International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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In the case of assets or CGUs with indefinite useful lives, the terminal value is calculated
by having regard to the forecast maintainable cash flows that are expected to be
generated by the assets or CGUs in the final year of the explicit forecast period (‘the
terminal year’). It is essential that the terminal year cash flows reflect maintainable cash
flows as otherwise any material one-off or abnormal cash flows that are forecast for the
terminal year will inappropriately increase or decrease the valuation.
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The maintainable cash flow expected to be generated by the asset or CGU is then
capitalised by a perpetuity factor based on either:
• the discount rate if cash flows are forecast to remain relatively constant; or
• the discount rate less the long term growth rate if cash flows are forecast to grow.
Care is required in assessing the growth rate to ensure consistency between the long
term growth rate used and the assumptions used by the entity generally in its business
planning. IAS 36 requires an entity to use in the VIU calculation a steady or declining
growth rate for subsequent years, unless an increasing rate can be justified. This growth
rate must not exceed the long-term average growth rate for the products, industries, or
country or countries in which the entity operates, or for the market in which the asset
is used, unless a higher rate can be justified. [IAS 36.33].
7.1.5
Foreign currency cash flows
Foreign currency cash flows should first be estimated in the currency in which they will
be generated and then discounted using a discount rate appropriate for that currency.
An entity should translate the present value calculated in the foreign currency using the
spot exchange rate at the date of the value in use calculation. [IAS 36.54]. This is to avoid
the problems inherent in using forward exchange rates, which are based on differential
interest rates. Using such a rate would result in double-counting the time value of
money, first in the discount rate and then in the forward rate. [IAS 36.BCZ49]. However,
the method requires an entity to perform, in effect, separate impairment tests for cash
flows generated in different currencies but make them consistent with one another so
that the combined effect is meaningful. This is an extremely difficult exercise. Many
different factors need to be taken into account including relative inflation rates and
relative interest rates as well as appropriate discount rates for the currencies in question.
Because of this, the possibility for error is great and the greatest danger is understating
the present value of cash outflows by using too high a discount rate. In practice, valuers
may assist entities to obtain a sufficiently accurate result by assuming that cash flows
are generated in a single currency even though they may be received or paid in another.
Significantly, the rate used to translate the cash flows could well be different from that
used to translate the foreign currency assets, goodwill and liabilities of a subsidiary at
the period end. For example, a non-monetary asset such as an item of property, plant
and equipment may be carried at an amount based on exchange rates on the date on
which it was acquired but generates foreign currency cash flows. In order to determine
its recoverable amount if there are indicators of impairment, IAS 21 – The Effects of
Changes in Foreign Exchange Rates – states that the recoverable amount will be
calculated in accordance with IAS 36 and the present value of the cash flows translated
at the exchange rate at the date when that value was determined. [IAS 21.25]. IAS 21 notes
that this may be the rate at the reporting date. The VIU is then compared to the carrying
value and the item is then carried forward at the lower of these two values.
7.1.6
Internal transfer pricing
If the cash inflows generated by the asset or CGU are based on internal transfer
pricing, the best estimate of an external arm’s length transaction price should be used
in estimating the future cash flows to determine the asset’s or CGU’s VIU. [IAS 36.70].
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Note that this applies to any cash inflow once a CGU has been identified; it is not
restricted to CGUs that have been identified because there is an active market for
their outputs, which are described at 3.2 above.
In practice, transfer pricing may be based on estimated market values, perhaps with a
discount or other adjustment, be a cost-based price or be based on specific negotiation
between the group companies. Transfer prices will reflect the taxation consequences to
the transferring and acquiring companies and the prices may be agreed with the relevant
taxation authorities. This is especially important to multinational companies but may
affect transfer prices within a single jurisdiction.
Transfer pricing is extremely widespread. The following example describes a small
number of bases for the pricing and the ways in which it might be possible to verify
whether they approximate to an arm’s length transaction price (and, of course, even
where the methodology is appropriate, it is still necessary to ensure that the inputs into
the calculation are reasonable). An arm’s length price may not be a particular price point
but rather a range of prices.
Example 20.12: Transfer prices
A vehicle manufacturer, Entity A has a CGU that manufactures parts, transferring them to the vehicle
assembly division. The parts are specific to the manufacturer’s vehicles and the manufacturer cannot
immediately source them on the open market. However, Entity A and other manufacturers in the sector
do enter into parts supply arrangements with third parties, which set up the specific tooling necessary
to manufacture the parts and could provide an external comparable transaction to help validate that the
parts’ internal transfer price is equivalent to an arm’s length transaction. If not, the forecasts should
be adjusted.
Entity B is an oil company that transfers crude oil from the drilling division to the refinery, to be used in the
production of gasoline. There are market prices for crude oil that can be used to estimate cash inflows in the
drilling division CGU and cash outflows for the refinery CGU.
7.1.7
Overheads and share-based payments
When calculating the VIU, entities should include projections of cash outflows that are:
(i) necessarily incurred to generate the cash inflow from continuing use of the asset
(or CGU); and
(ii) can be directly attributed, or allocated on a reasonable and consistent basis to the
asset (or CGU). [IAS 36.39(b)].
Projections of cash outflows include those for the day-to-day servicing of the
asset/CGU as well as future overheads that can be attributed directly, or allocated on a
reasonable and consistent basis, to the use of the asset/CGU. (IAS 36.41).
In principle, all overhead costs should be considered and most should be allocated to
CGUs when testing for impairment, subject to materiality.
Judgements might however be required to determine how far down to allocate some
overhead costs and in determining an appropriate allocation basis, in particular when it
comes to ste
wardship costs and overhead costs incurred at a far higher level in a group
to the CGU/asset assessed for impairment. Careful consideration of the entity’s specific
relevant facts and circumstances and cost structure is needed.
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Generally, overhead costs that provide identifiable services to a CGU (e.g. IT costs from
a centralised function) as well as those that would be incurred by a CGU if it needed to
perform the related tasks when operating on a ‘stand-alone basis’ (e.g. financial
reporting function) should be allocated to the CGU being tested for impairment.
Conversely, overhead costs that are incurred with a view to acquire and develop a new
business (e.g. costs for corporate development such as M&A activities) would generally
not be allocated. These costs are similar in nature to future cash inflows and outflows
that are expected to arise from improving or enhancing a CGU’s performance which are
not considered in the VIU according to IAS 36.44.
The selection of a reasonable and consistent allocation basis of overhead costs will
require analysis of various factors including the nature of the CGU itself. A reasonable
allocation basis for identifiable services may be readily apparent, for example in some
cases volume of transaction processing for IT services or headcount for human resource
services may be appropriate. However, a reasonable allocation basis for stewardship
costs that are determined to be necessarily incurred by the CGU to generate cash
inflows may require more analysis. For example, an allocation basis for stewardship
costs such as revenue or headcount may not necessarily be reasonable when CGUs have
different regulatory environments, (i.e. more regulated CGUs may require more
governance time and effort) or maturity stages (i.e. CGUs in mature industries may
require less governance effort). The allocation basis may need to differ by type of cost
and in some cases may need to reflect an average metric over a period of time rather
than a metric for a single period or may need to reflect future expected, rather than
historic, metrics.
Overheads not fully pushed down to the lowest level of CGUs might need to be included
in an impairment test at a higher level group of CGUs if it can be demonstrated that the
overhead costs are necessarily incurred and can be attributed directly or allocated on a
reasonable and consistent basis at that higher level. After a careful analysis, there could
be instances when certain overhead costs are excluded from cash flow projections on
the basis that they do not meet the criteria under paragraph 39(b) of IAS 36.
Many entities make internal charges, often called ‘management charges’, which purport
to transfer overhead charges to other group entities. Care must be taken before using
these charges as a surrogate for actual overheads as they are often based on what is
permitted, (e.g. by the taxation authorities), rather than actual overhead costs. There is
also the danger of double counting if a management charge includes an element for the
use of corporate assets that have already been allocated to the CGU being tested, e.g.
an internal rent charge.
In certain situations it may be argued that some stewardship costs are already included
in the impairment test through the discount rate used. This would among other factors
depend on the way the discount rate has been determined, and whether the relevant
stewardship cost should be regarded more as a shareholder cost covered in the
shareholders’ expected return rather than a cost necessarily incurred by the CGU to
generate the relevant cash flows. Due to the complexity of such an approach it would
need to be applied with appropriate care.
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In many jurisdictions employees’ remuneration packages include share-based
payments. Share-based payments may be cash-settled, equity-settled or give the entity
or the counterparty the choice of settlement in equity or in cash. In practice, many
share-based payment transactions undertaken by entities are awards of equity-settled
shares and options. This gives the entity the possibility of rewarding employees without
incurring any cash outflows and instead the cash costs are ultimately borne by the
shareholders through dilution of their holdings.
When it comes to impairment assessment, a question that often faces entities is whether
and how to consider share-based payments in the recoverable amount, in particular the
VIU calculation. IAS 36 itself does not provide any specific guidance as to whether or
how share-based payments should be considered in determining the recoverable amount.
As IAS 36 focuses on cash flows in determining VIU, it seems that expected cash
outflows in relation to cash-settled share-based payments would need to be reflected
in the VIU calculation. The future expected cash outflow could, for example, be
reflected by the fair value of the award at the balance sheet date, through including the
amount of that fair value expected to vest and be paid out in excess of the liability
already recognised at that date in the VIU calculation. In such a case the liability already
recognised at the date of the VIU determination would not form part of the carrying
value of the CGU.
While theoretically this seems to be straight forward, in practice it can be quite a
challenging and judgemental task, in particular when the entity consists of a large
number of CGUs. Share-based payments are in general awarded by the parent to
employees within the group. There may be no correlation between any change in the
value of share-based payments after the grant date and the performance of the
employing CGU. This may be relevant in assessing whether and how such changes in
value and the ultimate expected cash flows are allocated to a specific CGU.
What is even less clear is whether an entity should reflect in the VIU calculation
equity-settled share-based payments. Such share-based payment transactions will
never result in any cash outflows for the entity, and therefore a literal reading of
IAS 36 may indicate that they can be ignored in determining the recoverable
amount. However, some might argue an entity should appropriately reflect all share-
based payments in the VIU calculation, whether or not these result in a real cash
outflow to the entity. Such share-based payments are part of an employee’s
remuneration package and therefore costs (in line with the treatment under IFRS 2
– Share-based Payment) incurred by the entity for services from the employee are
necessary as part of the overall cash flow generating capacity of the entity. Others
may argue that they need to be considered through adjusting the discount rate in
order to reflect a higher return to equity holders to counter the dilutive effects of
equity settled share based payment awards.
The time span over which the recoverable amount is calculated is often much longer
than the time period for which share-based payments have been awarded. Companies
and their employees would often expect that further share-based payment awards will
be made in the future during the time period used for the recoverable amount
calculation. Depending on the respective facts and circumstances an e
ntity would need
Impairment of fixed assets and goodwill 1469
to consider whether to include the effect of share-based payments over a longer period,
considering the discussion above.
7.1.8
Events after the reporting period
Events after the reporting period and information received after the reporting period
end should be considered in the impairment assessment only if changes in assumptions
provide additional evidence of conditions that existed at the end of the reporting period.
Judgement of all facts and circumstances is required to make this assessment.
Information available after the year end might provide evidence that conditions were
much worse than assumed. Whether an adjustment to the impairment assessment would
be required or not would depend on whether the information casts doubts on the
assumptions made in the estimated cash flows for the impairment assessment.
Competitive pressures resulting in price reductions after the year end do not generally
arise overnight but normally occur over a period of time and may be more a reaction to
conditions that already existed at the year-end in which case management would reflect
this in the year end impairment assessment.
IAS 10 – Events after the Reporting Period – distinguishes events after the reporting
period into adjusting and non-adjusting events (see Chapter 34). IAS 10 mentions
abnormally large changes after the reporting period in asset prices or foreign exchange
rates as examples of non-adjusting events and therefore would in general not be a
reason to update year end impairment calculations. The standard implies that
abnormally large changes must be due to an event that occurred after the period end
and therefore more or less assumes that the cause of such abnormally large changes are
not conditions that already existed at the year-end. However, management would need
to carefully assess the reason for the abnormally large change and consider whether it
is due to conditions which already existed at the period end.
7.1.9
‘Traditional’ and ‘expected cash flow’ approach to present value
The elements that must be taken into account in calculating VIU are described at 7
above. IAS 36 requires an estimate of the future cash flows the entity expects to derive