1. business and industrial

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In depth
A look at current financial
reporting issues
March 2015
No. INT2015-08
What’s inside:
Tip 1 - Reasonable and
supportable
Tip 2 - Cross-check
Tip 3 - Carrying amount
Tip 4 - Terminal value
Tip 5 – Discount rates
Impairment of non-financial assets – Expanding on
the top 5 tips for impairment testing
At a glance
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 nonfinancial assets’. This In depth provides a more detailed look at those 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
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.
[IAS36 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.
This content is for general information purposes only, and should not be used as a substitute
for consultation with professional advisors.
© 2015 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its
member firms, each of which is a separate legal entity. Please see www.pwc.com/structure for
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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.
Key assumptions should be disclosed
Key assumptions and management’s approach to determining values assigned to each
of those assumptions should be disclosed. [IAS36 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 companies 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:
This content is for general information purposes only, and should not be used as a substitute
for consultation with professional advisors.
© 2015 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its
member firms, each of which is a separate legal entity. Please see www.pwc.com/structure for
further details.
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

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 indefinitelived 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 cashgenerating 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:
Gross margin
Growth rate
Original assumption
25%
5%
Sensitivity analysis
24%
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).
This content is for general information purposes only, and should not be used as a substitute
for consultation with professional advisors.
© 2015 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its
member firms, each of which is a separate legal entity. Please see www.pwc.com/structure for
further details.
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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
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)].
Market capitalisation below net asset value
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for consultation with professional advisors.
© 2015 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its
member firms, each of which is a separate legal entity. Please see www.pwc.com/structure for
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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
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
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.
This content is for general information purposes only, and should not be used as a substitute
for consultation with professional advisors.
© 2015 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its
member firms, each of which is a separate legal entity. Please see www.pwc.com/structure for
further details.
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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
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
This content is for general information purposes only, and should not be used as a substitute
for consultation with professional advisors.
© 2015 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its
member firms, each of which is a separate legal entity. Please see www.pwc.com/structure for
further details.
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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.
Questions?
Authors
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 the IFRS Manual of Accounting chapter 18.
Mary Dolson
Partner
Phone: + (44) 207 804 2930
Email: mary.dolson@uk.pwc.com
Ruth Preedy
Senior Manager
Phone: + 44 (0) 207 213 2123
Email: ruth.e.preedy@uk.pwc.com
This content is for general information purposes only, and should not be used as a substitute
for consultation with professional advisors.
© 2015 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its
member firms, each of which is a separate legal entity. Please see www.pwc.com/structure for
further details.