International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
Page 293
up the post-tax rate at the standard rate of tax is included for comparison.
Year
1 2 3 4 5
Post-tax
discount
rate
10% 10% 10% 10% 10%
Pre-tax discount rate – correct
13.1%
13.1%
13.2%
13.3%
13.3%
Pre-tax discount rate – incorrect, based on cost
14.4%
15.4%
16.7%
19.1%
23.8%
Pre-tax rate – approximation based on
gross-up
13.3% 13.3% 13.3% 13.3% 13.3%
Note that in circumstances where tax amortisation is equal to accounting depreciation, a straightforward
gross-up at the tax rate may give a satisfactory discount rate.
A rate based on actual post-tax cash flows will also vary from year to year depending
on the tax situation.
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Neither of these distortions is consistent with the principle that the pre-tax discount
rate is the rate that reflects current market assessments of the time value of money and
the risks specific to the asset. [IAS 36.55].
7.2.6
Determining pre-tax rates taking account of tax losses
A common problem relates to the effect of tax losses on the impairment calculation,
as they may reduce the total tax paid in the period under review or even eliminate
it altogether. As noted above, however, a post-tax discount rate is based on certain
assumptions about the tax-deductibility of the asset and not the actual tax cash
flows. It is therefore 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. The pre-tax
rate should not include the benefit of available tax benefits and any deferred tax
asset arising from tax losses carried forward at the reporting date must be excluded
from the assets of the CGU if the impairment review is based on VIU. Similarly, if
the entity calculates a post-tax VIU (see 7.2.3 above), it will also make assumptions
about taxation and not base the calculation on the actual tax cash flows.
In many circumstances, the past history of tax losses affects the level of risk in the cash
flows in the period under review, but one must take care not to increase the discount
rate to reflect risks for which the estimated cash flows have been adjusted. [IAS 36.A15].
To do so would be to double count.
7.2.7
Entity-specific WACCs and different project risks within the entity
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 against an established
product. Therefore, entities must ensure that the different business risks of
different CGUs are properly taken into account when determining the appropriate
discount rates.
It must be noted that these areas of different risk will not always coincide with the assets
or CGUs that are being tested for impairment as this is a test for impairment and not
necessarily a determination of business value.
Example 20.16: Different project risks and CGUs
An aircraft manufacturer makes both civilian and military aircraft. The risks for both sectors are
markedly different as they are much lower for defence contractors than for the civilian market. The
assembly plants for civilian and military aircraft are separate CGUs. In this sector there are entities that
are based solely in one or other of these markets, i.e. they are purely defence or civilian contractors, so
there will be a basis for identifying the different discount rates for the different activities. If the entity
makes its own components then the defence CGU or CGUs could include the manufacturing activity if
defence is vertically integrated and components are made solely for military aircraft. Manufacturing
could be a separate CGU if components are used for both activities and there is an external market for
the products.
A manufacturer of soft drinks uses the same plant to produce various flavours of carbonated and uncarbonated
drinks. Because the market for traditional carbonated drinks is declining, it develops and markets a new
uncarbonated ‘health’ drink, which is still produced using the same plant. The risks of the product are higher
than those of the existing products but it is not a separate CGU.
Impairment of fixed assets and goodwill 1485
Many sectors generate many new products but have a high attrition rate as most of their
new products fail (pharmaceuticals and biotechnology, for example) and this is likely
built into industry WACCs. If the risk of failure is not reflected in the industry WACC
because the entity is not typical of the industry then either the WACC or the cash flows
ought to be adjusted to reflect the risk (but not so as to double count).
7.2.8
Entity-specific WACCs and capital structure
The discount rate is 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]. 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. In other words, would the market assess
the cash flows from the asset or unit as being riskier or less risky than the entity-wide
risks reflected in the entity-wide WACC? Some of the risks that need to be thought
about are country risk, currency risks and price risk.
Country risk will reflect the area in which the assets are located. In some areas assets
are frequently nationalised by governments or the area may be politically unstable and
prone to violence. In addition, the potential impact of physical instability such as
weather or earthquakes, and the effects of currency volatility on the expected return
from the asset, must be considered.
Two elements of price risk are the gearing ratio of the entity in question (if, for example,
it is much more or less geared than average) and any default risk built into its cost of
debt. However, IAS 36 explicitly notes that the discount rate is independent of the
entity’s capital structure and the way the entity financed the purchase of the asset,
because the future cash flows expected to arise from an asset do not depend on these
features. [IAS 36.A19].
Example 20.17: Effect of entity default risk on its WACC
The formula for calculating the (post tax) WACC, as given in Example 20.13 at 7.2 above, is
g
g
WACC = (1 – t) × D ×
+ E × 1 –
1 + g
1 + g
where:
t is the rate of tax relief available on the debt servicing payments;
D is the pre-tax 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.
The cost of equity is calculated as follows:
Cost of equity = risk-free rate + (levered beta (β*) × market risk premium) + size premium (if
deemed required)
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> Assume that the WACC of a typical sector participant is as follows:
Cost of equity
Risk free rate
4%
Levered beta (β) 1.1
Market risk premium 6%
Cost of equity after tax (market risk premium × β + risk-free rate)
10.6%
Cost of debt
Risk free rate
4%
Credit
spread
3%
Tax
rate
25%
Cost of debt (pre-tax)
7%
Cost of debt (post-tax)
5.25%
Capital structure
Debt / (debt + equity)
25%
Equity / (debt + equity)
75%
Post-tax cost of equity (10.6 × 75%)
8%
Post-tax cost of debt (5.25 × 25%)
1.3%
WACC (Post tax, nominal)
9.3%
* The beta is explained in Example 20.13 at 7.2 above.
However, the company has borrowed heavily and is in some financial difficulties. Its gearing ratio is 75%
and its actual cost of debt, based on the market price of its listed bonds, is 18% (13.5% after taking account
of tax at 25%). This makes its individual post-tax WACC 12.8% (10.6 × 25% + 13.5 × 75%). As a matter of
fact the entity’s individual post-tax WACC might actually be even higher than 12.8% as this rate is based on
a levered beta for a typical sector participant, while the entity’s own beta will probably be higher. Having
said this, the entity’s WACC is not an appropriate WACC for impairment purposes because it does not
represent a market rate of return on the assets. Its entity WACC has been increased by default risk.
Ultimately, it might be acceptable to use the entity’s own WACC, but an entity cannot
conclude on this without going through the exercise of assessing for risk each of the
assets or units and concluding on whether or not they contain additional risks that are
not reflected in the WACC.
7.2.9
Use of discount rates other than the WACC
IAS 36 allows an entity to use rates other than the WACC as a starting point in
calculating the discount rate. These include:
(a) the entity’s incremental borrowing rate; and
(b) other market borrowing rates. [IAS 36.A17].
If borrowing rates (which are, of course, pre-tax) were used as a starting point, could
this avoid some of the problems associated with adjusting the WACC for the effects of
taxation? Unfortunately, this is unlikely. Debt rates reflect the entity’s capital structure
and do not reflect the risk inherent in the asset. A pure asset/business risk would be
obtained from an entity funded solely by equity and equity risk premiums are always
observed on a post-tax basis. Therefore, the risk premium that must be added to reflect
the required (increased) return over and above a risk free rate by an investor will always
have to be adjusted for the effects of taxation.
Impairment of fixed assets and goodwill 1487
It must be stressed that the appropriate discount rate, which is the one that reflects current
market assessments of the time value of money and the risks specific to the asset in
question, ought to be the same whatever the starting point for the calculation of the rate.
Vodafone in its description of its pre-tax discount rate starts from the relevant bond (i.e.
debt) rate (Extract 20.3 at 14.3 below). However, this note also describes many of the
elements of the WACC calculation and how Vodafone has obtained these; it does not
suggest that Vodafone has used anything other than an adjusted WACC as a discount
rate for the purposes of the impairment test.
7.3
Differences between fair value and value in use
IFRS 13 is explicit that it does not apply to value in use, noting that its measurement and
disclosure requirements do not apply to ‘measurements that have some similarities to
fair value, such as [..] value in use ...’. [IFRS 13.6(c)]. IAS 36 includes an explanation of the
ways in which fair value is different to value in use. Fair value, it notes, ‘reflects the
assumptions market participants would use when pricing the asset. In contrast, value in
use reflects the effects of factors that may be specific to the entity and not applicable to
entities in general.’ [IAS 36.53A]. It gives a number of specific examples of factors that are
excluded from fair value to the extent that they would not be generally available to
market participants: [IAS 36.53A]
• the additional value derived from the grouping of assets. IAS 36’s example is of the
creation of a portfolio of investment properties in different locations;
• synergies between the asset being measured and other assets;
• legal rights or legal restrictions that are specific only to the current owner of the
asset; and
• tax benefits or tax burdens that are specific to the current owner of the asset.
By contrast, an entity calculating FVLCD may include cash flows that are not permitted
in a VIU calculation but only to the extent that other market participants would consider
them when evaluating the asset. For example, cash inflows and outflows relating to
future capital expenditure could be included if they would be taken into account by
market participants (see 7.1.2 above).
8
IMPAIRMENT OF GOODWILL
8.1
Goodwill and its allocation to cash-generating units
By definition, goodwill can only generate cash inflows in combination with other assets
which means that an impairment test cannot be carried out on goodwill alone. Testing
goodwill for impairment requires it to be allocated to a CGU or to a group of CGUs of the
acquirer. This is quite different to the process by which CGUs themselves are identified
as that depends on identifying the smallest group of assets generating largely independent
cash inflows. The cash flows of the CGU, or those of a CGU group if appropriate, must be
sufficient to support the carrying value both of the assets and any allocated goodwill.
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IFRS 3 states that the acquirer measures goodwill acquired in a business combination at
the amount recognised at the acquisition date less any accumulated impairment losses
and refers to IAS 36. [IFRS 3.B63(a)]. Initial recognition and measurement of goodwill
acquired in a business combination is discussed in Chapter 9 at 6.
From the acquisition date, acquired goodwill is to be allocated to each of the acquirer’s
CGUs, or to a group of CGUs, that are expected to benefit from the synergies of the
combination. This is irrespective of whether other assets or liabilities of the acquiree
are assigned to those CGUs or group of CGUs. [IAS 36.80].
The standard recognises that goodwill sometimes cannot be allocated on a non-
arbitrary basis to an individual CGU, so permits it to be allocated to a group of CGUs.
However, each CGU or group of CGUs to which the goodwill is so allocated must:
(a) represent the lowest level within the entity at which the goodwill is monitored for
internal management purposes; and
(b) not be larger than an operating segment determined in accordance with IFRS 8 –
Operating Segments – before aggregation. [IAS 36.80, 81].
All CGUs or groups of C
GUs to which goodwill has been allocated have to be tested for
impairment on an annual basis.
The standard takes the view that applying these requirements results in goodwill being
tested for impairment at a level that reflects the way an entity manages its operations
and with which the goodwill would naturally be associated. Therefore, the development
of additional reporting systems is typically not necessary. [IAS 36.82].
This is, of course, consistent with the fact that entities do not monitor goodwill directly.
Rather, they monitor the business activities, which means that goodwill allocated to the
CGUs or CGU groups that comprise those activities will be ‘monitored’ indirectly. This
also means, because goodwill is measured as a residual, that the goodwill balance in the
statement of financial position may include elements other than goodwill relating to
synergies. Some of these issues and their implications are discussed at 8.1.1 below. It also
means that internally-generated goodwill will be taken into account when calculating
the recoverable amount because the impairment test itself does not distinguish between
purchased and internally-generated goodwill.
However, the difficulties with the concept of monitoring goodwill do not mean that
entities can default to testing at an arbitrarily high level, e.g. at the operating segment
level or for the entire entity by arguing that goodwill is not monitored.
IAS 36 emphasises that a CGU to which goodwill is allocated for the purpose of
impairment testing may not coincide with the level at which goodwill is allocated in
accordance with IAS 21 for the purpose of measuring foreign currency gains and losses
(see Chapter 15). [IAS 36.83]. In many cases, the allocation under IAS 21 will be at a lower
level. This will apply not only on the acquisition of a multinational operation but could
also apply on the acquisition of a single operation where the goodwill is allocated to a
larger cash generating unit under IAS 36 that is made up of businesses with different