from the asset and the time value of money, represented by the current market risk-free
rate of interest, to be reflected in the VIU calculation. However, the other elements that
must be taken into account, all of which measure various aspects of risk, may be dealt
with either as adjustments to the discount rate or to the cash flows. These elements are:
• expectations about possible variations in the amount or timing of those future cash
flows;
• the price for bearing the uncertainty inherent in the asset; and
• other factors, such as illiquidity that market participants would reflect in pricing
the future cash flows the entity expects to derive from the asset. [IAS 36.30].
Adjusting for these factors in the discount rate is termed the ‘traditional approach’ in
Appendix A to IAS 36. Alternatively, under the ‘expected cash flow’ approach these
adjustments are made in arriving at the risk-adjusted cash flows. Either method may be
used to compute the VIU of an asset or CGU. [IAS 36.A2].
1470 Chapter 20
The traditional approach uses a single set of estimated cash flows and a single discount
rate, often described as ‘the rate commensurate with the risk’. This approach assumes
that a single discount rate convention can incorporate all expectations about the future
cash flows and the appropriate risk premium and therefore places most emphasis on the
selection of the discount rate. [IAS 36.A4].
Due to the problems and difficulties around capturing and reflecting all of the variables
into a single discount rate, IAS 36 notes that the expected cash flow approach may be
the more effective measurement tool. [IAS 36.A6, A7].
The expected cash flow approach is a probability weighted net present value approach.
This approach uses all expectations about possible cash flows instead of a single most
likely cash flow and assigns probabilities to each cash flow scenario to arrive at a
probability weighted net present value. The use of probabilities is an essential element
of the expected cash flow approach. [IAS 36.A10]. The discount rate then considers the
risks and variability for which the cash flows have not been adjusted. Appendix A notes
some downsides of this approach, e.g. that the probabilities are highly subjective and
that it might be inappropriate for measuring a single item or one with a limited number
of outcomes. Nonetheless, it considers the most valid objection to the method to be the
costs of obtaining additional information when weighed against its ‘greater reliability’.
[IAS 36.A10-13].
Whichever method is used, an entity needs to ensure that consistent assumptions are
used for the estimation of cash flows and the selection of an appropriate discount rate
in order to avoid any double-counting or omissions.
7.2
Identifying an appropriate discount rate and discounting the
future cash flows
Finally, although probably inherent in their identification, the forecast cash flows of the
CGU have to be allocated to different periods for the purpose of the discounting step.
The present value of these cash flows should then be calculated by discounting them.
The discount rate is to be a pre-tax rate that reflects current market assessments of the
time value of money and the risks specific to the asset for which the future cash flow
estimates have not been adjusted. [IAS 36.55].
This means the discount rate to be applied should be an estimate of the rate that the
market would expect on an equally risky investment. The standard states:
‘A rate that reflects current market assessments of the time value of money and the
risks specific to the asset is the return that investors would require if they were to
choose an investment that would generate cash flows of amounts, timing and risk
profile equivalent to those that the entity expects to derive from the asset.’
[IAS 36.56].
Therefore, if at all possible, the rate is to be obtained from market transactions or market
rates, which means the rate implicit in current market transactions for similar assets or
the weighted average cost of capital (WACC) of a listed entity that has a single asset (or
a portfolio of assets) with similar service potential and risks to the asset under review.
[IAS 36.56]. If such a listed entity could be found, care would have to be taken in using its
WACC as the standard specifies for the VIU the use of a pre-tax discount rate that is
Impairment of fixed assets and goodwill 1471
independent of the entity’s capital structure and the way it financed the purchase of the
asset (see below). The effect of gearing and its effect on calculating an appropriate
WACC is illustrated in Example 20.13.
Only in rare cases (e.g. property assets) can such market rates be obtained. If an
asset-specific rate is not available from the market, surrogates should be used.
[IAS 36.A16]. The discount rate that investors would require if they were to choose an
investment that would generate cash flows of amounts, timing and risk profile
equivalent to those that the entity expects to derive from the asset will not be easy
to determine. IAS 36 suggests that, as a starting point, the entity may take into
account the following rates:
(a) the entity’s weighted average cost of capital determined using techniques such as
the Capital Asset Pricing Model;
(b) the entity’s incremental borrowing rate; and
(c) other market borrowing rates. [IAS 36.A17].
Appendix A also gives the following guidelines for selecting the appropriate discount rate:
• it should be adjusted to reflect the specific risks associated with the projected cash
flows (such as country, currency, price and cash flow risks) and to exclude risks
that are not relevant; [IAS 36.A18]
• to avoid double counting, the discount rate does not reflect risks for which future
cash flow estimates have been adjusted; [IAS 36.A18]
• the discount rate is independent of the entity’s capital structure and the way it
financed the purchase of the asset; [IAS 36.A19]
• if the basis for the rate is post-tax (such as a weighted average cost of capital), it is
adjusted for the VIU calculation to reflect a pre-tax rate; [IAS 36.A20] and
• normally the entity uses a single discount rate but it should use separate discount
rates for different future periods if the VIU is sensitive to different risks for
different periods or to the term structure of interest rates. [IAS 36.A21].
The discount rate specific for the asset or CGU will take account of the period over
which the asset or CGU is expected to generate cash inflows and it may not be sensitive
to changes in short-term rates – this is discussed at 2.1.4 above. [IAS 36.16].
It is suggested that the incremental borrowing rate of the business is relevant to the
selection of a discount rate. This could only be a starting point as the appropriate
discount rate should be independent of the entity’s capital structure or the way in which
it financed the purchase of the asset. In addition, the incremental borrowing rate may
include an element of default risk for the entity as a whole, which is not relevant in
assessing the return expected from the assets.
In practice, many entities use t
he WACC to estimate the appropriate discount rate.
The appropriate way to calculate the WACC is an extremely technical subject, and
one about which there is much academic literature and no general agreement. The
selection of the rate is obviously a crucial part of the impairment testing process and
in practice it will probably not be possible to obtain a theoretically perfect rate. The
objective, therefore, must be to obtain a rate which is sensible and justifiable. There
are probably a number of acceptable methods of arriving at the appropriate rate and
1472 Chapter 20
one method is set out below. While this illustration may appear to be quite complex,
it has been written at a fairly general level as the calculation of the appropriate
discount rate may be difficult and specialist advice may be needed.
Example 20.13: Calculating a discount rate
This example illustrates how to estimate a discount rate (WACC) for a CGU. As it is highly unlikely that a
listed company with a similar risk profile to the CGU in questions exists, the WACC has to be simulated by
looking at a hypothetical company with a similar risk profile.
When estimating the WACC for the CGU, the following three elements needs to be estimated:
• gearing, i.e. the ratio of market value of debt to market value of equity;
• cost of debt; and
• cost of equity.
Gearing can best be obtained by reviewing quoted companies operating predominantly in the same industry
as the CGU and identifying an average level of gearing for such companies. The companies need to be quoted
so that the market value of equity can be readily determined.
Where companies in the sector typically have quoted debt, the cost of such debt can be determined
directly. In order to calculate the cost of debt for bank loans and borrowings more generally, one method
is to take the rate implicit in fixed interest government bonds – with a period to maturity similar to the
expected life of the assets being reviewed for impairment – and to add to this rate a bank’s margin, i.e.
the commercial premium that would be added to the bond rate by a bank lending to the hypothetical
company in this sector. In some cases, the margin being charged on existing borrowings to the company
in question will provide evidence to help with establishing the bank’s margin. Obviously, the
appropriateness of this will depend upon the extent to which the risks facing the CGU being tested are
similar to the risks facing the company or group as a whole.
If goodwill or intangible assets with an indefinite life were being included in a CGU reviewed for impairment
(see 8 and 10 below) the appropriate Government bond rate to use might have to be adjusted towards that for
irredeemable bonds. The additional bank’s margin to add would be a matter for judgement but would vary
according to the ease with which the sector under review was generally able to obtain bank finance and, as
noted above, there might be evidence from the borrowings actually in place of the likely margin that would
be chargeable. Sectors that invest significantly in tangible assets such as properties that are readily available
as security for borrowings, would require a lower margin than other sectors where such security could not be
found so easily.
Cost of equity is the hardest component of the cost of capital to determine. One technique referred to in
the standard, frequently used in practice and written up in numerous textbooks is the ‘Capital Asset
Pricing Model’ (CAPM). The theory underlying this model is that the cost of equity is equal to the risk-
free rate plus a multiple, known as the beta, of the market risk premium. The risk-free rate is the same
as that used to determine the nominal cost of debt and described above as being obtainable from
government bond yields with an appropriate period to redemption. The market risk premium is the
premium that investors require for investing in equities rather than government bonds. There are also
reasons why this rate may be loaded in certain cases, for instance to take account of specific risks in the
CGU in question that are not reflected in its market sector generally. Loadings are typically made when
determining the cost of equity for a small company. The beta for a quoted company is a number that is
greater or less than one according to whether market movements generally are reflected in a
proportionately greater (beta more than one) or smaller (beta less than one) movement in the particular
stock in question. Most betas fall into the range 0.4 to 1.5.
Various bodies, such as The London Business School, publish betas on a regular basis both for individual
stocks and for industry sectors in general. Published betas are in general levered, i.e. they reflect the level of
gearing in the company or sector concerned (although unlevered betas (based on risk as if financed with 100%
equity) are also available and care must be taken not to confuse the two).
Impairment of fixed assets and goodwill 1473
In addition to the volatility expressed in the beta, investors also reflect the exposure of the stock to a limited
niche sector or exposure to a limited customer base. As a result, size premium could be required when the
CGU is smaller size compared to its direct competitors.
The cost of equity for the hypothetical company having a similar risk profile to the CGU is:
Cost of equity = risk-free rate + (levered beta × market risk premium) + size premium (if deemed required)
Having determined the component costs of debt and equity and the appropriate level of gearing, the WACC
for the hypothetical company having a similar risk profile to the CGU in question is:
g
g
WACC = (1 – t) × D ×
+ E × 1 –
1 + g
1 + g
where:
D is the cost of debt;
E is the cost of equity;
g is the gearing level (i.e. the ratio of debt to equity) for the sector; and
t is the rate of tax relief available on the debt servicing payments.
IAS 36 requires that the forecast cash flows are before tax and finance costs, though it
is more common in discounted cash flow valuations to use cash flows after tax.
However, as pre-tax cash flows are being used, the standard requires a pre-tax discount
rate to be used. [IAS 36.55]. This will theoretically involve discounting higher future cash
flows (before deduction of tax) with a higher discount rate. This higher discount rate is
the post-tax rate adjusted to reflect the specific amount and timing of the future tax
flows. In other words, the pre-tax discount rate is the rate that gives the same present
value when discounting the pre-tax cash flows as the post-tax cash flows discounted at
the post-tax rate of return. [IAS 36.BCZ85].
Once the WACC has been calculated, the pre-tax WACC can be calculated. If a
simple gross up is appropriate, it can be calculated by applying the fraction 1/(1–t).
Thus, if the WACC comes out at, say, 10% the pre-tax WACC will be 10% divided
by 0.7, if the relevant tax rate for the reporting entity is 30%, which will give a pre-
tax rate of 14.3%. However, the standard warns that in many circumstances a gross
up will not give a good enough answer as the pre-tax discount rate also depends on
the timing of future tax cash flows and the useful life of the asset; these tax flows
ca
n be scheduled and an iterative process used to calculate the pre-tax discount
rate. [IAS 36.BCZ85]. The relationship between pre- and post-tax rates is discussed
further at 7.2.2 below.
The selection of discount rates leaves considerable room for judgement in the
absence of more specific guidance, and it is likely that many very different
approaches will be applied in practice, even though this may not always be evident
from the financial statements. However, once the discount rate has been chosen,
the future cash flows are discounted in order to produce a present value figure
representing the VIU of the CGU or individual asset that is the subject of the
impairment test.
1474 Chapter 20
7.2.1
Discount rates and the weighted average cost of capital
The WACC is often used in practice. It is usually acceptable to auditors as it is supported
by valuation experts and is an accepted methodology based on a well-known formula
and widely available information. In addition, many entities already know their own
WACC. However, it can only be used as a starting point for determining an appropriate
discount rate and some of the issues that must be taken into account are as follows:
a)
the WACC is a post-tax rate and IAS 36 requires VIU to be calculated using pre-
tax cash flows and a pre-tax rate. In the majority of cases, converting the former
into the latter is not simply a question of grossing up the post-tax rate by the
effective tax rate;
b)
an entity’s own WACC may not be suitable as a discount rate if there is anything atypical
about the entity’s capital structure compared with ‘typical’ market participants;
c) the WACC must reflect the risks specific to the asset and not the risks relating to
the entity as a whole, such as default risk; and
d) the entity’s WACC is an average rate derived from its existing business, yet entities
frequently operate in more than one sector. Within a sector, different types of projects
may have different levels of risk (e.g. a start-up as against an established product).
These issues are discussed further below.
One of the most difficult areas in practice is the effect of taxation on the WACC. In
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 290
