What Is Cash Generating Units?
A cash generating unit (CGU) is defined in international-financial-reporting-standards (IFRS) as the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. This concept is fundamental in financial accounting, particularly for impairment-testing non-financial assets under IFRS, such as property, plant, equipment, and intangible-assets, including goodwill. The purpose of identifying a cash generating unit is to determine if its carrying-amount exceeds its recoverable-amount, which would necessitate an impairment loss.
History and Origin
The concept of cash generating units gained prominence with the introduction of International Accounting Standard (IAS) 36, "Impairment of Assets," by the International Accounting Standards Committee (IASC) in June 1998. The International Accounting Standards Board (IASB) adopted and revised IAS 36 in March 2004, consolidating requirements for assessing asset recoverability.23 Before IAS 36, various standards addressed impairment individually, but the introduction of a cohesive standard mandated the use of CGUs when individual assets could not be assessed for impairment due to a lack of independent cash flows.22 This standard ensures that an asset is not carried in the financial-statements at a value higher than what can be recovered through its use or sale.
Key Takeaways
- A cash generating unit (CGU) is the smallest group of assets whose cash inflows are largely independent of other assets.
- CGUs are primarily used in impairment-testing under International Financial Reporting Standards (IFRS).
- The recoverable amount of a CGU is determined by comparing its fair value less costs of disposal and its value-in-use.
- If a CGU's carrying amount exceeds its recoverable amount, an impairment loss is recognized.
- Goodwill is always tested for impairment at the CGU level or a group of CGUs, as it does not generate independent cash flows.21
Formula and Calculation
The core calculation involving a cash generating unit is the determination of its recoverable amount for impairment testing purposes. The recoverable amount of an asset or a cash generating unit is the higher of its fair value less costs of disposal and its value in use.20
An impairment loss is recognized if:
Carrying Amount > Recoverable Amount
Where:
- Carrying Amount ((CA)): The amount at which an asset (or CGU) is recognized in the balance sheet after deducting accumulated depreciation and amortization, and accumulated impairment losses.19
- Recoverable Amount ((RA)): The higher of:
- Fair Value less Costs of Disposal ((FVLCS)): The price that would be received to sell an asset in an orderly transaction, minus the costs of disposal.18
- Value in Use ((VIU)): The present value of the estimated future cash-flow expected to be derived from the continuing use of an asset (or CGU) and from its disposal at the end of its useful life.17 This typically involves discounting future cash flows using an appropriate discount-rate.
Thus, the condition for impairment can be expressed as:
For determining value in use, future cash flows are estimated over a period (typically three to five years) and then discounted to their present value.16
Interpreting the Cash Generating Unit
The identification and interpretation of a cash generating unit are crucial steps in financial reporting, particularly under IFRS, to ensure that assets are not overstated on the balance sheet. Companies must exercise significant judgement when defining CGUs, as incorrect identification can mask impairments or lead to misrepresentations of financial health.15 A CGU is often identified at the lowest level within an entity where cash inflows are largely independent.14 For instance, if a large conglomerate has several distinct product lines, each product line might be considered a separate cash generating unit if its operations generate cash flows largely independent of the others. The Financial Reporting Council (FRC) frequently emphasizes the importance of providing relevant information about significant judgments and key assumptions used in estimating the recoverable amount of assets and cash generating units.13
Hypothetical Example
Consider "Alpha Manufacturing Co.," a diversified industrial company. One of its divisions, "Widgets Inc.," produces specialized widgets for the automotive industry. This division includes its own manufacturing plant, machinery, sales team, and management structure. The cash inflows generated by the sale of these widgets are largely independent of Alpha Manufacturing's other divisions, such as its "Gears Division."
In an annual impairment-testing cycle, Alpha Manufacturing identifies Widgets Inc. as a separate cash generating unit. The carrying-amount of Widgets Inc.'s assets (including property, plant, equipment, and any goodwill allocated to it) is determined to be $50 million. Alpha's finance team then calculates the recoverable amount for Widgets Inc. They estimate its fair value less costs of disposal at $48 million and its value in use (based on discounted future cash-flow projections) at $45 million.
Since the recoverable amount is the higher of the two, it is $48 million. Comparing this to the carrying amount:
As the carrying amount ($50 million) exceeds the recoverable amount ($48 million), an impairment loss of $2 million ($50 million - $48 million) would be recognized for the Widgets Inc. cash generating unit. This loss would reduce the carrying amount of the CGU's assets on Alpha Manufacturing's balance-sheet.
Practical Applications
Cash generating units are primarily applied in financial-reporting under IFRS, especially for companies conducting impairment-testing. Companies like Thomson Reuters, which apply IFRS, routinely perform impairment tests for their cash generating units to which goodwill and intangible-assets are allocated.12 This ensures that the recorded values of these assets do not exceed their future economic benefits.11
CGUs are also crucial when a company undergoes significant corporate changes, such as business-combinations or divestitures. In such scenarios, goodwill arising from an acquisition is allocated to the cash generating units expected to benefit from the synergies of the combination.10 Regulatory bodies, such as the Financial Reporting Council (FRC), regularly review companies' disclosures related to IAS 36 to ensure proper application and transparency, emphasizing sufficient detail on estimates and assumptions.9
Limitations and Criticisms
While essential for accurate financial reporting, the use of cash generating units presents certain limitations and criticisms. A significant challenge lies in the subjective nature of identifying a cash generating unit. Although IAS 36 defines a CGU as the smallest identifiable group of assets generating largely independent cash-flow, applying this in practice often requires considerable judgement.8 For instance, in vertically integrated businesses, determining whether a component generates truly independent cash inflows can be difficult if its output is largely used internally.7
Another criticism stems from the estimation of value-in-use, which relies on future cash flow forecasts and the discount-rate. These projections inherently involve management's assumptions, which can be optimistic, potentially delaying the recognition of impairment-losses.6 Regulatory bodies like the FRC have highlighted common disclosure omissions and areas for improvement, particularly regarding the sensitivity analysis of key assumptions and inconsistencies between assumptions used for impairment and other financial statement sections.5,4 If a reasonably possible change in a key assumption would cause the CGU's carrying amount to exceed its recoverable amount, this sensitivity analysis must be disclosed.3
Cash Generating Units vs. Individual Assets
The distinction between a cash generating unit and an individual asset is fundamental in impairment-testing under International Financial Reporting Standards (IFRS).
| Feature | Cash Generating Unit (CGU) | Individual Asset |
|---|---|---|
| Definition | Smallest identifiable group of assets generating largely independent cash inflows. | A single asset that can generate cash inflows on its own. |
| Impairment Test | Primarily used when an individual asset's recoverable amount cannot be determined independently. Mandatory for goodwill and intangible-assets with indefinite useful lives.2 | Tested for impairment individually if it generates independent cash inflows. |
| Examples | A specific product line, a factory producing distinct products, a hotel, a chain of stores. | A single piece of machinery, a delivery truck, an office building (if rented out). |
| Complexity | Requires aggregation of assets and allocation of shared costs and goodwill. | Simpler, as it focuses on the asset's own cash flows. |
The concept of a cash generating unit arises precisely because many assets do not generate cash-flow independently. For example, a single machine on a production line might not generate its own independent cash flows; its value is tied to the output of the entire line. In such cases, the production line itself, or a broader segment of the business, would be identified as the cash generating unit for impairment-testing purposes.
FAQs
What is the primary purpose of a cash generating unit?
The primary purpose of a cash generating unit is to facilitate the impairment-testing of assets, especially those that do not generate independent cash flows, under International Financial Reporting Standards (IFRS). It ensures that the carrying-amount of assets on the balance-sheet does not exceed their recoverable value.
How is a cash generating unit identified?
A cash generating unit is identified as the smallest identifiable group of assets that produces cash-flow that are largely independent of the cash flows from other assets or groups of assets. This identification often involves considerable judgement by management.
Are cash generating units used in U.S. GAAP?
While U.S. Generally Accepted Accounting Principles (GAAP) also require impairment testing, the specific terminology and approach to aggregating assets differ from IFRS. U.S. GAAP uses the concept of an "asset group" for impairment testing of long-lived assets, which serves a similar purpose to a cash generating unit but has different rules for identification and measurement.
How often must a cash generating unit be tested for impairment?
A cash generating unit to which goodwill or intangible-assets with indefinite useful lives have been allocated must be tested for impairment at least annually. For other CGUs, an impairment test is required only when there is an indication that the unit may be impaired.1