International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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flow
920 220 232 243 256 268 281 295 310 325
Assuming the same post-tax WACC of 8.1%, the pre-tax WACC is now considerably lower owing to the
effect of the tax deduction in the first year. It can be calculated using an iterative process at 8.76%, rather
than 10.92%, which is the pre-tax rate in (a) and (b) above. Therefore, the NPV of the pre- and post-tax cash
inflows is €2,367 rather than €2,139 – the first year tax allowances enhance the VIU of the project. If the
entity discounted the pre-tax cash flows at 11.57%, the post-tax rate grossed up at the standard rate of taxation,
these cash flows would have a NPV of €2,077, which is approximately 12% lower than the actual NPV. It is
clear that a standardised gross up will not give a reasonable approximation in these circumstances.
(d)
Correctly measuring impairment using post-tax information
If an entity applies a post-tax rate to post-tax cash flows, what can it do to ensure that impairment is correctly
measured in accordance with IAS 36?
Assume, in example (c) above, that cash inflows decline by 20% commencing at the beginning of year 2. The
net present value of the pre-tax cash flows at 8.76% is €1,516.
Year
2 3 4 5 6 7 8 9 10
€ € € € € € € € €
Pre-tax
cash
flow
210 221 232 243 255 268 281 295 310
Taxation
63
66
69
73
77
80
84
89
93
Post-tax cash flows
147
155
163
170
178
188
197
206
217
The asset’s book value, assuming straight line depreciation over 10 years, is €2,130. Impairment calculated
using pre-tax cash flows and discount rates is as follows:
€
Original investment
2,367
Net book value (end of year 1)
2,130
Pre-tax cash flows, discounted at pre-tax discount rate
8.76%
1,516
Impairment
614
Deferred tax asset (reduction in deferred tax liability)
(184)
Net impairment loss
430
A post-tax calculation overstates the impairment, as follows:
€
Original investment
2,367
Net book value (end of year 1)
2,130
Post-tax cash flows, discounted at post-tax discount rate
8.1%
1,092
Impairment – overstated by 424
1,038
Deferred tax asset (reduction in deferred tax liability)
(311)
Net impairment loss – overstated by 297
727
It can be seen that unless adjustments are made to the post-tax calculation, it will overstate the impairment loss.
There are two ways in which the post-tax calculation can be adjusted so as to give the right impairment charge.
1480 Chapter 20
Method (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. 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.
This means assuming that the VIU of the asset (1,516) is deductible for tax purposes in year 2. This would
usually be calculated iteratively
Year
2 3 4 5 6 7 8 9 10
€ € € € € € € € €
Pre-tax
cash
flow
210 221 232 243 255 268 281 295 310
Deemed
tax
amortisation
1,516
Taxation
(392) 66 69 73 77 80 84 89 93
Post-tax
cash
flows
602 155 163 170 178 188 197 206 217
The present value of the notional post-tax cash flows at the post-tax discount rate of 8.1% is now €1,516, i.e.
the VIU of the asset is fully deductible for tax purposes, so the impairment charge, before taxation, is €614,
which is the same impairment as calculated above under the pre-tax cash flow model.
Method (2): Post-tax cash flows reflecting actual tax cash flows as adjusted for deferred tax. Again, this is an
iterative calculation.
Year
2 3 4 5 6 7 8 9 10
€ € € € € € € € €
Pre-tax
cash
flow
210 221 232 243 255 268 281 295 310
Deferred tax
(455)
Taxation
63 66 69 73 77 80 84 89 93
Post-tax
cash
flows
147 155 163 170 178 188 197 206 217
Post-tax cash flows as
adjusted
for
deferred
tax
602 155 163 170 178 188 197 206 217
The net present value of the post-tax cash flows at the post-tax discount rate is €1,092. The NPV of the post-
tax cash flows as adjusted for deferred tax (see bottom line in the table), which is the VIU of the asset being
tested for impairment, is €1,516 and the gross deferred tax liability relating to the asset is 1,516 at 30%, i.e.
€455. The NPV of €455, discounted for one year at the post-tax discount rate of 8.1%, is €424. The deferred
tax liability is discounted for one year due to the assumption used that all tax cash flows take place at the end
of the year. Revised, the post-tax calculation is a follows:
€
Original investment
2,367
Net book value (end of year 1)
2,130
Post-tax cash flows, discounted at post-tax discount rate
8.1%
1,092
Discounted deferred tax
424
Impairment (2,130 – (1,092 + 424))
614
The impairment loss will impact the deferred tax calculation in the usual way, i.e. 614 at 30% = €184.
It will rarely be practicable to apply this methodology to calculate a discount rate for a
CGU, as so many factors need to be taken into account. Even if all assets within the CGU
are individually acquired or self-constructed, they may have a range of lives for
depreciation and tax amortisation purposes, up to and including indefinite lives.
If goodwill is being tested it has an indefinite life whilst the underlying assets in the CGU
or CGU group to which it has been allocated will usually have finite lives. It is likely that
a reasonable approximation to the ‘true’ discount rate is the best that can be achieved
and this is discussed further below.
Impairment of fixed assets and goodwill 1481
7.2.4
Approximations and short cuts
The illustrations in Example 20.14 at 7.2.3 above are of course simplified, and in reality it is
unlikely that entities will need to schedule all of the tax cash flows and tax consequences
in order to calculate a pre-tax discount rate every time they perform an impairment review.
In practice, it will probably not be possible to obtain a rate that is theoretically perfect –
the task
is just too intractable for that. The objective, therefore, must be to obtain a rate
which is sensible and justifiable. Some of the following may make the exercise a bit easier.
An entity may calculate a pre-tax rate using adjusted tax cash flows based on the
methods and assumptions described above and then apply that rate to discount pre-tax
cash flows for the VIU calculation. This pre-tax rate will only need to be reassessed in
following years when there is an external factor that affects risks, relevant market rates
or the taxation basis of the asset or CGU.
The market may conclude that the risks relating to a particular asset are higher or lower
than had previously been assumed. The market might consider risks to have reduced if, for
example, a new project, process or product proves to be successful; the converse would
also be true if there were previously unforeseen problems with an activity. Relevant changes
in market rates are those for instruments with a period to maturity similar to the expected
life of the assets being reviewed for impairment, so these will not necessarily need to be
recalculated every time an impairment review is carried out. Short-term market rates may
increase or decrease without affecting the rate of return that the market would require on
long-term assets. Significant changes in the basis of taxation could also affect the discount
rate, e.g. if tax deductions are applied or removed for all of a class of asset or activity. The
discount rate will not necessarily be affected if the entity ceases to make taxable profits.
Valuation practitioners often use approximations when computing tax cash flows that
may also make the task more straightforward. It may often be a valid approximation to
assume that the tax amortisation of assets equals their accounting depreciation. Tax
cash flows will be based on the relevant corporate tax rate and the forecast earnings
before interest and taxation to give post-tax ‘cash flows’ that can then be discounted
using a post-tax discount rate. The circumstances in which this could lead to a material
distortion (perhaps in the case of an impairment test for an individual asset) will
probably be obvious. This approach is consistent with the overall requirement of
IAS 36, which is that the appropriate discount rate to select is one that reflects current
market assessments of the risks specific to the asset in question.
The circumstances in which a standardised gross up at the corporation tax rate will give
the relevant discount rate are:
• no growth in cash flows;
• a perpetuity calculation; and
• tax cash flows that are a constant percentage of total cash flows.
As long as these conditions remain unchanged, it will be straightforward to determine
the discount rate for an impairment review at either the pre- or post-tax level.
There may be a close approximation to these criteria for some CGUs, particularly if
accounting and tax amortisation of assets is similar. This is illustrated in Example 20.15
below – see the comparison of discount rates at the end of the example. A simple gross
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up may be materially correct. The criteria are unlikely to apply to the VIU of individual
assets because these are rarely perpetuity calculations and the deductibility for tax
purposes may not resemble accounting depreciation. If it is inappropriate to make such
a gross up, an iterative calculation may be necessary to compute the appropriate pre-
tax discount rate.
7.2.5
Disclosing pre-tax discount rates when using a post-tax methodology
If an entity calculates impairment using a post-tax methodology, it must still disclose the
appropriate pre-tax discount rate. [IAS 36.134(d)(v)]. There is a widely-held view that the
relevant pre-tax discount rate is the rate that will discount the pre-tax cash flows to the
same VIU as the post-tax cash flows discounted using the post-tax discount rate. This
will not necessarily give an answer that is consistent with IAS 36, which makes it clear
that pre- and post-tax discount rates will only give the same answer if ‘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]. It is no different in principle whether
grossing up for a pre-tax rate or grossing up for disclosure purposes.
IAS 36 indicates that the appropriate tax base to calculate VIU in a post-tax setting, is
the VIU itself. Therefore, the calculated (post-tax) VIU should also be used to derive the
pre-tax discount rate. Depreciation for tax purposes must also be based on the
calculated VIU.
Assuming that there is no impairment, the post-tax VIU will be higher than the carrying value
of the asset. To calculate the pre-tax rate, the tax amortisation must be based on this figure.
If tax amortisation is based on the cost of the asset, the apparent pre-tax discount rate will
show a rising trend over the life of the asset as the ratio of pre- to post-tax cash flows changes
and the effect of discounting becomes smaller. These effects can be very marked.
Example 20.15: Calculating pre-tax discount rates from post-tax VIUs
The assumptions underlying these calculations are as follows:
€
Tax rate
25%
Post-tax discount rate
10%
Carrying amount beginning of year 1
1,500
Remaining useful life (years)
5
Straight line tax amortisation
If the tax amortisation is based on the cost of the asset, the apparent pre-tax discount rate in each of the five
years is as follows:
Year 1
2
3
4
5
€
€
€
€
€
Revenue 1,000
1,020
1,040
1,061
1,082
Pre-tax cash flow
500
510
520
531
541
Tax amortisation
(300)
(300)
(300)
(300)
(300)
Taxation 50
53
55
58
60
Post-tax cash flows
450
457
465
473
481
NPV of post-tax cash flows using a
10% discount rate
1,756
1,484
1,175
827
437
Impairment of fixed assets and goodwill 1483
The apparent pre-tax discount rate in any year will be the rate that discounts the pre-tax cash flows to the
same NPV as the post-tax cash flows using the post-tax discount rate.
Apparent
pre-tax
discount
rate
14.4% 15.4% 16.7% 19.1% 23.8%
It is quite clear that these apparent pre-tax discount rates are incorrect. Although pre-tax rates are not
observable in the market, they are derived from market rates and would not increase in a mechanical fashion
over the life of the asset.
The correct way to calculate the tax amortisation is based on the VIU. Years 1 and 2 are illustrated in the
>
following table:
Year
1 2 3 4 5
€ € € € €
Revenue
1,000 1,020 1,040 1,061 1,082
Pre-tax
cash
flow
500 510 520 531 541
Year 1
Notional
tax
amortisation
(VIU
1,819/5)
(364) (364) (364) (364) (364)
Taxation
34 37 39 42 44
Post-tax
cash
flows
466 473 481 489 497
Year 2
Notional
tax
amortisation
(VIU
1,554/4
(389) (389) (389) (389)
Taxation
30 33 36 38
480 487 495 503
The NPV of the post-tax cash flows, which is the VIU of the asset being tested for impairment, is €1,819 in
year 1 and €1,554 in year 2, and the tax base allowing for a tax amortisation is based on these VIUs as well,
both solved iteratively. Years 3, 4 and 5 are calculated in the same way, with tax amortisation based on the
VIUs in the following table:
Year
1 2 3 4 5
€ € € € €
VIU (NPV of post-tax cash flows)
1,819
1,554
1,247
890
478
Annual
depreciation
for
remaining
term
364 389 416 445 478
(1,819/5) (1,554/4) (1,247/3) (890/2)
478
Pre-tax
discount
rate
13.1% 13.1% 13.2% 13.3% 13.3%
We can now compare the correct and incorrectly computed pre-tax discount rates. A rate based on grossing