IAS 36 - Impairment of non-financial assets – Expanding on the top 5 tips for impairment testing INT2015-08

Publication date: 02 Mar 2015

Recent months have been marked by increased volatility in global markets. This economic environment could lead to revised budgets and forecasts with an expectation of lower cash flows from existing non-financial assets. The amount of headroom in impairment tests is therefore likely to diminish. If an impairment review results in a ‘near miss’, entities should review their impairment methodology. Where a proxy for recoverable amount has previously been used, entities should reconfirm the methodology and check that the underlying assumptions are appropriate. Furthermore, impairment continues to be an area of concern for regulators as they push for increased transparency in disclosures.

We recently issued In brief 2015-02 ‘Top 5 tips for impairment reviews of non-financial assets’.

adobe_pdf_file_icon_32x32 In depth INT2015-08 provides a more detailed look at 5 key areas to focus on when completing your impairment review for non-financial assets.

There are two methods to calculate recoverable amount under IAS 36: fair value less cost of disposal (FVLCD); and value in use (VIU). FVLCD is a market participant approach, although almost always based on a cash flow model. VIU is cash flow model, with specific requirements and limitations defined by the standard. The carrying amount of the assets or CGU is compared to the higher of FVLCD and VIU to determine any impairment charge.

1. Cash flows must be reasonable and supportable - Realistic assumptions

Publication date: 15 Apr 2014

Cash flow forecasts should be based on the latest management-approved budgets or forecasts. Assumptions made in the cash flows should be reasonable and supportable. [IAS 36 para 33]. They should represent management’s best estimate of the economic circumstances that will prevail over the remaining life of the asset or cash-generating unit (CGU). The cash flows to be used in a discounted cash flow prepared to determine FVLCD might well be different from those in a VIU calculation. Any differences in the cash flows used under the two methods should be considered for reasonableness.

Greater weight should be given to external evidence. For example, the cash flows/forecasts should be compared with external information, such as analysts’ reports, the views of other third-party experts and economic forecasters. Disclosure is required if the cash flows are inconsistent and there is an increased chance of regulator comment.

Example 1 – Supportable growth rates

Entity L is a manufacturer and retailer of household furniture. Management has estimated growth of 4.5% for the next year and 6% for the following two years in the cash flow forecasts. Growth in recent years has been broadly in line with these estimates.

What are some other factors that management should consider?

In assessing whether the assumptions are reasonable for the next few years, these growth assumptions could firstly be compared to the overall market GDP growth. This is predicted to be approximately 1.25% in 20X6 based on current market data, and this might suggest that the assumptions are optimistic.

Management might want to look at market data available on consumer spending. Considerable growth in discretionary spending might be unlikely, given the high personal debt levels, tighter credit conditions and sharply increasing bills in other areas.

A recent summary of independent economic forecasts indicates that personal consumption is expected to rise 1.8% this year, with no growth in 20X6. Management has observed that historic sales growth patterns vary in line with personal consumption. Sector-specific forecasts could also be considered.

Management might decide to revise forecasts of volume growth in line with market expectations of no growth for the next three years. This would give rise to an impairment of purchased goodwill.

1. Cash flows must be reasonable and supportable - Key assumptions should be disclosed

Publication date: 15 Apr 2014

Key assumptions and management’s approach to determining values assigned to each of those assumptions should be disclosed. [IAS 36 para 134]. If key assumptions differ from those indicated by external sources of information or past experience, an explanation is also required.

IAS 36, ‘Impairment of assets’, and IAS 1, ‘Presentation of financial statements’, have extensive disclosure requirements. Market regulators around the world have identified that some entities are not including all of the required disclosures.

The European Securities and Markets Authority (ESMA) Enforcement Priorities 2014 included the following on impairment:

“When the safety margin in a goodwill impairment test is low, issuers should provide more detailed assumptions (together with explanations as to how these assumptions were made, linking them to external evidence and past experience) and disclose analyses related to the sensitivity of the results of the test.”

Common disclosure omissions include:

  • The long-term growth rate assumptions for both VIU and FVLCD. [IAS 36 para 134(d), (e)].
  • Each key assumption made and management’s approach to determining values assigned to each assumption. [IAS 36 para 134].

Key assumptions are those to which the recoverable amount is most sensitive (for example, assumptions on revenue growth and profit margins).

Additional sensitivity disclosures are required for significant goodwill or indefinite-lived intangible asset balances if a reasonably possible change in a key assumption causes the carrying amount to exceed its recoverable amount [IAS 36 para 134(f)], known as a ‘near miss’. Sensitivity analysis deserves extra attention, given the current volatile markets.

The following example illustrates the level of additional disclosure that is required.

Example 2 – Sensitivity disclosure

Management of entity C has carried out an impairment test on a group of cash-generating units (CGUs) with allocated goodwill of CU125 million. It has identified that the recoverable amount is marginally higher than the carrying amount.

The recoverable amount is CU10 million or 3% higher than the carrying amount. A sensitivity analysis was performed where the following changes in key assumptions resulted in the recoverable amount falling to an amount equal to the carrying amount:

  Original assumption Sensitivity analysis
Gross margin 25% 24%
Growth rate 5% 4.7%

These potential changes in key assumptions fall well within historic variations experienced by the business and are reasonably possible.

What are the additional disclosure requirements that are triggered?

Many disclosures are already required, including descriptions of the CGUs, the approach to impairment testing and forecasts, and what they have been based on. Below is a list of the additional disclosures required for a ‘near miss’:

  • The amount of headroom − that is, the amount by which the recoverable amount exceeds the carrying value (CU10 million).
  • The values assigned to the key assumptions used in the sensitivity analysis (gross margin of 25%, and revenue growth rate of 5%).
  • The amounts by which the key assumptions would have to change in order for the change to result in the recoverable amount equalling the carrying amount (gross margin fall by 1%, and growth rate decrease by 0.3%).
  • The aggregate carrying amount of goodwill allocated to the CGU(s) (CU125 million), and the aggregate carrying amount of intangible assets with indefinite useful lives allocated to the CGU(s).

Management might regard values assigned to key assumptions as sensitive, but there are no disclosure exemptions.

2. Use cross-checks to gain comfort - Cross-check to market data

Publication date: 15 Apr 2014

The cash flow forecast should be cross-checked to ensure that the final answer reconciles to external market data. The current economic climate means that assumptions that were reasonable a year ago might no longer be appropriate. For example, growth in cash flows might be unlikely in the Eurozone, where the market view is that there is a significant risk of deflation and a lack of real growth in many countries. 

It is possible to obtain analyst reports for most market sectors. These should be considered as evidence to support growth assumptions. Comparable transactions, and multiples implied in these transactions, can also be a useful benchmark.

Example 3

Entity H, a construction company, has prepared its discounted cash flow calculations for impairment testing as at 30 June 20X4 (year end).

Management bases its value-in-use calculation on a number of key assumptions (including a rapid recovery from the current downturn). The model produces a recoverable amount that is 10 times forecast earnings for 20X5. The calculation indicates that there is no impairment.

Management should cross-check its cash flow calculations to available market data. For example, a competitor to entity H was recently sold at a price equivalent to a multiple of five times 20X5 forecast earnings, a considerable drop from 12 months ago when it was quoted at a share price that valued it at a multiple of 12 times forecast earnings.

Property prices in the local market over the past year have dropped considerably. With the experts predicting no recovery until after 20X6, the slump in the housing market has severe implications for the wider construction industry.

Considering the external market data from a number of sources, entity H’s management might be optimistic in its calculation. If the assumptions used by management remain inconsistent with external information, management will be required to disclose this fact and the reasons why it thinks it is appropriate to use these assumptions. [IAS 36 para 134(d)(ii)].

2. Use cross-checks to gain comfort - Market capitalisation below net asset value

Publication date: 15 Apr 2014

If the entity is a public company, market capitalisation is another external data point that should be considered to reconcile to cash flow forecasts. Market capitalisation below net asset value is an explicit trigger for an impairment test. [IAS 36 para 12(d)]. If the market capitalisation is lower than a VIU calculation, a reasonable challenge to the appropriateness of the assumptions is justified.

3. Carrying amount

Publication date: 15 Apr 2014

Cash flows being used in the recoverable amount should be consistent with the assets being tested in the carrying amount of the CGU. The impairment test should compare like with like. Working capital and tax are two key areas to consider. 

The carrying amount includes only the assets that generate future cash flows used in determining VIU. Many entities preparing cash flow forecasts for the purposes of impairment testing base their forecasts on the underlying cash flow forecasts for the business. These include cash flows from the settlement of working capital balances at the year end. IAS 36 permits these entities to leave the forecasts unadjusted, as long as the carrying value of the CGU is increased by the amount of the working capital assets and reduced by the value of the working capital liabilities.

Cash outflows relating to obligations that have already been recognised as liabilities are generally excluded, as the related liability is excluded from the CGU. Examples of such liabilities include debt, pensions and provisions. A liability is only included in the CGU if the recoverable amount of the CGU cannot be determined without consideration of this liability. [IAS 36 para 76(b)]. Decommissioning liabilities are often included, because they cannot be detached from the related assets.   

Cash flow forecasts should exclude cash flows relating to financing (including interest payments); this is because liabilities are excluded from the carrying amount, and the cost of capital is taken into account by discounting the cash flows. Cash flows should exclude cash flows relating to tax losses, because these do not affect the recoverable amount of the CGU being tested. Current and deferred taxes are excluded from VIU cash flows [IAS 36 para 50(a)] but should be included in FVLCD cash flows.

4. Terminal value

Publication date: 15 Apr 2014

An asset with a finite life should have cash flows projected over that period. An asset or business with an indefinite life requires a terminal value in the cash flow forecast. This represents what an investor might pay for the cash flows beyond the specific forecast period.

This is calculated either as an exit multiple or as a perpetuity formula which takes the last year of cash flows and projects them indefinitely. An exit multiple should be based on market data and is applied to the cash flow in the last year of the projections. Whichever method is chosen, it is important that the cash flows used are sustainable. Careful consideration is needed as to whether the business is cyclical and whether there is any mismatch between capital expenditure and depreciation.

It is important to ensure that the forecast period is long enough to achieve normalised growth and margin levels. If it is too short, the entire valuation will be dependent on the terminal value; any bias or error will be amplified.

The long-term growth rate should be reasonable in comparison to long-term inflation expectations. Nominal long-term growth rates in excess of long-term nominal GDP growth imply that the business will eventually grow larger than the economy itself. This is unlikely to be appropriate.

5. Discount rates

Publication date: 15 Apr 2014

Many companies use the capital asset pricing model to determine the discount rate. 

Many of the inputs into this model have changed, given current market conditions. Bond yields in many major currencies (such as Sterling, US Dollar, Euro) are lower at 31 December 2014 than they were at 31 December 2013. The decline in the risk-free rate (government bond yields) might be offset by an increase in other inputs (for example, the equity market risk premium). 

The discount rate used is the rate that reflects the specific risks of the asset or CGU. Different CGUs might warrant different discount rates. The discount rate should not be adjusted for risks that have already been considered in projecting future cash flows. In most cases, however, discounted cash flow calculations based on approved budgets will not have been risk-adjusted, so an adjustment should be made to the discount rate. Management should also consider country risk, currency risk and cash flow risk.

Example 5

A group’s businesses include water utility and biotechnology subsidiaries.

The water utility has a lower risk profile than the biotechnology subsidiary. The biotechnology subsidiary was financed entirely by debt at formation; the water utility was financed by debt and equity. The debt is secured on the assets of the entire group.

The subsidiaries are separate CGUs. The discount rate used to test the biotechnology subsidiary for impairment should be derived separately from the water utility subsidiary, in view of the greater risk in the biotechnology sector. Further, the rate should be determined regardless of the actual capital structure of the subsidiaries.

VIU is calculated on pre-tax cash flows using a pre-tax rate. The weighted average cost of capital (WACC) is commonly used as the discount rate in impairment testing and is a post-tax rate. So an iterative process is needed. In practice, however, where the headroom is considered sufficiently high, entities often use post-tax cash flows against a post-tax rate. In the current economic environment, this approach might no longer be appropriate, and a pre-tax model should be used.

Foreign currency cash flows add complexity to the discount rate. The future cash flows are estimated in the currency in which they will be generated and then discounted at an appropriate rate for that currency. This discount rate might not be easy to determine. It is likely to be different from the rate used for the remainder of the present value calculation, because it is country and currency-risk specific.

The present value of the foreign currency cash flows should be translated at the spot rate at the date when the impairment review is being performed. A more reliable estimate of future exchange rates than the current rate cannot be made. IAS 36 prohibits use of the forward rate existing at the date of the impairment review.


PwC clients who have questions about this In depth should contact their engagement partner. Engagement teams that have questions should contact members of the business combinations team in Accounting Consulting Service. More information on impairments can be found in chapter 18 of the Manual of accounting - IFRS.

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