of 2020 no longer existed one year later.7There is a further factor in this analysis which is that the Telecom Italia results included in the Vivendi financial statements have a 3-month lag. It is the Telecom Italia results for the year to 30th September 2021 that is included in the December 2021 Vivendi results. This is significant because Telecom Italia had a large goodwill impairment in the 4th quarter of 2021 which was therefore not included in the share of profit that formed part of the Vivendi profit and loss. The goodwill impairment loss was instead included in the Vivendi first half results in 2022.

In our view this illustrates how application of impairment triggers is subjective, which limits the usefulness of impairments for investors.

Determining recoverable amount

Vivendi refers to both fair value and value-in-use calculations being used to determine recoverable amount but does not appear to specify which is the ‘higher of’ used for the impairment.

We would expect that the fair value is simply the quoted price multiplied by the number of shares; however, reference is also made in the above notes to the application of valuation multiples and the consideration of comparable transactions to measure fair value. We find this surprising because valuation techniques are normally only used to determine a fair value if a quoted price is not available.

Fair value should be the quoted price if a security is listed in an active market

Indeed IFRS 13, which deals with how fair value should be measured, says that fair value is an estimate of the price at which an asset would be sold in a transaction “between market participants at the valuation date under current market conditions” whilst “maximising the use of relevant observable inputs and minimising the use of unobservable inputs”. We think that IFRS 13 clearly requires that if an asset is quoted in an active market (which is presumably the case for Telecom Italia) then fair value should be the quoted price.

Vivendi mentions in several of its annual reports that it either does not believe that a decline in the Telecom Italia price is permanent (see 2020 above) or that it expects a price recovery in future periods. We do not believe that simply expecting a future increase in the share price is a convincing argument why an estimate of fair value can be higher than the current price quoted in an active market.

As we explain above, value-in-use could be higher or lower than fair value. Vivendi does not provide any details on its calculation of value-in-use; it says that it uses a discounted cash flow calculation but provides no details about the inputs used (although the company does give more extensive disclosures for its impairments related to cash generating units).

If the value-in-use is the basis on which the recoverable amount has been determined, in our view, it would be unusual that it is so much higher than the quoted market price. We accept that the expected cash flows in an entity specific valuation may differ from those implicit in the share price but, unless there is some other factor present, such as a business relationship that affects cash flows, we do not understand why the value-in-use number should differ so significantly from fair value.

However, despite our questions regarding the calculation of the recoverable amount, we note that the auditors, while acknowledging the subjectivity of the figures, have signed off on the impairment.

Vivendi audit report extract

Vivendi 2021 financial statements

To be clear, we are not saying that Vivendi has failed to comply with IFRS or that it has overstated its measurement of the value-in-use for its investment in Telecom Italia. However, our analysis is restricted because of the limited disclosure about the basis for their value-in-use measurement (or even whether VIU is indeed the basis for the impairment in the first place). Nevertheless, our main concern is about the accounting rules that Vivendi is required to apply.

Our view

We do not think that the equity accounting method applied to associates and the related impairment testing, as required by IFRS, provides useful information for investors. Equity accounting itself is neither a good basis for valuation in the balance sheet, being essentially a cost measure, nor does the limited information about underlying profitability of that investment help in performance measurement.

Fair value measurement rather than equity accounting would help investors

In our view it would be better to measure associates at fair value, in the same manner as other minority equity investments. We think that fair value and changes therein (which we believe are best reported in profit and loss and not OCI, as permitted by IFRS 9) provide the most relevant performance information for investors. Fair value is also the amount we think should be included in enterprise value calculations.

The use of fair value (equal to the quoted price) for the investment in Telecom Italia, instead of the equity accounting that is required, would have produced very different results for Vivendi. For example, we estimate a gain of €244m would have been reported in 2021 rather than the impairment loss and negative earnings contribution of €741m that was actually recognised.  

Although profit would have been more volatile if fair value measurement were to be used, we think it would have been more informative and a closer depiction of the underlying economics. Vivendi presents income from Telecom Italia below operating profit as income from non-core activities, which suggests this is a financial investment and, consequently, more suited to fair value measurement.

Insights for investors

  • Remember that equity accounting measures associates (effectively) at cost less impairment. For enterprise value calculations, or when including associates as non-core assets in valuations, the balance sheet value is unlikely to be relevant.
  • Impairments of equity accounted associates may not be as timely or severe as you might expect. The impairment may be a poor reflection of the actual loss in value that has occurred.
  • The concept of ‘significant or prolonged’ decline in value, that is one of the key triggers for impairment testing under IFRS, may be applied very differently by different companies.
  • Value-in-use applies a management perspective to valuing associates. This may be significantly higher than the fair value and you may find limited information about the assumptions used.
  • Impairments are not required for other equity investments. IFRS 9 requires that these be measured at fair value with value changes either recognised in profit and loss or other comprehensive income.

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