The standard describes in some detail the responsibilities of management towards the estimation of cash flows. Management is required to ensure that the assumptions on which its current cash flow projections are based are consistent with past actual outcomes by examining the causes of differences between past cash flow projections and actual cash flows. If actual cash flows have been consistently below projected cash flows, then management has to investigate the reason for it and assess whether the current cash flow projections are realistic or require adjustment. [IAS 36.34].

IAS 36 states that the cash flows must be based on the most recent budgets and forecasts for a maximum of five years because reliable forecasts are rarely available for a longer period. If management is confident that its projections are reliable and can demonstrate this from past experience, it can use a longer period. [IAS 36.35]. In using budgets and forecasts, management is required to consider whether these really are the best estimate of economic conditions that will exist over the remaining useful life of the asset. [IAS 36.38]. In particular the standard observes that estimated cash flows and discount rates must be free from both bias and factors unrelated to the asset in question. [IAS 36.A3].

An example of the use of cash flow projections for a period shorter than five years is given by Hunter Douglas N.V. The following extract from the annual report of Hunter Douglas N.V. refers to cash flow projections covering a single year.

Cash flows for the period beyond that covered by the forecasts or budgets assume a steady, declining or even negative rate of growth. An increase in the rate can be used if it is supported by objective information about patterns over a product or industry lifecycle. [IAS 36.36].

Therefore, only in exceptional circumstances can an increasing growth rate be used, or can the period before a steady or declining growth rate be assumed to extend to more than five years. This five year rule is based on general economic theory that postulates above-average growth rates will only be achievable in the short-term, because such above-average growth will lead to competitors entering the market. This increased competition will, over a period of time, lead to a reduction of the growth rate, towards the average for the economy as a whole. IAS 36 suggests that entities will find it difficult to exceed the average historical growth rate for the products, countries or markets over the long-term, say twenty years. [IAS 36.37].

This stage of the impairment test illustrates the point that it is not only fixed assets that are being assessed. The future cash flows to be forecast are all cash flows - receipts from sales, purchases, administrative expenses, etc. It is akin to a free cash flow valuation of a business with the resulting valuation then being compared to the carrying value of the assets in the CGU.

As explained in the following standard extract, the cash flow forecast must include three elements: [IAS 36.39]

Cash flows can be estimated by taking into account general price changes caused by inflation (nominal terms), or on the basis of stable prices (real terms). If inflation is excluded from the cash flow, then the discount rate selected must also be adjusted to remove the inflationary effect. [IAS 36.40]. Generally, entities will use whichever method is most convenient to them that is consistent with the method they use in their budgets and forecasts. It is, of course, fundamental that cash flows and discount rate are both estimated on a consistent basis.

Whereas IAS 36 requires the cash flow projections to be based on the most recent financial budgets/forecasts approved by management, significant adjustments can be necessary to ensure the resulting future cash flows satisfy the requirements of the standard (for example the exclusion of lease payments included in lease liabilities or cash flows that are expected to arise from improving or enhancing the asset’s performance). Depending on the entity’s facts and circumstances, these adjustments can require significant effort and judgement. It is important for entities to consider materiality when determining the extent to which the task can be simplified.

In some cases entities are receiving government grants and these cash flows are part of the recoverable amount, for example government grants intended to compensate the asset or CGU’s operating costs such as employee benefits or commodities. Entities should carefully consider the conditions of any government grant in order to assess whether the inclusion of such amounts in the impairment test is based on reasonable and supportable assumptions that represent management’s best estimate of the range of economic conditions that will exist over the remaining useful life of the asset or CGU.

To avoid the danger of double counting, the future cash flows exclude those relating to financial assets, including receivables and liabilities such as payables, pensions and provisions. [IAS 36.43]. However, section 4 above notes that IAS 36.79 allows the inclusion of such assets and liabilities for practical reasons, in which case the cash flows must be reflected as well, and includes a discussion of some of the assets and liabilities that entities can choose to reflect together with the implications of doing so. [IAS 36.79].

The expected future cash flows of the CGU being assessed for impairment must not include cash inflows or outflows from financing activities (including lease payments included in lease liabilities) or tax receipts or payments. This is because the discount rate used represents the financing costs and the future cash flows are themselves determined on a pre-tax basis. [IAS 36.50, IAS 36.51].

Whilst a part-completed asset must have the costs to complete it included in the cash flows, [IAS 36.42], the general rule is that future cash flows must be forecasted for CGUs or assets in their current condition. Forecasts must not include estimated future cash inflows or outflows that are expected to arise from improving or enhancing the asset’s performance. [IAS 36.44]. Projections of cash flow must include costs of day-to-day servicing that can be reasonably attributed to the use of the asset (for overheads see section 7.1.7 below). [IAS 36.41].

While the restriction on enhanced performance is understandable, it adds an element of unreality that is hard to reconcile with other assumptions made in the VIU process. For example, the underlying future cash flows that the standard requires management to use will obviously be based on the business as it is actually expected to develop in the future, growth, improvements and all. Producing a special forecast based on unrealistic assumptions, even for this limited purpose, can be difficult.

Nevertheless, IAS 36.48 explicitly states that improvements to the current performance of an asset cannot be included in the estimates of future cash flows until the entity incurs the expenditure that provides those improvements. The treatment of such expenditure is illustrated in Example 6 in the standard’s accompanying section of illustrative examples. [IAS 36.48]. The implication of this requirement is that if an asset is impaired, and even if the entity is going to make the future expenditure to reverse that impairment, the asset will still have to be written down. Subsequently, the asset’s impairment can be reversed, to the degree appropriate, after the expenditure has taken place. Reversal of asset impairment is discussed in section 11.4 below.

IAS 36 makes it clear that for a part-completed asset, all expected cash outflows required to make the asset ready for use or sale must be considered in the estimate of future cash flows, and mentions a building under construction or a development project as examples. [IAS 36.42]. The standard is also clear that the estimate of future cash flows must not include the estimated future cash inflows that are expected to arise from the increase in economic benefits associated with cash outflows to improve or enhance an asset’s performance until an entity incurs these cash outflows. [IAS 36.48]. This raises the question of what to do once a project to enhance or improve the performance of an asset or a CGU has commenced and it has started to incur cash outflows.

An assumption of new capital investment is in practice intrinsic to the VIU test. What has to be assessed are the future cash flows of a productive unit such as a factory or hotel. The cash flows, out into the far future, will include the sales of product, cost of sales, administrative expenses, etc. They must necessarily include capital expenditure as well, at least to the extent required to keep the CGU functioning as forecast. This is explicitly acknowledged in the standard: [IAS 36.49]

Accordingly, some capital expenditure cash flows must be built into the future cash flows. Whilst improving capital expenditure cannot be recognised, routine or replacement capital expenditure necessary to maintain the function of the asset or assets in the CGU has to be included. Entities must therefore distinguish between maintenance, replacement and enhancement expenditure. This distinction is not always easy to draw in practice, as shown in the following Illustration.

Further examples indicate another problem area - the effects of future expenditure that the entity has identified but which the entity has not yet incurred. One example is an entity that has acquired an asset with the intention of enhancing it in future and, therefore, has paid for future synergies which will be reflected in the calculation of goodwill. Another example is an entity with plans for an asset that involve expenditure that will enhance its future performance and without which the asset is impaired.

Examples could include:

• A social media company that, in acquiring another, would expect to pay for the future right to migrate users from the competing platform to its own platform.

  Or

• An aircraft manufacturer that expects to be able to use one of the acquired plants for a new model at a future point, a process that will involve replacing much of the current equipment.

In both cases the long-term plans reflect both the capital spent and the cash flows that will flow from it. There is no obvious alternative to recognising an impairment when calculating the CGU or group of CGUs’ VIU as IAS 36 insists that the impairment test has to be performed for the asset in its current condition. This means that it is not permitted to include the benefit of improving or enhancing the asset’s performance in calculating its VIU.

In the TV example above, it does not appear to matter whether the entity recognises goodwill or has a separable intangible right that is not yet available for use.

An entity in this situation can avoid or reduce an impairment write down by calculating the appropriate FVLCD, as this is not constrained by rules regarding future capital expenditure. As discussed above, these cash flows can be included only to the extent that other market participants would consider them when evaluating the asset. It is not permissible to include assumptions about cash flows or benefits from the asset that would not be available to or considered by a typical market participant.

An example of the inclusion of capital expenditure cash flows in the forecasted cash flows is given by ArcelorMittal. The following extract from the annual report of ArcelorMittal refers to the inclusion of future decarbonization capital expenditures.

The standard contains similar rules with regard to any future restructuring that affects the VIU of the asset or CGU. The prohibition on including the results of restructuring applies only to those plans to which the entity is not committed. Again, this is because of the general rule that the cash flows must be based on the asset in its current condition so future events that change that condition are not to be taken into account. [IAS 36.44, IAS 36.45]. When an entity becomes committed to a restructuring (as set out in IAS 37 see Chapter 26), IAS 36 then allows an entity’s estimates of future cash inflows and outflows to reflect the cost savings and other benefits from the restructuring, based on the most recent financial budgets/forecasts approved by management. [IAS 36.46, IAS 36.47]. Treatment of such a future restructuring is illustrated by Example 5 in the standard’s accompanying section of illustrative examples. The standard specifically points out that the increase in cash inflows as a result of such a restructuring is not taken into account until after the entity is committed to the restructuring. [IAS 36.47].

Entities will sometimes be required to recognise impairment losses that will be reversed once the expenditure has been incurred and the restructuring completed.

In the case of non-current assets, a large component of value attributable to an asset or CGU arises from its terminal value, which is the net present value of all of the forecasted free cash flows that are expected to be generated by the asset or CGU after the explicit forecast period. IAS 36 includes specific requirements if the asset is to be sold at the end of its useful life. The disposal proceeds and costs must be based on current prices and costs for similar assets, adjusted if necessary for price level changes if the entity has chosen to include this factor in its forecasts and selection of a discount rate. The entity must take care that its estimate is based on a proper assessment of the amount that would be received in an arm’s length transaction. [IAS 36.52, IAS 36.53].

Whether the life of an asset or CGU is considered to be finite or indefinite will have a material impact on the terminal value. It is therefore of the utmost importance for management to assess carefully the cash generating ability of the asset or CGU and whether the period over which this asset or CGU is capable of generating cash flows is defined or not. While many CGUs containing goodwill will have an indefinite life, the same is not necessarily true for CGUs without allocated goodwill. For example, if a CGU has one main operating asset with a finite life, as in the case of a mine, the cash flow period needs to be limited to the life of the mine. Whether it would be reasonable to assume that an entity would replace the principal assets of a CGU and therefore whether it would be appropriate to calculate the terminal value under consideration of cash flows into perpetuity will depend on the specific facts and circumstances.

In the case of assets or CGUs with indefinite useful lives, the terminal value is calculated by having regard to the forecasted maintainable cash flows that are expected to be generated by the assets or CGUs in the final year of the explicit forecast period (‘the terminal year’). It is essential that the terminal year cash flows reflect maintainable cash flows as otherwise any material one-off or abnormal cash flows that are forecast for the terminal year will inappropriately increase or decrease the valuation.

The maintainable cash flow expected to be generated by the asset or CGU is then capitalised by a perpetuity factor based on either:

• The discount rate if cash flows are forecast to remain relatively constant

  Or

• The discount rate less the long-term growth rate if cash flows are forecast to grow

Care is required in assessing the growth rate to ensure consistency between the long-term growth rate used and the assumptions used by the entity generally in its business planning. IAS 36 requires an entity to use in the VIU calculation a steady or declining growth rate for subsequent years, unless an increasing rate can be justified. This growth rate must not exceed the long-term average growth rate for the products, industries, or country or countries in which the entity operates, or for the market in which the asset is used, unless a higher rate can be justified. [IAS 36.33].

Foreign currency cash flows are first estimated in the currency in which they will be generated and then discounted using a discount rate appropriate for that currency. An entity translates the present value calculated in the foreign currency using the spot exchange rate at the date of the value in use calculation. [IAS 36.54]. This is to avoid the problems inherent in using forward exchange rates, which are based on differential interest rates. Using such a rate would result in double-counting the time value of money, first in the discount rate and then in the forward rate. [IAS 36.BCZ49]. However, the method requires an entity to perform, in effect, separate impairment tests for cash flows generated in different currencies but make them consistent with one another so that the combined effect is meaningful. This is an extremely difficult exercise. Many different factors need to be taken into account including relative inflation rates and relative interest rates as well as appropriate discount rates for the currencies in question. Because of this, the possibility for error is great and the greatest danger is understating the present value of cash outflows by using too high a discount rate. In practice, valuers can assist entities to obtain a sufficiently accurate result by assuming that cash flows are generated in a single currency even though they are received or paid in another. Significantly, the rate used to translate the cash flows could well be different from that used to translate the foreign currency assets, goodwill and liabilities of a subsidiary at the period end. For example, a non-monetary asset such as an item of property, plant and equipment can be carried at an amount based on exchange rates on the date on which it was acquired but generates foreign currency cash flows. In order to determine its recoverable amount if there are indicators of impairment, IAS 21 The Effects of Changes in Foreign Exchange Rates states that the recoverable amount will be calculated in accordance with IAS 36 and the present value of the cash flows translated at the exchange rate at the date when that value was determined. [IAS 21.25]. IAS 21 notes that this can be the rate at the reporting date. The VIU is then compared to the carrying value and the item is then carried forward at the lower of these two values.

If the cash inflows generated by the asset or CGU are based on internal transfer pricing, the best estimate of an external arm’s length transaction price must be used in estimating the future cash flows to determine the asset’s or CGU’s VIU. [IAS 36.70]. Note that this applies to any cash inflow once a CGU has been identified; it is not restricted to CGUs that have been identified because there is an active market for their outputs, which are described in section 3.3 above.

In practice, transfer pricing can be based on estimated market values, perhaps with a discount or other adjustment, be a cost-based price or be based on specific negotiation between the group companies. Transfer prices will reflect the taxation consequences to the transferring and acquiring companies and the prices can be agreed with the relevant taxation authorities. This is especially important to multinational companies but can also affect transfer prices within a single jurisdiction.

Transfer pricing is extremely widespread. The following Illustration describes a small number of bases for the pricing and the ways entities verify whether they approximate an arm’s length transaction price. Even where the methodology is appropriate, it is still necessary to ensure that the inputs into the calculation are reasonable. It is possible that an arm’s length price is not a particular price point but rather a range of prices.

When calculating the VIU, entities include projections of cash outflows that are:

1. (i)

   Necessarily incurred to generate the cash inflow from continuing use of the asset (or CGU)

   And

2. (ii)

   Can be directly attributed, or allocated on a reasonable and consistent basis to the asset (or CGU) [IAS 36.39(b)]

Projections of cash outflows include those for the day-to-day servicing of the asset/CGU as well as future overheads that can be attributed directly, or allocated on a reasonable and consistent basis, to the use of the asset/CGU. [IAS 36.41].

Generally, overhead costs that provide identifiable services to a CGU (e.g., IT costs from a centralised function) as well as those that would be incurred by a CGU if it needed to perform the related tasks when operating on a ‘stand-alone basis’ (e.g., financial reporting function) must be allocated to the CGU being tested for impairment.

Conversely, overhead costs that are incurred with a view to acquire and develop a new business (e.g., costs for corporate development such as M&A activities) would generally not be allocated. These costs are similar in nature to future cash inflows and outflows that are expected to arise from improving or enhancing a CGU’s performance which are not considered in the VIU according to IAS 36.44. [IAS 36.44].

The selection of a reasonable and consistent allocation basis of overhead costs will require analysis of various factors including the nature of the CGU itself. A reasonable allocation basis for identifiable services can be readily apparent, for example in some cases volume of transaction processing for IT services or headcount for human resource services can be appropriate. However, a reasonable allocation basis for stewardship costs that are determined to be necessarily incurred by the CGU to generate cash inflows can require more analysis. For example, an allocation basis for stewardship costs such as revenue or headcount can be inappropriate when CGUs have different regulatory environments, (i.e., more regulated CGUs can require more governance time and effort) or maturity stages (i.e., CGUs in mature industries can require less governance effort). The allocation basis can differ by type of cost and in some cases can reflect an average metric over a period of time rather than a metric for a single period or can reflect future expected, rather than historic, metrics.

Overheads not fully pushed down to the lowest level of CGUs need to be included in an impairment test at a higher level group of CGUs if it can be demonstrated that the overhead costs are necessarily incurred and can be attributed directly or allocated on a reasonable and consistent basis at that higher level. After a careful analysis, there could be instances when certain overhead costs are excluded from cash flow projections on the basis that they do not meet the criteria under IAS 36.39(b).

Many entities make internal charges, often called ‘management charges’, which purport to transfer overhead charges to other group entities. Care must be taken before using these charges as a surrogate for actual overheads as they are often based on what is permitted, (e.g., by the taxation authorities), rather than actual overhead costs. There is also the danger of double counting if a management charge includes an element for the use of corporate assets that have already been allocated to the CGU being tested, e.g., an internal rent charge.

In certain situations, it can be argued that some stewardship costs are already included in the impairment test through the discount rate used. This would among other factors depend on the way the discount rate has been determined, and whether the relevant stewardship cost is regarded more as a shareholder cost covered in the shareholders’ expected return rather than a cost necessarily incurred by the CGU to generate the relevant cash flows. Due to the complexity of such an approach it would need to be applied with appropriate care.

In many jurisdictions employees’ remuneration packages include share-based payments. Share-based payments are cash-settled, equity-settled or give the entity or the counterparty the choice of settlement in equity or in cash. In practice, many share-based payment transactions undertaken by entities are awards of equity-settled shares and options. This gives the entity the possibility of rewarding employees without incurring any cash outflows and instead the cash costs are ultimately borne by the shareholders through dilution of their holdings.

When it comes to impairment assessment, a question that entities often face is whether and how to consider share-based payments in the recoverable amount, in particular the VIU calculation. IAS 36 itself does not provide any specific guidance as to whether or how share-based payments are considered in determining the recoverable amount.

As IAS 36 focuses on cash flows in determining VIU, it seems that expected cash outflows in relation to cash-settled share-based payments would need to be reflected in the VIU calculation. As noted in section 4.1 above, consistency is a very important principle underlying IAS 36. Therefore, in relation to cash-settled share-based payments, entities must be consistent in the extent to which cash flows resulting from these arrangements are included in the carrying amount of the CGU and the cash flows used to determine the value in use. Where the future expected cash flows used in determining the value in use are limited to the expected cash outflows in excess of the liability already recognised at that date in the VIU calculation, the liability already recognised at the date of the VIU determination cannot be included in the carrying amount of the CGU. In contrast, if the entity includes all the future expected cash outflows in determining the value in use, the liability already recognised at the date of the VIU determination must be included in the carrying amount of the CGU in order to be consistent.

Assume for example a cash-settled share-based payment plan with total expected cash outflow of CU90 of which CU30 has already been recognised in a liability. If CU60 is included in the cash flows used to determine the value in use, the liability of CU30 cannot be included in the carrying amount of the CGU. If on the other hand CU90 is included in the cash flows used to determine the value in use, the liability of CU30 must be included in the carrying amount of the CGU.

While theoretically this seems to be straight forward, in practice it can be quite a challenging and judgemental task, in particular when the entity consists of a large number of CGUs. Share-based payments are in general awarded by the parent to employees within the group. It is possible that there is no correlation between any change in the value of share-based payments after the grant date and the performance of the employing CGU. This can be relevant in assessing whether and how such changes in value and the ultimate expected cash flows are allocated to a specific CGU.

What is even less clear is how an entity reflects equity-settled share-based payments in the VIU calculation. Such share-based payment transactions may never result in any cash outflows for the entity - for example when newly issued shares are used to settle the equity-settled share-based payment plan, and therefore a literal reading of IAS 36 can indicate that they can be ignored in determining the recoverable amount. However, some argue an entity must appropriately reflect all share-based payments in the VIU calculation, whether or not these result in a real cash outflow to the entity. They note that share-based payments are part of an employee’s remuneration package and therefore represent costs (in line with the treatment under IFRS 2 Share-based Payment) incurred by the entity for services from the employee. Others argue that they need to be considered through adjusting the discount rate in order to reflect a higher return to equity holders to counter the dilutive effects of equity settled share-based payment awards. This also depends on the way the discount rate is determined, and whether the level of equity-settled share-based plans are in line with the peer group used to determine the discount rate. If this is not the case it is likely adjustments are needed in order to reflect the higher return in the current market assessment. In practice this can be very difficult and judgmental to determine.

IAS 36 mentions averages and computational short cuts may provide reasonable approximations of the detailed computations. In certain situations IAS 36 allows for elements to be included either in the discount rate or in the cash flows. Based on this it might be possible to adjust the cash flows in order to get to a reasonable approximation of the effect on value in use. [IAS 36.23, 32].

The time span over which the recoverable amount is calculated is often much longer than the time period for which share-based payments have been awarded. Companies and their employees would often expect that further share-based payment awards will be made in the future during the time period used for the recoverable amount calculation. Depending on the respective facts and circumstances an entity would need to consider how to include the effect of share-based payments over a longer period, considering the discussion above.

7.1.9.A Lease payments during the lease term

7.1.9.B Lease payments beyond the current lease term

Events after the reporting period and information received after the end of the reporting period must be considered in the impairment assessment only if changes in assumptions provide additional evidence of conditions that existed at the end of the reporting period. Judgement of all facts and circumstances is required to make this assessment.

Information available after the year end can provide evidence that conditions were much worse than assumed. Whether an adjustment to the impairment assessment would be required or not would depend on whether the information casts doubts on the assumptions made in the estimated cash flows for the impairment assessment.

Competitive pressures resulting in price reductions after the year end do not generally arise overnight but normally occur over a period of time and can represent a reaction to conditions that already existed at the year-end in which case management would reflect this in the year end impairment assessment.

IAS 10 Events after the Reporting Period distinguishes events after the reporting period between adjusting and non-adjusting events (see Chapter 33). IAS 10 mentions abnormally large changes after the reporting period in asset prices or foreign exchange rates as examples of non-adjusting events and therefore these changes would in general not be a reason to update year end impairment calculations. The standard implies that abnormally large changes must be due to an event that occurred after the period end and therefore more or less assumes that the cause of such abnormally large changes are not conditions that already existed at the year-end. However, management would need to carefully assess the reason for the abnormally large change and consider whether it is due to conditions which already existed at the period end.

As stated in section 7.1 above, cash flow projections used for the impairment test are based on recent financial budgets/forecasts approved by management. This begs the question what to do if a new budget/forecast is approved by management after the reporting period end but before the accounts are authorised for issue? A similar question arises in group scenarios where subsidiaries’ accounts are authorised for issue a significant time after the group accounts were authorised for issue. In both scenarios the same general considerations as explained above would apply. An entity would need to assess whether the revised budget/forecast is due to conditions that already existed at the reporting period end and therefore would need to be considered in the impairment assessment, or whether the change in budget/forecast is due to circumstances that arose after the end of the reporting period and therefore would only be considered in subsequent impairment tests. In a group scenario, this could lead to a situation where the revised budget/forecast would need to be considered on a subsidiary level when the subsidiaries’ accounts are authorised for issue after the revised budget was approved, despite the fact that the group accounts were already authorised for issue based on the previous budget.

The elements that must be taken into account in calculating VIU are described in section 7 above. IAS 36 requires an estimate of the future cash flows the entity expects to derive from the asset and the time value of money, represented by the current market risk-free rate of interest, to be reflected in the VIU calculation. However, the other elements that must be taken into account, all of which measure various aspects of risk, are dealt with either as adjustments to the discount rate or to the cash flows. These elements are:

• Expectations about possible variations in the amount or timing of those future cash flows

• The price for bearing the uncertainty inherent in the asset

  And

• Other factors, such as illiquidity that market participants would reflect in pricing the future cash flows the entity expects to derive from the asset [IAS 36.30]

Adjusting for these factors in the discount rate is termed the ‘traditional approach’ in Appendix A to IAS 36. Alternatively, under the ‘expected cash flow’ approach these adjustments are made in arriving at the risk-adjusted cash flows. Either method can be used to compute the VIU of an asset or CGU. [IAS 36.A2].

The traditional approach uses a single set of estimated cash flows and a single discount rate, often described as ‘the rate commensurate with the risk’. This approach assumes that a single discount rate convention can incorporate all expectations about the future cash flows and the appropriate risk premium and therefore places most emphasis on the selection of the discount rate. [IAS 36.A4].

Due to the problems and difficulties around capturing and reflecting all of the variables into a single discount rate (for example, when there is significant uncertainty related to future events), IAS 36 notes that the expected cash flow approach could be the more effective measurement tool. [IAS 36.A6, IAS 36.A7].

The expected cash flow approach is a probability weighted net present value approach. This approach uses all expectations about possible cash flows instead of a single most likely cash flow and assigns probabilities to each cash flow scenario to arrive at a probability weighted net present value. The use of probabilities is an essential element of the expected cash flow approach. [IAS 36.A10]. The discount rate then considers the risks and variability for which the cash flows have not been adjusted. Appendix A notes some of the downsides of this approach, e.g., that the probabilities are highly subjective and that it can be inappropriate for measuring a single item or one with a limited number of outcomes. Nonetheless, it considers the most valid objection to the method to be the costs of obtaining additional information when weighed against its ‘greater reliability’. [IAS 36.A10, IAS 36.A11, IAS 36.A12, IAS 36.A13].

Even where an expected cash flow approach is used, an entity would still need to consider adjusting the discount rate for the general uncertainties and risks not reflected in the cash flows. The key message is therefore that an entity needs to ensure that consistent assumptions are used for the estimation of cash flows and the selection of an appropriate discount rate in order to avoid any double-counting or omissions. [IAS 36.51].

An example of the use of the expected cash flow approach is given by Tesco Plc. The following extract from the annual report of Tesco PLC refers to scenarios reflecting different outcomes from risks presented by Brexit, COVID-19, a macroeconomic downturn and climate change.

The WACC is often used in practice. It is usually acceptable to auditors as it is supported by valuation experts and is an accepted methodology based on a well-known formula and widely available information. In addition, many entities already know their own WACC. However, it can only be used as a starting point for determining an appropriate discount rate and some of the issues that must be taken into account are as follows:

• The WACC is a post-tax rate and IAS 36 requires VIU to be calculated using pre-tax cash flows and a pre-tax rate. In the majority of cases, converting the former into the latter is not simply a question of grossing up the post-tax rate by the effective tax rate.

• An entity’s own WACC is not suitable as a discount rate if there is anything atypical about the entity’s capital structure compared with ‘typical’ market participants (for example the extent to which leases are used to finance the operations).

• The WACC must reflect the risks specific to the asset and not the risks relating to the entity as a whole, such as default risk.

  And

• 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 can have different levels of risk (e.g., a start-up as against an established product).

These issues are discussed further below.

One of the most difficult areas in practice is the effect of taxation on the WACC. In order to determine an appropriate pre-tax discount rate it is likely to be necessary to adjust the entity’s actual tax cash flows.

Ultimately, the appropriate discount rate to select is one that reflects current market assessments of the time value of money and the risks specific to the asset in question, including taxation. Such a rate is one that reflects “…the return that investors would require if they were to choose an investment that would generate cash flows of amounts, timing and risk profile equivalent to those that the entity expects to derive from the asset”. [IAS 36.56].

VIU is primarily an accounting concept rather than a business valuation of the asset or CGU. One fundamental difference is that IAS 36 requires pre-tax cash flows to be discounted using a pre-tax discount rate. Why not calculate VIU on a post-tax basis? The reason is the complexities created by tax losses carried forward, temporary tax differences and deferred taxes.

The standard explains in the Basis for Conclusions that future income tax cash flows can affect recoverable amount. It is convenient to analyse future tax cash flows into two components:

1. (a)

   The future tax cash flows that would result from any difference between the tax base of an asset (the amount attributed to it for tax purposes) and its carrying amount, after recognition of any impairment loss. Such differences are described in IAS 12 as ‘temporary differences’.

   And

2. (b)

   The future tax cash flows that would result if the tax base of the asset were equal to its recoverable amount. [IAS 36.BCZ81].

The concept is complex but refers to the following issues.

An impairment test, say at the end of 20X1, takes account of estimated future cash flows. The tax that an entity will pay in future years that will be reflected in the actual tax cash flows that it expects can depend on tax depreciation that the entity has already taken (or is yet to take) in respect of the asset or CGU being tested for impairment. The value of the asset to the business on a post-tax basis must take account of all tax effects including those relating to the past and not only those that will only arise in future.

Although these ‘temporary differences’ are accounted for as deferred taxation, IAS 12:

• Does not allow entities to recognise all deferred tax liabilities or deferred tax assets

• Does not recognise deferred tax assets using the same criteria as deferred tax liabilities

  And

• Deferred tax is not recognised on a discounted basis

Therefore, deferred taxation as provided in the income statement and statement of financial position is not sufficient to take account of the actual temporary differences relating to the asset or CGU.

At the same time, an asset valuation implicitly assumes that the carrying amount of the asset is deductible for tax. For example, if the tax rate is 25%, an entity must receive pre-tax cash flows with a present value of 400 in order to recover a carrying amount of 300. [IAS 36.BCZ88]. In principle, therefore, VIU on a post-tax basis would include the present value of the future tax cash flows that would result if the tax base of the asset were equal to its value in use. Hence, IAS 36 indicates that the appropriate tax base to calculate VIU in a post-tax setting, is the VIU itself. [IAS 36.BCZ84]. Therefore, the calculated VIU must also be used to derive the pre-tax discount rate. It follows from this that the ‘tax cash flows’ to be taken into account will be those reflected in the post-tax VIU, so they will be neither the tax cash flows available in relation to the asset (based on its cost) nor the actual tax cash flows payable by the entity.

For these reasons, the (then) IASC decided to require an enterprise to determine value in use by using pre-tax future cash flows and a pre-tax discount rate.

This means that there is a different problem, calculating an appropriate pre-tax discount rate because there are no observable pre-tax discount rates. Two important points must be taken into account:

• The pre-tax discount rate is not always the post-tax discount rate grossed up by a standard rate of tax. There are some circumstances in which a gross-up will give a reasonable approximation, discussed further in section 7.2.4 below.

• The pre-tax discount rate is not the post-tax rate grossed up by the effects of the entity’s actual tax cash flows. As discussed above, a post-tax discount rate such as the WACC is based on certain assumptions about the tax-deductibility of the asset and not the actual tax cash flows experienced by the entity.

Recognising this, IAS 36.BCZ85 states that “…in theory, discounting post-tax cash flows at a post-tax discount rate and discounting pre-tax cash flows at a pre-tax discount rate should give the same result, as long as 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].

Therefore, the only accurate way to calculate a pre-tax WACC is to calculate the VIU by applying a post-tax rate to post-tax cash flows, tax cash flows being based on the allowances and charges available to the asset and to which the revenue is subject (see discussion in section 7.2.3 below). The effective pre-tax rate is calculated by removing the tax cash flows and, by iteration, one can identify the pre-tax rate that makes the present value of the adjusted cash flows equal the VIU calculated using post tax cash flows.

Paragraph BCZ85 includes an example of how to calculate a pre-tax discount rate where the tax cash flows are irregular because of the availability of tax deductions for the asset’s capital cost. See also the calculations in Illustration 7-4 below - (a) illustrates a calculation of a pre-tax discount rate. This is a relatively straightforward calculation for a single asset at the inception of the relevant project.

It can be far more complex at a later date. This is the case when entities attempt to calculate a discount rate starting with post-tax cash flows and a post-tax discount rate at a point in time when there are already temporary differences relating to the asset. A discount rate based on an entity’s prospective tax cash flows under- or overstates IAS 36’s impairment charge unless it reflects these previous allowances or disallowances. This is the same problem that will be encountered if an entity attempts to test VIU using post-tax cash flows as described in section 7.2.3 below.

A notional adjustment will have to be made if the entity is not paying tax because it is making, or has made, tax losses. It is 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 as this will be double counting. It is taking advantage of the losses in the cash flows but excluding that value from the assets of the CGU.

Entities can attempt to deal with the complexity of determining a pre-tax rate by trying to calculate VIU on a post-tax basis but this approach means addressing the many difficulties that have been identified by the IASB and the reasons why it mandated a pre-tax approach in testing for impairment in the first place.

Some approximations and short cuts that can give an acceptable answer in practice are dealt with in section 7.2.4 below.

Because of the challenges in calculating an appropriate pre-tax discount rate and because it aligns more closely with their normal business valuation approach, some entities attempt to perform a VIU calculation based on a post-tax discount rate and post-tax cash flows.

In support of the post-tax approach, the example in IAS 36.BCZ85, which explains how to calculate a pre-tax discount rate, is mistakenly understood as a methodology for a post-tax VIU calculation using an entity’s actual tax cash flows.

Entities that try a post-tax approach generally use the year-end WACC and estimated post-tax cash flows for future years that reflect the actual tax that they expect to pay in those years. A calculation on this basis will only by chance correspond to an impairment test in accordance with IAS 36 because it is based on inappropriate assumptions, i.e., it does not take account of the temporary differences that affect the entity’s future tax charges and will not be based on the assumption that the VIU is tax deductible. Some include in the post-tax calculation the benefit of tax deductions or tax losses by bringing them into the cash flows in the years in which the tax benefit is expected to be received. In these cases the calculation will not correctly take account of the timing differences reflected in the tax cash flows and not accurately reflect the differences created by the assumption that the VIU is tax deductible.

In order to calculate a post-tax VIU that is the equivalent to the VIU required by IAS 36, an entity will usually have to make adjustments to the actual tax cash flows or otherwise adjust its actual post-tax cash flows.

There are two approaches that can give a post-tax VIU that is equivalent to IAS 36’s pre-tax calculation:

1. (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 as described in IAS 36.BCZ85. 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. In addition, no account is taken of the existing tax losses of the entity. Both of these assumptions will probably mean making appropriate notional adjustments.

2. (2)

   Post-tax cash flows reflecting actual tax cash flows. The relevant deferred tax asset or liability, discounted as appropriate, must be treated as part of the net assets of the relevant CGU.

It is very important to note that these are methodologies to determine IAS 36’s required VIU and they will only be acceptable if the result can be shown to be materially the same as a pre-tax impairment calculation as required by IAS 36.

Note that for illustrative purposes all of the following Illustrations assume that there is no headroom, i.e., the NPV of the relevant cash flows is exactly equal to the carrying value of the asset. This is to make it easier to observe the relationship between pre- and post-tax calculations. See section 7.2.5 below for worked examples including headroom.

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 can have a range of useful lives for depreciation and tax amortisation purposes, up to and including indefinite useful lives.

If goodwill is being tested, it has an indefinite useful life. However, the underlying assets in the CGU or group of CGUs to which it has been allocated will usually have finite useful 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.

The examples in Illustration 7-4 in section 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 test. 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 can make the exercise a bit easier.

An entity can 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 can conclude that the risks relating to a particular asset are higher or lower than had previously been assumed. Such risk adjustments can occur if, for example, a new project, process or product proves to be successful or 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 useful life of the assets being reviewed for impairment, so these will not necessarily need to be recalculated every time an impairment test is carried out. Short-term market rates can 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 can also make the task more straightforward. It is often 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 test at either the pre- or post-tax level.

A close approximation to these criteria is possible for some CGUs, particularly if accounting and tax amortisation of assets is similar. This is illustrated in Illustration 7-5 below - see the comparison of discount rates at the end of the example. A simple gross up can be materially correct. The criteria are unlikely to apply to the VIU of individual assets because these are rarely perpetuity calculations and it is possible that the deductibility for tax purposes does not resemble accounting depreciation. If it is inappropriate to make such a gross up, an iterative calculation can be necessary to compute the appropriate pre-tax discount rate.

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 also has to 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 useful 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.

A rate based on actual post-tax cash flows will also vary from year to year depending on the tax situation.

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].

A common problem relates to the effect of tax losses on the impairment calculation, as they can 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 does 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 test is based on VIU. Similarly, if the entity calculates a post-tax VIU (see section 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.

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 can 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.

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).

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 is not suitable as a discount rate if there is anything atypical about the entity’s capital structure compared with ‘typical’ market participants (for example, the entity’s use of leases to finance its operations). 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 is 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].

Ultimately, it can 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.

IAS 36 allows an entity to use rates other than the WACC as a starting point in calculating the discount rate. These include:

• The entity’s incremental borrowing rate

  And

• 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.

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.