IAS 36 Impairment Testing (Forecasts & Discount Rates)

Relies on forecasts and discount rates for impairment testing both can be heavily influenced by board’s/management to the detriment of shareholders.

Unlike the cash flows used in an impairment test that are entity specific, the discount rate is supposed to appropriately reflect the current market assessment of the time value of money and the risks specific to the asset or CGU (cash generating unit).

When a specific rate for an asset or CGU is not directly available from the market, which is usually the case, the entity’s Weighted Average Cost of Capital (WACC), the entity’s incremental borrowing rate or other market rates can be used as a starting point. While not prescribed, WACC is by far the most commonly used base for the discount rate.

Cost of equity

The cost of equity is the most difficult component of the cost of capital to determine and one that is subject to considerable debate by experts.

One issue is the financial crisis and recession has increased equity risk. This is an element of the WACC for which it is advisable to obtain independent expert advice on to ensure consistency with the other assumptions in the impairment test.

For Example regarding Forecasts

Management has recently approved a stretch forecast that shows production rising from 14,000 units to 20,000 units over five years. Recent years have demonstrated a track record of undershooting stretch forecasts. Analysts covering the sector are assuming that production will only rise marginally over the next few years due to forecast weaknesses in demand, together with oversupply in the market. Should the most recently approved forecast be used without adjustment?


Solution

The approved forecast appears to be neither reasonable nor supportable. The forecasts will need to be adjusted based on the entity’s historic record of meeting projections and external evidence.


For Example regarding Discount Rates

How is the appropriate pre-tax discount rate for a VIU (Value in Use) calculation determined from a post-tax starting point?

The following two-step approach can be applied to derive iteratively the implicit pre-tax discount rate from post-tax data. This pre-tax rate is applied to the discounted cash flows that are the basis of the VIU:

Step 1
From pre-tax cash flow projections, the expected actual tax cash payments are calculated to arrive at post-tax cash flows. These post-tax cash flows are discounted at an appropriate post-tax discount rate derived using information observable on the capital markets.

Step 2
The pre-tax discount rate is derived by determining the rate required to be applied to the pre-tax cash flows to arrive at the result obtained in step 1 (ie, same methodology used for computing an internal rate of return).


Fair value less costs to sell

When there is neither a binding sale agreement nor an active market, FVLCTS may be estimated as the amount that the entity could obtain from disposal of the asset in an arm’s length transaction based on data from recent market transactions. Discounted cash flow techniques may be used in estimating the fair value of the asset.