International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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order to determine an appropriate pre-tax discount rate it is likely to be necessary to
adjust the entity’s actual tax cash flows.
Ultimately, the appropriate discount rate to select is one that reflects current market
assessments of the time value of money and the risks specific to the asset in question,
including taxation. Such a rate is one that reflects ‘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].
7.2.2
Calculating a pre-tax discount rate
VIU is primarily an accounting concept rather than a business valuation of the asset or
CGU. One fundamental difference is that IAS 36 requires pre-tax cash flows to be
discounted using a pre-tax discount rate. Why not calculate VIU on a post-tax basis?
The reason is the complexities created by tax losses carried forward, temporary tax
differences and deferred taxes.
The standard explains in the Basis for Conclusions that, future income tax cash flows
may affect recoverable amount. It is convenient to analyse future tax cash flows into
two components:
(a) the future tax cash flows that would result from any difference between the tax
base of an asset (the amount attributed to it for tax purposes) and its carrying
amount, after recognition of any impairment loss. Such differences are described
in IAS 12 as ‘temporary differences’; and
(b) the future tax cash flows that would result if the tax base of the asset were equal to
its recoverable amount. [IAS 36.BCZ81].
The concepts are complex but it refers to the following issues.
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An impairment test, say at the end of 2016, takes account of estimated future cash flows.
The tax that an entity will pay in future years that will be reflected in the actual tax cash
flows that it expects may depend on tax depreciation that the entity has already taken
(or is yet to take) in respect of the asset or CGU being tested for impairment. The value
of the asset to the business on a post-tax basis must take account of all tax effects
including those relating to the past and not only those that will only arise in future.
Although these ‘temporary differences’ are accounted for as deferred taxation, IAS 12:
(i)
does not allow entities to recognise all deferred tax liabilities or deferred tax assets;
(ii) does not recognise deferred tax assets using the same criteria as deferred tax
liabilities; and
(iii) deferred tax is not recognised on a discounted basis.
Therefore, deferred taxation as provided in the income statement and statement of
financial position is not sufficient to take account of the actual temporary differences
relating to the asset or CGU.
At the same time, an asset valuation implicitly assumes that the carrying amount of the asset
is deductible for tax. For example, if the tax rate is 25%, an entity must receive pre-tax cash
flows with a present value of 400 in order to recover a carrying amount of 300. [IAS 36.BCZ88].
In principle, therefore, VIU on a post-tax basis would include the present value of the future
tax cash flows that would result if the tax base of the asset were equal to its value in use.
Hence, IAS 36 indicates that the appropriate tax base to calculate VIU in a post-tax setting, is
the VIU itself. [IAS 36.BCZ84]. Therefore, the calculated VIU should also be used to derive the
pre-tax discount rate. It follows from this that the ‘tax cash flows’ to be taken into account
will be those reflected in the post-tax VIU, so they will be neither the tax cash flows available
in relation to the asset (based on its cost) nor the actual tax cash flows payable by the entity.
For these reasons, the (then) IASC decided to require an enterprise to determine value
in use by using pre-tax future cash flows and a pre-tax discount rate.
This means that there is a different problem, calculating an appropriate pre-tax discount
rate because there are no observable pre-tax discount rates. Two important points must
be taken into account:
• The pre-tax discount rate is not always the post-tax discount rate grossed up by a
standard rate of tax. There are some circumstances in which a gross-up will give a
reasonable approximation, discussed further at 7.2.4 below.
• The pre-tax discount rate is not the post-tax rate grossed up by the effects of the
entity’s actual tax cash flows. As discussed above, a post-tax discount rate such as
the WACC is based on certain assumptions about the tax-deductibility of the asset
and not the actual tax cash flows experienced by the entity.
Recognising this, paragraph BCZ85 of IAS 36 states that ‘in theory, discounting post-tax
cash flows at a post-tax discount rate and discounting pre-tax cash flows at a pre-tax
discount rate should give the same result, as long as the pre-tax discount rate is the post-
tax discount rate adjusted to reflect the specific amount and timing of the future tax cash
flows’. [IAS 36.BCZ85].
Therefore, the only accurate way to calculate a pre-tax WACC is to calculate the VIU
by applying a post-tax rate to post-tax cash flows, tax cash flows being based on the
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allowances and charges available to the asset and to which the revenue is subject (see
discussion at 7.2.3 below). The effective pre-tax rate is calculated by removing the tax
cash flows and, by iteration, one can identify the pre-tax rate that makes the present
value of the adjusted cash flows equal the VIU calculated using post tax cash flows.
Paragraph BCZ85 includes an example of how to calculate a pre-tax discount rate
where the tax cash flows are irregular because of the availability of tax deductions for
the asset’s capital cost. See also the calculations in Example 20.14 below – (a) illustrates
a calculation of a pre-tax discount rate. This is a relatively straightforward calculation
for a single asset at the inception of the relevant project.
It may be far more complex at a later date. This is because entities may be attempting
to calculate a discount rate starting with post-tax cash flows and a post-tax discount rate
at a point in time when there are already temporary differences relating to the asset. A
discount rate based on an entity’s prospective tax cash flows may under- or overstate
IAS
36’s impairment charge unless it reflects these previous allowances or
disallowances. This is the same problem that will be encountered if an entity attempts
to test VIU using post-tax cash flows as described at 7.2.3 below.
A notional adjustment will have to be made if the entity is not paying tax because it is
making, or has made, tax losses. It is unwarranted to assume that the post- and pre-tax
discount rates will be the same if the entity pays no tax because of its own tax losses as
this will be double counting. It is taking advantage of the losses in the cash flows but
excluding that value from the assets of the CGU.
Entities may attempt to deal with the complexity of determining a pre-tax rate by trying
to calculate VIU on a post-tax basis but this approach means addressing all of the many
diff
iculties that have been identified by the IASB and the reasons why it mandated a
pre-tax approach in testing for impairment in the first place.
Some approximations and short cuts that may give an acceptable answer in practice are
dealt with at 7.2.4 below.
7.2.3
Calculating VIU using post-tax cash flows
Because of the challenges in calculating an appropriate pre-tax discount rate and
because it aligns more closely with their normal business valuation approach, some
entities attempt to perform a VIU calculation based on a post-tax discount rate and post-
tax cash flows.
In support of the post-tax approach, the example in paragraph BCZ85 of IAS 36, which
explains how to calculate a pre-tax discount rate, is mistakenly understood as a
methodology for a post-tax VIU calculation using an entity’s actual tax cash flows.
Entities that try a post-tax approach generally use the year-end WACC and estimated
post-tax cash flows for future years that reflect the actual tax that they expect to pay in
those years. A calculation on this basis will only by chance correspond to an impairment
test in accordance with IAS 36 because it is based on inappropriate assumptions, i.e. it
does not take account of the temporary differences that affect the entity’s future tax
charges and will not be based on the assumption that the VIU is tax deductible. Some
include in the post-tax calculation the benefit of tax deductions or tax losses by bringing
them into the cash flows in the years in which the tax benefit is expected to be received.
Impairment of fixed assets and goodwill 1477
In these cases the calculation will not correctly take account of the timing differences
reflected in the tax cash flows and may not accurately reflect the differences created by
the assumption that the VIU is tax deductible.
In order to calculate a post-tax VIU that is the equivalent to the VIU required by IAS 36,
an entity will usually have to make adjustments to the actual tax cash flows or otherwise
adjust its actual post-tax cash flows.
There are two approaches that can give a post-tax VIU that is equivalent to IAS 36’s
pre-tax calculation:
(1) Post-tax cash flows based on notional tax cash flows. The assumptions that need
to be made are the same as those used in calculating a pre-tax discount rate as
described in paragraph BCZ85. Therefore, there must be no temporary differences
associated with the asset which means including only the future cash flows that
would result if the tax base of the asset were equal to its VIU. In addition, no
account is taken of the existing tax losses of the entity. Both of these assumptions
will probably mean making appropriate notional adjustments.
(2) Post-tax cash flows reflecting actual tax cash flows. The relevant deferred tax asset
or liability, discounted as appropriate, should be treated as part of the net assets of
the relevant CGU.
It is very important to note that these are methodologies to determine IAS 36’s required
VIU and they will only be acceptable if the result can be shown to be materially the
same as a pre-tax impairment calculation as required by IAS 36.
Note that for illustrative purposes all of the following examples assume that there is no
headroom, i.e. the NPV of the relevant cash flows is exactly equal to the carrying value
of the asset. This is to make it easier to observe the relationship between pre- and post-
tax calculations. See 7.2.5 below for worked examples including headroom.
Example 20.14: Impairment calculations using pre- and post-tax cash flows and
discount rates
The following examples illustrate impairment calculations using pre- and post-tax cash flows and discount
rates.
(a)
Comparing pre- and post-tax rates
An entity has invested €2,139 in a facility with a 10 year life. Revenue and operating costs are expected to
grow by 5% annually. The net present value of the post-tax future cash flows, discounted at the WACC of
8.1%, is equal to the cost of the plant.
The budgeted pre-tax cash flows are as follows:
Year
1 2 3 4 5 6 7 8 9 10
€ € € € € € € € € €
Revenues
500 525 551 579 608 638 670 703 739 776
Operating
expenses 200 210 220 232 243 255 268 281 296 310
Pre-tax
cash
flow
300 315 331 347 365 383 402 422 443 466
The following tax amortisation and tax rate apply to the business:
Tax and accounting depreciation
straight line
Tax rate
30%
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These apply to the budgeted cash flows as follows:
Year
1 2 3 4 5 6 7 8 9 10
€ € € € € € € € € €
Tax
amortisation
214 214 214 214 214 214 214 214 214 214
Taxation
26 30 35 40 45 51 56 62 69 75
Post-tax
cash
flow 274 285 296 307 320 332 346 360 374 391
The pre-tax rate can be calculated using an iterative calculation and this can be compared to a gross up using
the standard rate of tax. The NPV using these two rates is as follows:
Pre-tax rate (day 1) – iterative calculation
10.92%
Cost of investment at NPV future cash flows
€2,139
Standard gross up (day 1) (8.1% ÷ 70%).
11.57%
NPV at standard gross up
€2,077
The NPV of the pre-tax cash flows at 11.57% is €2,077. This is only 2.9% lower than the number calculated
using the true pre-tax rate. In many circumstances, this difference would not have a material effect.
If the tax and accounting depreciation are straight line then the distortion introduced by a standard gross-up
can be relatively small and could be of less significance to an impairment test than, for example, the potential
variability in cash flows. See also 7.2.4 below.
(b)
Comparing pre- and post-tax rates when the asset is impaired
Assume that the facility is much less successful than had previously been assumed and that the revenues are
20% lower than the original estimates. The pre- and post-tax cash flows are as follows.
Year
1 2 3 4 5 6 7 8 9 10
€ € € € € € € € € €
Revenues
400 420 441 463 486 511 536 563 591 621
Operating
expenses 200 210 220 232 243 255 268 281 296 310
Pre-tax
cash
flow
200 210 221 232 243 255 268 281 295 310
Tax
amortisation
214 214 214 214 214 214 214 214 214 214
Taxation
(4) (1) 2 5 9 12 16 20 24 29
Post-tax
cash
flow
204 211 219 227 234 243 252 261 271 281
The asset is clearly impaired as the previous cash flows were just sufficient to recover the carrying amount
of the investment. If these revised cash flows are discounted using the pre- and post-tax discount rates
discussed above, the resulting impairment is as follows:
NPV
Impairment
Deferred tax
Net loss
Original investment
2,139
Pre-tax cash flows, discounted at
10.92% 1,426
713
214 499
pre-tax discount rate
Post-tax cash flows discounted at
8.1% 1,569
570
171 399
post-tax discount rate
Unless adjustments are made to the post-tax calculation, it will understate the impairment loss by 143 (pre-
tax) and 100 (post-tax, assuming full provision for the deferred tax asset). This difference is the present value
of the deferred tax on the actual impairment loss, a point explored in more detail in (d) below.
(c)
Impairment and variable tax cash flows
The assumption of straight-line amortisation for taxation and accounting purposes does not reflect the
circumstances of certain sectors, particularly where there are significant deductions for tax for the cost of the
asset being tested for impairment, e.g. in the extractive sector. Impairment tests have to be calculated on finite
life assets and variable tax cash flows. In many jurisdictions there are, or have been, substantial tax allowances
for the construction of the asset but high rates of tax in the production phase.
Impairment of fixed assets and goodwill 1479
The following example assumes that the entity gets a tax deduction for the cost of the asset in year 1. Once
again, this assumes that in year 1 the cost of the investment is equal to the NPV of the cash flows.
Year
1 2 3 4 5 6 7 8 9 10
€ € € € € € € € € €
Revenues
500 525 551 579 608 638 670 704 739 776
Operating
expenses
200 210 220 232 243 255 268 281 296 310
Pre-tax
cash
flow
300 315 331 347 365 383 402 422 443 465
Tax
amortisation 2,367
Taxation
(620) 95 99 104 109 115 121 127 133 140
Post-tax
cash