By Surachai Damnoenwong, Audit Director

Impairment tests are one of the most judgmental areas in IFRS. It is all about estimating, judging, evaluating, and forecasting. Sometimes it is like fortune telling and can be extremely confusing even for an audit firm in Thailand.

When we audit companies as an audit firm in Thailand, we are extremely cautious when undertaking impairment tests because all the client data to be evaluated appears reasonable and seldom indicate any signs of impairment whatsoever.

However, digging deeper into the assumptions and numbers can give different results.

Often, we discover assumptions to be unrealistic, wrong discount rates, incorrect items included in the cash flow projections, etc.

Why cash flow projections?

In fact, cash flow projections are crucial in impairment testing for two reasons:

  1. They are the basis for determining the Company’s assets or cash generating unit’s (“CGU”) value in use.
    When we are setting the value in use, we are estimating how much value the business gets out of the asset when using it or consuming it.

  2. When there is not enough market data, cash flow projections are the main input into fair value calculation.

    However the difference from value in use is that in this case, we are estimating cash flows based on what the market is willing to pay for the Company’s assets or CGU under review.

 Under IAS 36

The standard IAS 36 (article 33) gives the basic rules to follow when establishing the Company’s cash flow projections for the impairment testing:

  • Use reasonable and supportable assumptions as a basis for the Company’s cash flow projections. They must reflect management’s estimate of economic conditions over the remaining useful life of the asset while greater importance is given to external evidence.
  • Use the most recent financial budgets or forecasts approved by the management, while:
    • Exclude future cash flows from restructuring or improving or enhancing asset’s performance.
    • Cover a maximum of 5 years unless the Company can justify using longer periods.

The standard IAS 36 guides the Company further in preparing the Company’s cash flow projections.

How to set the Company’s cash flow projections?

Always bear in mind that the Company’s cash flows must be reasonable and supportable.

Here are a few tips to make it happen:

  • Use approved budgets and forecasts.
  • Put significant importance on external information. Look out for industry reports, experts’ valuations, forecasts about the economy, etc. Try to be consistent with this information as much as possible.
  • Always check the Company’s forecasts with market data. Did the Company incorporate growth rate even though there’s deflation forecast for the Company’s area of business? The Company needs to justify it.

 What to include in and what to exclude from the Company’s cash flow projections?

The IAS 36.39 standard sets three basic elements to include in the Company’s cash flow projections:

  1. Cash inflows from the continuing use of the asset.
    These include proceeds from revenues generated by the asset or CGU.
  2. Cash outflows necessarily incurred to generate cash inflows from continuing use of assets which are directly attributed or allocated to the assets on a reasonable and consistent basis.

The Company should estimate day-to-day servicing costs, maintenance costs, general and production overheads, and comparable items.

  1. Net cash flows from the disposal of the asset at the end of its useful life.

There are a few difficulties that arise when deciding whether to include or exclude a certain item in the Company’s cash flow projections.

1. Maintenance vs. improvement

While the Company needs to include maintenance costs in the cash flow projections, the Company should strongly keep in mind that these cash flows only include items for assets or CGUs in their current condition.

Thus, the Company should NOT include any outflows to be incurred for improving or enhancing the asset’s performance, nor any inflows resulting from enhanced assets.

Do NOT recognize improving capital expenditure but DO recognize replacement and servicing expenditure to maintain the asset’s capacity.

However, sometimes it is quite difficult and challenging to distinguish between maintenance and improvement expenses and some judgment is always needed.

There are two exceptions permitting the Company to recognize enhancing capital expenditure in the cash flow projections:

  1. Asset in progress – If the Company has already invested into the generating of some asset, but it has not been finished, then the Company should include all expected cash outflows required to make that asset ready for use or sale (see IAS 36.42).
  2. Restructuring – If the Company becomes committed to restructuring in accordance with IAS 37, then the Company can include the results of that restructuring in cash flow projections. Just be careful here, because the Company needs to meet certain conditions set by IAS 37 to conclude that the Company is committed to restructuring.

 2. Intercompany charges

Another frequent situation is when the Company makes intragroup sales or purchases and needs to include cash flows from these transactions in its projections.

The Company should always include these transactions at estimated market values, with some adjustments for discounts or other items (as soon as it reflects the “arm’s length”). 

3. Receivables and payables

In general, the Company should NOT include future cash flows related to settlement of receivables, payables, and tax liabilities in the projections.

The reason is to avoid double counting.

However, if it is more practical for the Company, then the Company can include settlement of these balances into the cash flows, but in this case the Company needs to be consistent and include the amount of receivables, payables and tax liabilities into the carrying amount of the Company’s CGU under testing.

If the Company has a liability that must be considered when determining a recoverable amount of CGU, then the Company must include the cash outflows related to that liability to cash flow projections.

For example, if the Company performs a testing of an oil rig station for impairment, the Company must include the decommissioning liability cash outflows into account since this liability is attached to the oil rig station.

Oh, and what about the repayment of loans?

In general no, the Company does not include these if the Company excluded loan liability from CGU being evaluated.

The Company also needs to ignore interest payments, because cost of the Company’s capital is taken care of by discounting.

 4. Terminal value

If the Company is evaluating an asset with an indefinite life, or with a useful life beyond the forecasted period, then the Company needs to include terminal value in the cash flow projections.

It is quite common that the terminal value represents more than 50%, sometimes even 80% of the total present value of the Company’s cash flow projections, therefore it is crucial to get it as close to accurate as possible.

In many cases, the terminal value is just the net proceeds that the Company expects to get from the sale of an asset at the end of its useful life – especially when that end happens to be the end of the Company’s cash flow forecasts.

In other cases, the terminal value is the estimate of what the Company would get for the cash flows beyond the Company’s forecast period.

If the Company operates an indefinite business, the Company does not know when it will terminate generating cash flows and the Company can make reliable forecasts for the next 5 years.

How to cover the period beyond 5 years?

For how much would the Company sell that business after 5 years?

The two most common methods to calculate this are:

  1. Exit multiple – this is the multiple of shareholders’ cash flows in the last year of projections.
  2. Perpetuity – the Company would take the last year’s projection and apply a perpetuity formula to it. The result would be an indefinite projection of cash flow in one number.

In fact, the Company is calculating growing perpetuity as a series of periodic payments that grow at a proportionate rate for an infinite amount of time.

There could be great differences in the terminal value when calculated either way and the reason is that as the Company is giving up on business risk when selling a business, the Company’s terminal value can be lower when applying an exit multiple.

Thus use the method consistent with the management’s estimate of the Company’s destiny at the time of performing the impairment testing. 

5. Discount rates for the impairment testing

The discount rate used to bring the cash flow projections to their present value should be:

  • a pre-tax rate
  • reflecting the current market assessments of the time value of money; and
  • incorporating the asset-specific risks for which the future cash flow estimates have not been adjusted.

Practically, the Company can use:

  • Market interest rate that is incorporated in the current market transactions for similar assets, or
  • Weighted average cost of capital (WACC) of a listed entity having a single asset or a portfolio with similar service potential and risks to the asset under review, or
  • Surrogates, such as:
    • The Company’s own WACC;
    • The Company’s own incremental borrowing rate; or
    • Other market borrowing rates.

Having that said, the Company needs to be careful enough to incorporate all the necessary risks that were not incorporated into the Company’s cash flows and vice versa.

The Company cannot incorporate the same risks to both discount rates and cash flows, otherwise it would be double counting.

The Company needs to use a pre-tax rate, while sometimes the rates are set post-tax. In this case. 

Finally, remember that some cash flows might require using different discount rates.

For example, when the Company has cash flows denominated in a foreign currency, or cash flows with different risks, it would be appropriate to use WACC for low-risk assets like buildings, but if the Company tests riskier assets like brands, or start-ups, then the Company might need to adjust the discount rate for higher risk. 

How many scenarios?

When we audited impairment tests in some companies, they presented only one single cash flow projection.

Well, if we are the auditors, the Company should be aware of human psychology, too.

Sometimes, businesspeople tend to be over-optimistic and thus management often includes too optimistic views of their future performance in cash flow projections.

Did the Company consider forecasts 3 years ago and compare them to the present results? How precise were the Company’s numbers and considerations?

 Of course, no one wants management to be a fortune-teller and have a crystal ball standing on their desk, but if the management was not so precise in their forecasts, it is time to include more than one scenario for cash flow projections.

The Company may consider preparing one cash flow projection for the great times, one for the miserable times and one if things go as expected.

Then the Company needs to weigh these cash flows by probabilities of scenarios occurring and calculate expected cash flows.

Alternatively, the Company can use the traditional approach and incorporate the risks and uncertainties to the Company’s discount rate.

Source of information: on the www.cpdbox.com website

Should you require any advice on the contents of this article or alternatively wish to learn more about RSM Audit Thailand Services, please do not hesitate to contact us for more information on [email protected]