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.
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.