The definition of value in use is “the present value of the future cash flows expected to be derived from an asset or cash-generating unit”.

Determining value in use involves estimating the future cash flows that are expected to arise from the asset or CGU being tested for impairment. The cash flows consist of those expected to arise from the continued use of the asset or CGU in its current condition and those, if any, expected to result from its ultimate disposal. An appropriate discount rate is then applied to those cash flows, in order to arrive at their present value.

Stages in the calculation of value in use

The calculation of value in use can be broken down into four stages:

• identification of cash-generating units;

If the recoverable amount of an asset can be individually determined, Stage 1 is omitted.

• estimation of expected future cash flows;
• determination of an appropriate discount rate; and
• discounting and aggregating expected cash flows to arrive at value in use.

Circumstances in which it is necessary to identify the cash-generating unit to which an asset belongs

It is often not possible to estimate the recoverable amount of an individual asset because assets frequently generate cash when working together rather than singly. When this is the case, an entity should determine the recoverable amount of the CGU to which the asset belongs.

IAS 36 specifically states that the recoverable amount of an individual asset cannot be determined when both of the following conditions exist:

• the value in use of the asset cannot be estimated to be close to its fair value less costs of disposal (e.g., when the future cash flows from the continuing use of the asset are not negligible); and
• the asset does not generate cash inflows that are largely independent of those from other assets.

When the recoverable amount of an individual asset cannot be determined, its CGU should be identified as the lowest aggregation of assets that generates largely independent cash inflows.

Example: Recoverable amount cannot be determined A mining entity owns a private railway to support its mining activities. The private railway could be sold only for scrap value and it does not generate cash inflows that are largely independent of the cash inflows from the other assets of the mine. It is not possible to estimate the recoverable amount of the private railway because its value in use cannot be determined and is probably different from scrap value. Therefore, the entity estimates the recoverable amount of the cash-generating unit to which the private railway belongs, i.e., the mine as a whole.

Example Lowest aggregation of assets that generate largely independent cash flows A bus company provides services under contract with a municipality that requires minimum service on each of five separate routes. Assets devoted to each route and the cash flows from each route can be identified separately. One of the routes operates at a significant loss. Because the entity does not have the option to curtail any one bus route, the lowest level of identifiable cash inflows that are largely independent of the cash inflows from other assets or groups of assets is the cash inflows generated by the five routes together. The cash-generating unit for each route is the bus company as a whole.

Whether a right-of-use asset generates largely independent cash inflows Generally, a right-of-use asset is assessed for impairment as part of a CGU rather than as an individual asset. This is because assets are usually leased and used as an input in the entity’s main operating activities (e.g., equipment, premises) and therefore do not generate independent cash inflows. However, a right-of-use asset that is subject to a sublease generates independent cash inflows. When this is the case, the right-of-use asset is tested for impairment as an individual asset. If a leased property is used to house corporate activities (e.g., when the headquarters’ premises are subject to a lease), the related right-of-use asset is a corporate asset and is allocated to the CGU or group of CGUs to which the leased asset belongs under the principles applicable to corporate assets.

Identifying the cash-generating unit in respect of a group of interchangeable assets – example A national wireless communication provider owns a number of sets of antennae, radio transmitters and receivers (collectively referred to as ‘antennae sets’) installed on cell towers which together provide the infrastructure for its telecommunications network. If a specific antennae set is damaged or otherwise is not capable of operating, its output can be delivered from similar antennae set on another cell tower so that services are virtually uninterrupted, and all cash flow streams will remain intact. This interchangeability is a feature deliberately built into the integrated logistical design of the network. In the circumstances described, the cash flows generated by each individual antennae set are not ‘largely independent’ as contemplated in the definition for a cash-generating unit; it is not appropriate to attribute specific cash flows to individual antennae sets because the sets are almost instantaneously interchangeable and, as a result, whether an individual antennae set is capable of operating does not affect cash inflows. However, each antennae set is part of a group of assets that make up the entity’s national network of towers and antennae. Because the wireless communication provider operates using a national network, the national network infrastructure asset group would be the smallest identifiable asset group that generates cash inflows that are largely independent; therefore, the national network infrastructure asset group is a cash-generating unit and it is at that level that the network should be assessed for impairment.

Identification of cash-generating units for entities operating in multiple locations – example For entities operating in multiple locations that generate cash inflows in the same (or a similar) manner, in some circumstances several of those locations can constitute a single CGU for the purpose of impairment testing. In line with the definition of a CGU, an individual location will constitute a single CGU when its cash inflows are independent of other locations. In some cases, however, there may be evidence of a significant degree of interdependence between the cash inflows from each location resulting from revenue substitution between those locations and it may be determined that the appropriate CGU comprises a group of two or more locations. This will be the case when there is evidence of a significant degree of revenue substitution between the locations in the group. In the circumstances under consideration, revenue substitution means a degree of interaction between the cash inflows from different locations of the entity such that a decrease in cash inflows in one location can be demonstrated to be accompanied by an increase in cash inflows from one or more other locations. Such interactions may occur, for example, in the following scenarios: a mining or manufacturing operation with multiple, interchangeable facilities providing overall available capacity that is used to fulfil demand for the same product or products; or multiple locations providing the same service to a common customer base (e.g., a network of dealerships for a car manufacturer). IAS 36 also gives an example of multiple locations (bus routes) used to provide goods or services under a single contract and concludes that this would represent a single CGU. In assessing whether the cash inflows of different locations are interdependent, it is important to consider any barriers to revenue substitution between locations (e.g., distance). Example 1 of the Illustrative Examples accompanying IAS 36 refers to this in the context of a chain of retail stores and states that the fact that all of the stores are in different neighborhoods suggests that each store would have a different customer base. In such cases, it would be difficult to demonstrate revenue substitution. It is also important to distinguish between interdependence of cash inflows from different locations operated by an entity and common dependence on an external factor (e.g., commodity prices) or an asset (e.g., a brand). In addition, as discussed, interdependence of cash outflows (resulting from, for example, a centralized purchasing function or shared management costs) is not relevant to the identification of CGUs.

Identification of cash-generating units in the retail industry – example Entity A, a retail company, operates three stores that generate largely independent cash inflows. The three stores share expenditures (cash outflows) such as on infrastructure, marketing and human resources. The definition of a CGU requires the identification of an asset’s CGU on the basis of independent cash inflows generated by the asset, not independent net cash flows (i.e., cash inflows and outflows). Outflows such as shared infrastructure and marketing expenditures are not considered when identifying a CGU. Consequently, in the circumstances described, it is not appropriate for Entity A’s CGU to be composed of the three stores, on the basis that the net cash flows associated with the stores are interdependent. When a store is tested for impairment under IAS 36, the store’s CGU is the store itself. This conclusion was confirmed by the IFRS Interpretations Committee in the March 2007 IFRIC Update. Whilst the conclusion that each store represents a separate CGU may be straightforward in cases when stores serve different customer bases and are managed locally, the assessment might be more difficult for stores operated as an integrated chain and if different types of retail stores (e.g., flagship stores compared to other ‘regular’ stores) are employed or when a retailer operates under an omni-channel business model. The appropriate identification of the CGU level for impairment testing purposes will depend on the specific facts and circumstances and requires careful judgement.

Identification of cash-generating unit: flagship store In the retail industry, the launch of flagship stores in prime locations with high customer footfall is a common feature. Flagship stores differ in their function from regular stores. They primarily serve as a marketing tool, representing the entity’s brand as opposed to the immediate generation of sales and profit. However, a flagship store will usually also offer products for sale (i.e., similar to a regular store), but primarily serving a distinct customer base (e.g., tourists) who attribute value to the enhanced customer experience that a flagship store provides. As a result, a flagship store will typically generate largely independent cash inflows on the single store level and, therefore, meet the definition of a CGU. This is in contrast, for example, to a showroom that displays the product range but does not make any sales directly. In rare circumstances, when sales are considered insignificant, the flagship store’s assets may instead be considered corporate assets in accordance with IAS 36. In this case, judgement is required considering all relevant facts and circumstances to determine which group of stores is presumed to benefit from the flagship store’s marketing function.

Identification of cash-generating units in omni-channel retailing As a result of the digitalization of the retail industry, companies are expanding their online presence and online sales activities to achieve an almost seamless connection of the various sales channels (omni-channel retail strategy). In executing such an integrated strategy, companies expect to realize positive sales synergies from the interaction of the various points of contact and sales channels. In the past, the purchase decision could usually be linked to the customer being physically present in the store and, therefore, the single store was likely to be identified as a CGU. However, the more integrated sales approach of the omni-channel retail strategy means that it is becoming more challenging for some retailers to identify the point of sale responsible for the final purchase decision of the customer and thus, it may not be feasible to map each transaction exclusively to just one of the sales channels. This in turn means that it is increasingly difficult for these retailers to assess the lowest level at which largely independent cash inflows are generated (for the purposes of identifying CGUs and applying IAS 36). As indicated, when there is evidence of a significant degree of revenue substitution between the locations within a group, it may be determined that the appropriate CGU comprises a group of two or more locations. To apply this principle to an entity that operates as an omni-channel retailer, a thorough analysis is necessary to understand whether and how integrated the various distribution channels actually are. Factors to consider in assessing whether stores in a given geographic area (for example, a city) and online sales to customers in the same location form an integrated distribution channel that represents a single CGU include whether the same products are offered to the same customer base through various channels and the extent to which online sales influence sales in stores in a given geographic area and vice versa. For example, the business model of an entity may be such that customers: order online and are able to pick up (click & collect) or return a product in a store; may reserve and pick up in a different store a product which is not available in the store originally visited; may exchange a product purchased online for a product in a store; may exchange a product purchased in one store for a product in another store in the same area; or may be encouraged when visiting a store to purchase online a product not available in a store. Further, there may be evidence that in-store traffic generated by collections and returns of products purchased online generates additional in-store sales. When online sales represent a significant percentage of total sales in a region and there is significant interaction of customers with the multiple distribution channels in that region, this may indicate that the lowest level at which independent cash inflows can be identified is at the regional level (i.e., the CGU comprises of all sales points in the region rather than the individual store). Conversely, when online sales are an insignificant percentage of total sales in a region and there is no significant interaction of customers with the multiple distribution channels in that region, this would indicate that the lowest level at which independent cash inflows can be identified is at the single store level. A further factor to consider when assessing whether stores in a given geographic area and online sales to customers in the same location form an integrated distribution channel that represents a single CGU is the level at which performance is assessed by management. As further explained, whilst not determinative in its own right, an entity’s internal management reporting may provide evidence that the lowest level at which independent cash inflows can be identified is a given geographic area. This may be the case when, for example, management: analyses the customers’ purchasing behavior considering total spending (including in store and online) and measures interdependencies; or includes online sales in determining store investments and closures between geographical areas.

Consideration of whether, and how, an asset will continue to be used If events and circumstances indicate that the carrying amount of an asset may not be recoverable, the appropriate accounting will depend on whether the entity expects to continue to use the asset and, if so, whether it will be used as part of a CGU. For example, consider the situation in which events and circumstances indicate that the carrying amount of a computer software asset developed (or under development) or purchased for internal use may not be recoverable. The appropriate accounting will depend on whether the entity expects to continue to use the software and, if so, whether it will be used as part of a CGU. The outcome of events and circumstances of the nature described may result in a determination, either during development or after development is completed, that the software is no longer expected to be placed into service or that it will be removed from service. In such circumstances, the entity should determine whether the software asset should be derecognised in accordance with IAS 38 . Alternatively, it may be determined that the software will continue to be used. If the software generates cash flows independently, the entity should estimate the software’s recoverable amount, which will be the higher of its fair value less costs of disposal (based on selling the software) and its value in use (based on the cash flows that it is expected to generate from use, less any associated costs). An impairment loss should be recognized if the software’s carrying amount is in excess of recoverable amount. If the software does not generate cash flows independently, it should generally be tested for impairment as part of the CGU to which it relates. In such circumstances, whether it is necessary to recognize an impairment loss will depend on the recoverable amount of the CGU as a whole. If the recoverable amount of the CGU as a whole exceeds its carrying amount, no impairment loss is recognized. This may be the case even though the software will be used less frequently than was originally intended and even though, had they foreseen this, the directors might not have been prepared to incur the costs of the software.

Relevance of internal management reporting to the identification of cash-generating units An entity’s internal management reporting is relevant to the identification of CGUs insofar as it provides evidence regarding the independence (or interdependence) of cash inflows generated by assets or groups of assets (including, as discussed, cash flows generated in different locations in which an entity operates). However, internal management reporting is not a determinative factor in its own right and should not override other evidence that demonstrates that cash inflows from an asset or a group of assets are indeed independent. As noted in IAS 36, the concept of CGUs is intended to be a matter of fact. The independence (or interdependence) of cash inflows is something which cannot be overridden by the internal management reporting process of an entity. Such reporting may provide insights as to how cash inflows are generated, but must be considered alongside other factors in order to determine the appropriate CGU. In considering an entity’s internal management reporting as part of the process of identifying CGUs, it should be noted that: IAS 36:69 refers to “how management monitors the entity’s operations”. In this context, ‘management’ may be at any level within the organization, not necessarily that of the chief operating decision maker (as defined in IFRS 8); and consistent with the concept of a CGU being based on largely independent cash inflows, the identification of a CGU does not require that management reporting presents a measure of operating profit for an asset or a group of assets (as is the case for the identification of operating segments in IFRS 8). Instead, reporting of a separate measure of revenue may be sufficient to indicate that a CGU exists at that level. IAS 36 also refers to “how management makes decisions about continuing or disposing of the entity’s assets and operations” as a factor in the identification of CGUs. Again, this decision-making process may provide insight into economic reality because, for example, a decision to retain or dispose of a manufacturing facility on the basis of the overall capacity needed to make a particular product may indicate a level of interdependence between cash inflows from a number of facilities dedicated to the manufacture of that product.

Active market for product used internally – example An entity manufactures two products – Product 1 and Product 2. Product 1 is manufactured in the entity’s factory in Country A, and all of the items produced are transferred to the entity’s factory in Country B where they are used in the assembly of Product 2. The entity does not sell Product 1 externally. If there is an active market for Product 1, the factory in Country A is treated as a separate CGU. The value in use of the factory in Country A is calculated using the market price of the units of Product 1 produced. The estimated value in use of the factory in Country B will be calculated using the market price of the units of Product 1 purchased as the basis for estimating cash outflows for the purchase of subcomponents. An entity manufactures two products – Product 1 and Product 2. Product 1 is manufactured in the entity’s factory in Country A, and all of the items produced are transferred to the entity’s factory in Country B where they are used in the assembly of Product 2. The entity does not sell Product 1 externally. If there is an active market for Product 1, the factory in Country A is treated as a separate CGU. The value in use of the factory in Country A is calculated using the market price of the units of Product 1 produced. The estimated value in use of the factory in Country B will be calculated using the market price of the units of Product 1 purchased as the basis for estimating cash outflows for the purchase of subcomponents.

Example Liability included in a cash-generating unit A company operates a mine in a country where legislation requires that the owner must restore the site on completion of its mining operations. The cost of restoration includes the replacement of the overburden, which must be removed before mining operations commence. A provision for the costs to replace the overburden was recognized as soon as the overburden was removed. The amount provided was recognized as part of the cost of the mine and is being depreciated over the mine’s useful life. The carrying amount of the provision for restoration costs is CU500, which is equal to the present value of the restoration costs. The entity is testing the mine for impairment. The cash-generating unit for the mine is the mine as a whole. The entity has received various offers to buy the mine at a price of around CU800. This price reflects the fact that the buyer will assume the obligation to restore the overburden. Disposal costs for the mine are negligible. The value in use of the mine is approximately CU1,200, excluding restoration costs. The carrying amount of the mine is CU1,000. The cash-generating unit’s fair value less costs of disposal is CU800. This amount considers restoration costs that have already been provided for. As a consequence, the value in use for the cash-generating unit is determined after consideration of the restoration costs and is estimated to be CU700 (CU1,200 less CU500). The carrying amount of the cash-generating unit is CU500, which is the carrying amount of the mine (CU1,000) less the carrying amount of the provision for restoration costs (CU500). Therefore, the recoverable amount of the cash-generating unit exceeds its carrying amount.

Treatment of the lease liability and make-good provision when testing a cash-generating unit containing a right-of-use asset for impairment (entities that have adopted IFRS 16) – example Entity A is a retail entity. Entity A has determined that each of its individual stores is a CGU for the purposes of impairment testing under IAS 36. Each CGU includes a right-of-use asset for the lease of the retail store and various other owned assets such as display units, cashier tills, fridges and freezers. The retail store lease agreements require Entity A to restore the property to its original condition at the end of the lease. In accordance with IFRS 16, Entity A capitalizes the restoration costs as part of the cost of the right-of-use asset and recognizes a provision for the related costs. This provision is recognized and measured in accordance with IAS 37 as required by IFRS 16. IAS 36 states that “the carrying amount of a cash-generating unit shall be determined on a basis consistent with the way the recoverable amount of the cash-generating unit is determined”. Furthermore, IAS 36 states that the carrying amount of a CGU “does not include the carrying amount of any recognized liability, unless the recoverable amount of the cash-generating unit cannot be determined without consideration of this liability”. IAS 36 states: “It may be necessary to consider some recognized liabilities to determine the recoverable amount of a cash-generating unit. This may occur if the disposal of a cash-generating unit would require the buyer to assume the liability. In this case, the fair value less costs of disposal (or the estimated cash flow from [the] ultimate disposal) of the cash-generating unit is the price to sell the assets of the cash-generating unit and the liability together, less the costs of disposal. To perform a meaningful comparison between the carrying amount of the cash-generating unit and its recoverable amount, the carrying amount of the liability is deducted in determining both the cash-generating unit’s value in use and its carrying amount.” In other words, IAS 36 would generally require Entity A to exclude the lease obligation and the restoration provision from the carrying amount of the CGU and exclude the related cash flows from the determination of the recoverable amount. However, if Entity A determines that buyers of the retail store would assume the lease obligation and the related restoration provision, the fair value less cost to sell of the CGU should reflect the fact that the buyers will assume these liabilities. To ensure consistency of assumptions, Entity A would include the carrying amount of the lease liability and of the restoration provision into both the carrying amount of the CGU and the recoverable amount calculation. This ensures that the carrying amount of the CGU and its recoverable amount (i.e., the higher of fair value less cost to sell and value in use) are established on a consistent basis, reflecting the fact that in this scenario, the lease obligation and the restoration provision are part of the CGU. This issue was considered by the IFRS Interpretations Committee in May 2016. For example, in performing the impairment test, the following have been calculated by Entity A: CU The net present value of expected cash flows (excluding lease and restoration obligation payments), discounted at the rate appropriate under IAS 36 4,500,000 Carrying amount of CGU assets (right-of-use asset, including the capitalization of the restoration costs, and other owned assets) 6,500,000 Carrying amount of lease liability (discounted at the incremental borrowing rate under IFRS 16) 3,000,000 Carrying amount of the restoration provision (recognized and measured under IAS 37) 800,000 Scenario 1 Entity A determines the carrying amount of the CGU, excluding the carrying amount of any recognized liability as the recoverable amount can be established without considering any recognized liability. Scenario 2 Entity A determines that if the CGU was disposed of, the buyer would assume both the lease liability and restoration provision. On this basis, Entity A applies the guidance in IAS 36 and includes the lease liability and the restoration provision in the carrying amount of the CGU and in its recoverable amount. Assuming that the recoverable amount of the CGU is its value in use (i.e., the value in use of the CGU is higher than its fair value less costs to sell), the result of the impairment test would be as follows: Scenario 1 Scenario 2 CU CU Recoverable amount (value in use) of the CGU The net present value of expected cash flows (excluding lease and restoration obligation payments), discounted at the rate appropriate under IAS 36 4,500,000 4,500,000 Carrying amount of lease liability (discounted at the incremental borrowing rate under IFRS 16) – (3,000,000) Carrying amount of the restoration provision (recognized and measured under IAS 37) – (800,000) 4,500,000 700,000 Carrying amount of the CGU Carrying amount of the CGU assets (right-of-use asset and other owned assets) 6,500,000 6,500,000 Carrying amount of lease liability (discounted at the incremental borrowing rate under IFRS 16) – (3,000,000) Carrying amount of the restoration provision (recognized and measured under IAS 37) – (800,000) 6,500,000 2,700,000 Impairment loss 2,000,000 2,000,000

Lease payments not included in the lease liability In most cases, as discussed, lease obligations are excluded from the carrying amount of a CGU and, accordingly, the related cash outflows are excluded from the determination of the recoverable amount. However, as the following lease payments are not included in the measurement of the lease liability under IFRS 16, the related cash outflows are included in the determination of the recoverable amount. Estimates of variable lease payments that do not depend on an index or rate and that are not in-substance fixed. Lease payments on short-term leases and leases of low value assets (if a lessee elects not to apply IFRS 16 to such leases, as permitted by IFRS 16). Further, under IFRS 16, variable lease payments that depend on an index or rate are included in the lease liability and measured initially based on the index or rate at the commencement date. The lease liability is remeasured only when the adjustment to the lease payments takes effect (IFRS 16). As the value in use of a CGU reflects an estimate of the future cash flows, the effect of future changes in the index or rate on the lease payments (and that are not included in the measurement of lease liability) must be included in determining the present value of the future cash flows.

Impairment testing of goodwill which arises as a result of a deferred tax liability recognized in a business combination In a business combination, a deferred tax liability may be recognized for temporary differences arising from the initial recognition of assets (IAS 12). The recognition of this deferred tax liability increases the goodwill recognized which is subject to impairment testing. Consistent with IAS 36, which requires the use of pre-tax cash flows when determining value in use, generally a deferred tax liability is not included in the carrying amount of the CGU. However, when the recognition of a deferred tax liability results in an increase in goodwill, excluding the deferred tax liability from the carrying amount of the CGU (or group of CGUs) to which goodwill has been allocated will result in an impairment loss at the acquisition date despite the absence of a decline in future cash flows. This does not appear reasonable. Therefore, to the extent that goodwill has been increased because of the recognition of a deferred tax liability in the purchase price allocation, it is acceptable to include the related deferred tax liability in the determination of the carrying amount of the CGU (or group of CGUs). Subsequently, if the recoverable amount reflects value in use, the carrying amount of the CGU (or group of CGUs) is adjusted for any remaining deferred tax liability at the impairment test date which resulted in an increase in goodwill (i.e., noting that the deferred tax liability recognized at the acquisition date may have fully or partially reversed).

Goodwill monitored at an entity level In many cases, the goodwill purchased in a business combination enhances the value of all of the acquirer’s pre-existing CGUs. Some might argue that, in such circumstances, goodwill should be tested for impairment at the entity level. The Board has rejected this argument and determined that the highest level at which goodwill should be tested for impairment is the operating segment level, before aggregation. If the entity monitors goodwill at a level higher than the operating segment level, it may be necessary to develop additional reporting systems to perform the impairment testing of goodwill mandated by IAS 36.

Level at which goodwill is tested for impairment – example Company A has three retail divisions, each of which is classified for reporting purposes as an operating segment under IFRS 8. All three divisions consist of a number of individual stores that operate independently of one another. Goodwill was recognized on the acquisition of each division. Management does not monitor goodwill for internal purposes. In accordance with the requirements of IAS 36, goodwill is assessed for impairment annually for financial reporting purposes. Management currently only monitors goodwill for impairment at an operating segment level. However, management also has the ability to allocate goodwill to each store within each operating segment and to monitor goodwill for impairment at that lower level. Even though management is capable of monitoring the impairment of goodwill at store level, it is not necessary for management to perform its goodwill impairment assessment at that lower level. IAS 36 requires goodwill to be assessed for impairment at a level no larger than an operating segment determined under IFRS 8, and which represents the lowest level at which goodwill is monitored for internal management purposes. Company A complies with both requirements and does not need to alter the level at which goodwill is currently assessed for impairment.

Allocation of goodwill by an unlisted entity – example Group A is an unlisted entity. It is therefore not within the scope of IFRS 8; nor does it choose to apply that Standard voluntarily. Group A acquired a subsidiary some years ago, which resulted in the recognition of goodwill. Management generally monitors Group A’s activities on a country-by-country basis. However, goodwill has not been allocated to individual countries for internal management purposes. If Group A were to apply IFRS 8, each country would represent an operating segment under that Standard. IAS 36 clarifies that the objective of the guidance in IAS 36 on allocating goodwill is to ensure that goodwill is tested for impairment “at a level that reflects the way an entity manages its operations and with which the goodwill would naturally be associated”. In specifying the level at which goodwill should be allocated, IAS 36 requires that the unit or group of units to which goodwill is allocated “not be larger than an operating segment as defined by paragraph 5 of IFRS 8 Operating Segments, before aggregation”. Note that this requirement does not refer to the level of reported operating segments. Therefore, irrespective of whether an entity reports segment information in respect of its operating segments in accordance with IFRS 8, it should assess its goodwill at the operating segment level in accordance with IAS 36. In the circumstances described, the level at which management generally monitors activities (i.e., the individual country level) appears to represent an appropriate operating segment level for Group A. Therefore, goodwill should be tested for impairment at that country level.

Goodwill allocation methodologies – example Entity M is a mining conglomerate. Entity M acquires Entity N, which operates a number of mines remotely located from each other, for consideration of CU10 million. For the purpose of accounting for the acquisition under IFRS 3, Entity M measures the fair value of the net identifiable assets of Entity N at CU8 million. Goodwill of CU2 million is therefore recognized at the acquisition date. IAS 36 requires that “for the purpose of impairment testing, goodwill acquired in a business combination shall, from the acquisition date, be allocated to each of the acquirer’s CGUs, or groups of CGUs, that is expected to benefit from the synergies of the combination, irrespective of whether other assets or liabilities of the acquiree are assigned to those units or groups of units”. Entity M determines that each independently operating mine is a CGU. In order to allocate the goodwill arising on the acquisition of Entity N among its CGUs, Entity M should first identify the CGUs or groups of CGUs throughout the group that are expected to benefit from the synergies of the combination, irrespective of whether other assets and liabilities of Entity N are allocated to those CGUs or groups of CGUs. Entity M should first identify the CGUs or groups of CGUs throughout the group that are expected to benefit from the synergies of the combination, irrespective of whether other assets and liabilities of Entity N are allocated to those CGUs or groups of CGUs. The level at which goodwill is required to be allocated to a CGU or group of CGUs is determined by the level at which management monitors goodwill and the operating segments of the entity. When it is necessary to allocate goodwill among individual CGUs or groups of CGUs, because that is the level at which the goodwill is monitored for internal management purposes, the Standard does not specify any particular method of allocation. In the circumstances described, assume that Entity M has concluded that only the newly acquired CGUs will benefit from the synergies of the combination. Consequently, Entity M needs to identify an appropriate method to allocate the goodwill among the Entity N mines that are expected to benefit from those synergies. For Entity M, appropriate methods of allocating the goodwill may include: in proportion to the relative fair value of the identifiable net assets in each CGU; or in proportion to the relative fair values of the CGUs; or in proportion to the possible reserves beyond proven and probable (whether or not used in determining the value of the purchased assets) in each CGU; or in proportion to proven reserves in each CGU. None of these allocation methods is prohibited by the Standard. However, other considerations to take into account include that: the method used to determine the purchase price may indicate an appropriate allocation methodology, which could include any of those proposed; and the allocation methodology used should not be inconsistent with any disclosed factors that support the goodwill figure. Note that  IFRS 6 addresses the determination of an accounting policy for allocating exploration and evaluation assets to CGUs or groups of CGUs for the purpose of assessing such assets for impairment. However, the allocation of any goodwill arising on the acquisition of a mining entity remains within the scope of IAS 36 rather than IFRS 6.

Impairment testing of goodwill when a cash-generating unit crosses more than one operating segment – example Entity A, a telecommunications company, operates its business using its own assets such as fixed lines, wireless networks, base-station equipment and antennas. Entity A properly identifies one CGU which covers its entire business in a region, in accordance with the definition and related requirements of IAS 36. However, Entity A also appropriately identifies two operating segments in the region based on types of customers (i.e., individual clients and business clients) in accordance with the definition of operating segments in IFRS 8. In the circumstances described, goodwill should be tested at an operating segment level. IAS 36 requires that, for the purpose of impairment testing, goodwill is allocated to each of the acquirer’s CGUs or group of CGUs, which should not be larger than an operating segment as defined by IFRS 8:5. Whilst allocation of goodwill to a level smaller than a CGU is usually not necessary, it is not prohibited by IAS 36 and is the only way to meet the requirement in IAS 36 in this scenario. Testing the impairment of goodwill at operating segment level is consistent with the Board’s intention in developing IAS 36 that there should be a link between the level of impairment testing and the level of internal reporting that reflects the way an entity is managed. To test goodwill at the operating segment level in this scenario, Entity A should allocate the assets of the CGU and the goodwill to each of two operating segments on a reasonable basis.

Interaction of goodwill allocation and identification of cash-generating units Entity Z operates from multiple locations spread over ten regions. In accordance with IAS 36, Entity Z has allocated goodwill at a regional level for the purposes of impairment testing. The allocation of goodwill at a regional level does not mean that each region is automatically considered a CGU. The identification of CGUs and the allocation of goodwill to those CGUs (or groups of CGUs) are two separate steps in the impairment testing process, with different considerations to be applied at each step. A CGU is defined as “the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets“. As discussed, the structure of an entity’s internal management reporting is only relevant to the identification of CGUs as an indicator of whether an asset or a group of assets generates cash inflows that are largely independent. Conversely, the allocation of goodwill to CGUs or groups of CGUs is driven by an entity’s internal reporting because it depends on: the level at which goodwill is monitored for internal management purposes; and the level at which operating results are regularly reviewed by the entity’s chief operating decision maker to make resource allocation decisions and to monitor performance (because this forms part of the definition of an operating segment in IFRS 8). The distinction between a CGU and a group of CGUs to which goodwill is allocated is important due to the ‘two-step’ approach required by IAS 36 whereby each individual CGU (excluding any goodwill) for which there is an indication of impairment is tested and any resulting impairment losses are recognized before groups of CGUs including goodwill are tested and any further impairment losses recognized.

Goodwill measured on the basis of relative values- example An entity sells for CU100 an operation that was part of a CGU to which goodwill has been allocated. The goodwill allocated to that unit cannot be identified or associated with an asset group at a level lower than that unit, except arbitrarily. The recoverable amount of the portion of the CGU retained is CU300. Because the goodwill allocated to the CGU cannot be non-arbitrarily identified or associated with an asset group at a level lower than that unit, the goodwill associated with the operation disposed of is measured on the basis of the relative values of the operation disposed of and the portion of the unit retained. Therefore, 25 per cent of the goodwill allocated to the CGU is included in the carrying amount of the operation that is sold.

Alternative methods for allocation of goodwill when part of a CGU is disposed of When goodwill cannot be allocated, except arbitrarily, at a lower level than that at which it is monitored for internal management purposes, the most appropriate method of allocation will generally be based on the relative values of the operation disposed of and the portion of the CGU retained. There may be circumstances when some other method better reflects the amount of goodwill associated with the operation disposed of, and IAS 36 allows the use of another method of allocation, provided that the superiority of the chosen method can be demonstrated. For example, assume that a CGU is acquired and integrated with a pre-existing CGU that did not include any goodwill. Assume that, almost immediately after the business combination, the entity disposes of a pre-existing loss-making operation from within the integrated CGU. In such circumstances, it might reasonably be argued that no part of the goodwill has been disposed of and, therefore, no part of its carrying amount should be derecognised by being included in the determination of the gain or loss on disposal.

Example Reorganization of reporting structure Goodwill had previously been allocated to CGU A. The goodwill allocated to A cannot be identified or associated with an asset group at a level lower than A, except arbitrarily. A is to be divided and integrated into three other CGUs, B, C and D. Because the goodwill allocated to A cannot be non-arbitrarily identified or associated with an asset group at a level lower than A, it is reallocated to units B, C and D on the basis of the relative values of the three portions of A before those portions are integrated with B, C and D.

Gross-up of goodwill for impairment testing when non-controlling interests are measured at their proportionate interest in the net identifiable assets of the subsidiary – example Entity A acquires 80 per cent of Entity B in a business combination. On acquisition, Entity A chooses to measure the components of non-controlling interests (NCI) that are present ownership interests in Entity B at their proportionate interest in the net identifiable assets of Entity B. This results in goodwill of CU20,000, which is allocated in its entirety to Entity B for the purposes of impairment testing under IAS 36. IAS 36 requires the carrying amount of goodwill to be grossed up to include the goodwill attributable to the NCI. The adjusted carrying amount should then be compared with the recoverable amount of Entity B to determine whether there is impairment. IAS 36 does not prescribe a method for grossing up goodwill to include the amount attributable to NCI when the components of NCI that are present ownership interests arising in a business combination are measured at the proportionate interest in the net identifiable assets of the subsidiary. Example 7A in the illustrative examples accompanying IAS 36 demonstrates a mathematical gross-up based on ownership interests. Therefore, in the above example, it would be appropriate to gross up goodwill to CU25,000 (being CU20,000 × 100/80). However, in the absence of guidance to the contrary, Entity A could gross up goodwill based on the fair value of NCI at the acquisition date (i.e., the amount of goodwill that would have been recognized if NCI had been measured at fair value at the acquisition date), if that information can be determined reliably.

Gross-up of goodwill for impairment testing when non-controlling interests are measured at their proportionate interest in the net identifiable assets of the subsidiary – changes in ownership interest When a parent entity that measures non-controlling interests at their proportionate interest in the net identifiable assets of the subsidiary subsequently acquires additional, or disposes of, shares of the subsidiary, it will need to consider how this may affect the application of the requirements in IAS 36 to perform a gross-up of the carrying amount of goodwill for impairment testing purposes. As IAS 36 does not provide explicit guidance on this, a parent entity needs to identify an appropriate approach which it applies as an accounting policy consistently to all similar transactions. The following discussion presents an appropriate approach. Other approaches may be acceptable. Subsidiary becomes wholly-owned If the parent acquires all the shares of the subsidiary held by the non-controlling interests such that the subsidiary becomes wholly-owned, it will be appropriate for the entity to cease performing a gross-up of goodwill for impairment testing purposes. IAS 36 explains that the gross-up is required due to the fact that “goodwill attributable to the non-controlling interests is included in the recoverable amount of the related cash-generating unit but is not recognized in the parent’s consolidated financial statements”. If the subsidiary becomes wholly-owned, this inconsistency no longer exists and therefore the gross-up of the goodwill is no longer required. Percentage of ownership in subsidiary increases but it does not become wholly-owned If the parent increases its percentage of ownership in the subsidiary, it will be appropriate for the parent to perform the gross-up of goodwill using the current ownership level. For example, if a parent increases its ownership in the subsidiary from 70 per cent to 80 per cent and initially measured the non-controlling interests at their proportionate interest in the net identifiable assets of the subsidiary, it will be appropriate for the parent to gross-up goodwill by 25 per cent (20%/80%, i.e., the current non-controlling interests’ percentage ownership over the parent’s ownership interest). Percentage of ownership in partly-owned subsidiary decreases but without loss of control If the parent disposes of shares in the partly-owned subsidiary such that the percentage held by the parent is reduced without a loss of control, it will be appropriate for the parent to gross up goodwill using the original percentage held by the non-controlling interests (i.e., the ownership interest before the decrease). For example, if a parent decreases its ownership in the subsidiary from 80 per cent to 70 per cent and initially measured the non-controlling interests at their proportionate interest in the net identifiable assets of the subsidiary, it will be appropriate for the parent to continue grossing up goodwill based on the percentage of ownership at the acquisition date, i.e., a gross-up of 25 per cent (20%/80%). This is to avoid goodwill being grossed up above 100 per cent. This can be viewed as consistent with the fact that no gross-up is required if non-controlling interests arise subsequent to the business combination and are measured at the proportionate share of net assets of the subsidiary. Percentage of ownership in subsidiary fluctuates without loss of control Circumstances may arise when the percentage held by the parent fluctuates as a result of transactions in which the parent does not lose control, for example the percentage of ownership increases and then decreases above or below the percentage held at the acquisition date (e.g., 60 per cent to 80 per cent and then to 70 per cent or 55 per cent). In this scenario, a reasonable approach may be to use the current ownership interest to perform the gross-up except when the ownership interest of the parent falls below the percentage of ownership at the acquisition date (i.e., below the percentage of interest reflected in the initial measurement of goodwill), in which case the percentage of ownership at the acquisition date is used.

Application of IAS 36 when non-controlling interests arise subsequent to the business combination and are measured at the proportionate share of net assets of the subsidiary IAS 36 does not apply to situations in which the non-controlling interests arise from transactions or events other than a business combination (e.g., a decrease in ownership in a subsidiary without loss of control) even if the components of non-controlling interests that are present ownership interests are measured at the proportionate share of a subsidiary’s net assets. This is because the purpose of IAS 36 is to ensure consistency (for the purpose of impairment testing) between the goodwill included in the recoverable amount of a CGU and the goodwill included in the carrying amount of that CGU. The cash flows used to determine the recoverable amount of a CGU reflect 100 per cent of its activities; as a result, the recoverable amount includes 100 per cent of the goodwill attributable to the CGU. When components of non-controlling interests that are present ownership interests arise as a result of a business combination and are measured at the proportionate share of the acquiree’s identifiable net assets, the goodwill recognized in the consolidated financial statements reflects only the parent’s share of the goodwill. Therefore, there is a potential mismatch for the purpose of impairment testing, which is avoided by IAS 36’s requirement to gross up the goodwill included in the carrying amount of the CGU. However, when a parent initially purchases 100 per cent of the subsidiary, the goodwill recognized in the consolidated financial statements represents 100 per cent of the goodwill of the subsidiary. This remains the case after a disposal of a non-controlling interest in the subsidiary, even when components of non-controlling interests that are present ownership interests recognized subsequent to the acquisition are measured at the proportionate share of the net assets. Therefore, grossing up goodwill for the purpose of impairment testing would not be appropriate. For example, on 1 January 20X3, Parent P acquires 100 per cent of Subsidiary S for CU1,900. At that date, the fair value of Subsidiary S’s net identifiable assets is CU1,500. Parent P recognizes goodwill of CU400 in its consolidated financial statements as a result of the business combination. On 1 July 20X3, Parent P disposes of 20 per cent of its interest in Subsidiary S for CU380. For simplicity, it is assumed that the fair value of Subsidiary S’s net identifiable assets on that date is still CU1,500. Parent P recognizes non-controlling interests of CU300 (20% × CU1,500) and the difference of CU80 between this amount and the proceeds received is recognized in equity. Because control is retained, there is no adjustment to the carrying amount of goodwill (i.e., goodwill remains at CU400). At the end of 20X5, Parent P determines that the recoverable amount of Subsidiary S is CU1,000. The carrying amount of the net assets of Subsidiary S, excluding goodwill, is CU1,350. Because all of the goodwill attributable to Subsidiary S is included in the recoverable amount of Subsidiary S and is also recognized in Parent P’s consolidated financial statements, no adjustment is required to gross up goodwill for the purpose of impairment testing. In the circumstances described, an impairment loss of CU750 should be recognized, calculated as follows. End of 20X5 Goodwill of Subsidiary S Net identifiable assets Total CU CU CU Carrying amount 400 1,350 1,750 Recoverable amount 1,000   750 In accordance with IAS 36, the impairment loss of CU750 is allocated to the assets in Subsidiary S by first reducing the carrying amount of goodwill. Therefore, CU400 of the CU750 impairment loss is allocated to the goodwill and the remaining impairment loss of CU350 is recognized by reducing the carrying amounts of Subsidiary S’s identifiable assets.

Allocation of goodwill impairment loss when non-controlling interests are measured at fair value – example Entity A acquires 80 per cent of Entity B for CU1,250. Entity B has identifiable net assets with a fair value of CU1,000 and the fair value of the non-controlling interests (NCI) is determined to be CU250. Ownership Share of identifiable net assets Fair value Goodwill Goodwill % CU CU CU % Parent interest 80 800 1,250 450 90 NCI 20   200   250   50 10 1,000 1,500  500 If an impairment loss of CU100 subsequently arises on Entity B’s goodwill, it is allocated 80 per cent to Entity A (CU80) and 20 per cent to the NCI (CU20). Equally, if the impairment loss arising on Entity B’s goodwill is CU300, CU60 (i.e., 20 per cent) is allocated to the NCI and CU240 (i.e., 80 per cent) is allocated to Entity A. This is so even though, in this example, the goodwill impairment allocated to the NCI exceeds the goodwill originally included in the NCI. If a subsidiary, or part of a subsidiary, with a non-controlling interest is part of a larger CGU, goodwill impairment losses are allocated to the parts of the CGU that have a non-controlling interest and the parts that do not. The impairment losses should be allocated to the parts of the CGU on the basis of: to the extent that the impairment relates to goodwill in the CGU, the relative carrying values of the goodwill of the parts before the impairment; and to the extent that the impairment relates to identifiable assets in the CGU, the relative carrying values of the net identifiable assets of the parts before the impairment. Any such impairment is allocated to the assets of the parts of each unit pro rata on the basis of the carrying amount of each asset in the part.

Impairment loss attributable to non-controlling interest relates to goodwill not recognized in the consolidated financial statements – example Entity A has an existing wholly-owned subsidiary, Entity B. Subsequently, Entity A acquires 80 per cent of Entity C in a business combination. Synergies arising from that business combination are expected to benefit Entity B. Accordingly, under IAS 36, some of the goodwill acquired in the business combination is allocated to CGUs within Entity B. Following the allocation of goodwill, Entity A compares the adjusted carrying amounts of the CGUs with their recoverable amounts. Entity A has chosen to measure the components of non-controlling interests that are present ownership interests at their proportionate interest in the net identifiable assets of Entity C at the acquisition date. Therefore, in accordance with IAS 36, the carrying amount of goodwill allocated to Entity C is grossed up to include the goodwill attributable to the non-controlling interests. On the basis of this comparison, Entity C is determined to be impaired. Adjusted carrying amount Recoverable amount Impairment  CU CU CU  Entity C 29,500 25,000 (4,500) Entity B 32,500 40,000 – The impairment of CU4,500 for Entity C relates to goodwill, and is allocated between the parent and the non-controlling interests on the same basis as that on which profit or loss is allocated, i.e., 80 per cent to the parent (CU3,600) and 20 per cent to the non-controlling interests (CU900). But, because the impairment loss attributable to the non-controlling interests relates to goodwill that is not recognized in the parent’s consolidated financial statements, that impairment is not recognized as a goodwill impairment loss. Accordingly, CU3,600 is recognized as a goodwill impairment loss in the consolidated financial statements, being the impairment loss relating to the goodwill that is allocated to the parent (Entity A).

Non-controlling interests measured initially as a proportionate share of the net identifiable assets In this example, tax effects are ignored. Background Parent acquires an 80 per cent ownership interest in Subsidiary for CU2,100 on 1 January 20X3. At that date, Subsidiary’s net identifiable assets have a fair value of CU1,500. Parent chooses to measure the non-controlling interests as the proportionate interest of Subsidiary’s net identifiable assets of CU300 (20% of CU1,500). Goodwill of CU900 is the difference between the aggregate of the consideration transferred and the amount of the non-controlling interests (CU2,100 + CU300) and the net identifiable assets (CU1,500). The assets of Subsidiary together are the smallest group of assets that generate cash inflows that are largely independent of the cash inflows from other assets or groups of assets. Therefore, Subsidiary is a cash-generating unit. Because other cash-generating units of Parent are expected to benefit from the synergies of the combination, the goodwill of CU500 related to those synergies has been allocated to other cash-generating units within Parent. Because the cash-generating unit comprising Subsidiary includes goodwill within its carrying amount, it must be tested for impairment annually, or more frequently if there is an indication that it may be impaired. At the end of 20X3, Parent determines that the recoverable amount of cash-generating unit Subsidiary is CU1,000. The carrying amount of the net assets of Subsidiary, excluding goodwill, is CU1,350. Testing Subsidiary (cash-generating unit) for impairment Goodwill attributable to non-controlling interests is included in Subsidiary’s recoverable amount of CU1,000 but has not been recognized in Parent’s consolidated financial statements. Therefore, in accordance with IAS 36, the carrying amount of Subsidiary is grossed up to include goodwill attributable to the non-controlling interest, before being compared with the recoverable amount of CU1,000. Goodwill attributable to Parent’s 80 per cent interest in Subsidiary at the acquisition date is CU400 after allocating CU500 to other cash-generating units within Parent. Therefore, goodwill attributable to the 20 per cent non-controlling interest in Subsidiary at the acquisition date is CU100. Schedule 1. Testing Subsidiary for impairment at the end of 20X3 End of 20X3 Goodwill of Subsidiary Net identifiable assets Total CU CU CU Carrying amount 400 1,350 1,750 Unrecognized non-controlling interests 100     –   100 Adjusted carrying amount 500 1,350 1,850 Recoverable amount 1,000 Impairment loss   850 Allocating the impairment loss In accordance with IAS 36, the impairment loss of CU850 is allocated to the assets in the unit by first reducing the carrying amount of goodwill. Therefore, CU500 of the CU850 impairment loss for the unit is allocated to the goodwill. In accordance with IAS 36, if the partially-owned subsidiary is itself a cash-generating unit, the goodwill impairment loss is allocated to the controlling and non-controlling interests on the same basis as that on which profit or loss is allocated. In this example, profit or loss is allocated on the basis of relative ownership interests. Because the goodwill is recognized only to the extent of Parent’s 80 per cent ownership interest in Subsidiary, Parent recognizes only 80 per cent of that goodwill impairment loss (i.e., CU400). The remaining impairment loss of CU350 is recognized by reducing the carrying amounts of Subsidiary’s identifiable assets (see Schedule 2). Schedule 2. Allocation of the impairment loss for Subsidiary at the end of 20X3 End of 20X3 Goodwill Net identifiable assets Total CU CU CU Carrying amount 400 1,350 1,750 Impairment loss (400)  (350)  (750) Carrying amount after impairment loss    – 1,000 1,000

Non-controlling interests measured initially at fair value and the related subsidiary is a stand-alone cash-generating unit In this example, tax effects are ignored. Background Parent acquires an 80 per cent ownership interest in Subsidiary for CU2,100 on 1 January 20X3. At that date, Subsidiary’s net identifiable assets have a fair value of CU1,500. Parent chooses to measure the non-controlling interests at fair value, which is CU350. Goodwill of CU950 is the difference between the aggregate of the consideration transferred and the amount of the non-controlling interests (CU2,100 + CU350) and the net identifiable assets (CU1,500). The assets of Subsidiary together are the smallest group of assets that generate cash inflows that are largely independent of the cash inflows from other assets or groups of assets. Therefore, Subsidiary is a cash-generating unit. Because other cash-generating units of Parent are expected to benefit from the synergies of the combination, the goodwill of CU500 related to those synergies has been allocated to other cash-generating units within Parent. Because Subsidiary includes goodwill within its carrying amount, it must be tested for impairment annually, or more frequently if there is an indication that it might be impaired. Testing Subsidiary for impairment At the end of 20X3, Parent determines that the recoverable amount of cash-generating unit Subsidiary is CU1,650. The carrying amount of the net assets of Subsidiary, excluding goodwill, is CU1,350. Schedule 1. Testing Subsidiary for impairment at the end of 20X3 End of 20X3 Goodwill Net identifiable assets Total CU CU CU Carrying amount 450 1,350 1,800 Recoverable amount 1,650 Impairment loss    150 Allocating the impairment loss In accordance with IAS 36, the impairment loss of CU150 is allocated to the assets in the unit by first reducing the carrying amount of goodwill. Therefore, the full amount of impairment loss of CU150 for the unit is allocated to the goodwill. In accordance with IAS 36, if the partially-owned subsidiary is itself a cash-generating unit, the goodwill impairment loss is allocated to the controlling and non-controlling interests on the same basis as that on which profit or loss is allocated.

Non-controlling interests measured initially at fair value and the related subsidiary is part of a larger cash-generating unit In this example, tax effects are ignored. Background Suppose that, for the business combination described in, the assets of Subsidiary will generate cash inflows together with other assets or groups of assets of Parent. Therefore, rather than Subsidiary being the cash-generating unit for the purposes of impairment testing, Subsidiary becomes part of a larger cash-generating unit, Z. Other cash-generating units of Parent are also expected to benefit from the synergies of the combination. Therefore, goodwill related to those synergies, in the amount of CU500, has been allocated to those other cash-generating units. Z’s goodwill related to previous business combinations is CU800. Because Z includes goodwill within its carrying amount, both from Subsidiary and from previous business combinations, it must be tested for impairment annually, or more frequently if there is an indication that it might be impaired. Testing Subsidiary for impairment At the end of 20X3, Parent determines that the recoverable amount of cash-generating unit Z is CU3,300. The carrying amount of the net assets of Z, excluding goodwill, is CU2,250. Schedule 3. Testing Z for impairment at the end of 20X3 End of 20X3 Goodwill Net identifiable assets Total CU CU CU Carrying amount 1,250 2,250 3,500 Recoverable amount  3,300 Impairment loss    200 Allocating the impairment loss In accordance with IAS 36, the impairment loss of CU200 is allocated to the assets in the unit by first reducing the carrying amount of goodwill. Therefore, the full amount of impairment loss of CU200 for cash-generating unit Z is allocated to the goodwill. In accordance with IAS 36, if the partially-owned subsidiary forms part of a larger cash-generating unit, the goodwill impairment loss would be allocated first to the parts of the cash-generating unit, Z, and then to the controlling and non-controlling interests of the partially owned Subsidiary. Parent allocates the impairment loss to the parts of the cash-generating unit on the basis of the relative carrying values of the goodwill of the parts before the impairment. In this example Subsidiary is allocated 36 per cent of the impairment (450/1,250). The impairment loss is then allocated to the controlling and non-controlling interests on the same basis as that on which profit or loss is allocated.

Future cash flows in hyperinflationary currencies In principle, the guidance in the final bullet above also applies when a currency is hyperinflationary. However, in the case of hyperinflation, frequently there will be difficulties in determining the likely future rate of inflation and the relevant nominal interest rate. Calculating the value in use generally will be easier in real terms.

Impact of inflation when forecasting future cash flows As noted, IAS 36 sets out two ways to deal with inflation when estimating future cash flows. The first method is to forecast cash flows in real terms – i.e., forecast cash flows that are increased or decreased in real terms, to reflect the likely relation between future changes in specific prices and general inflation. These cash flows are then discounted at a real discount rate (i.e., a rate that excludes general inflation). Alternatively, the forecast cash flows can reflect the estimated increase or decrease in specific prices in nominal terms, but those ‘nominal cash flows’ then need to be discounted at a nominal rate of interest (i.e., a rate that includes general inflation). Care will be needed when revenues and costs are expected to change at different rates in the future. This would happen when there are specific factors applicable to the different cash flow streams that will make them vary, other than general price level changes (the general price level change will be the same for all cash flow streams). For example, the regulator may restrict the revenues of a regulated entity, but its costs will be unrestricted. The entity’s costs and revenues, therefore, will be subject to different assumptions as to the rates at which they will change. In such circumstances: if the first method described above is used, it will be necessary to reflect the different estimated rates of variation of revenues and costs in real terms; and if the second method is used, it will be necessary to reflect the different estimated changes to revenues and costs in nominal terms.

Taking account of inflation when forecasting future cash flows – illustration of alternative methods – example Entity A is estimating the value in use of a machine with four years of remaining expected useful life. The following general information is relevant: forecast inflation for the next four years – 3 per cent per year; forecast interest (nominal rate) for the next four years – 9 per cent per year; and forecast interest (real rate) for the next four years – 5.8252* per cent per year. The specific revenues and costs of Entity A are expected to increase at the following rates for the next four years. Year 1 2 3 4 Revenues 3% 2% 2% 1% Raw material 4% 4% 5% 6% Labor 3% 3% 3% 3% Method 1 – real cash flows discounted using real rate of interest The following are the cash flows expected to be generated by the machine in real terms. Cash flows forecast in real terms Base Total (Year 0) Year 1  Year 2  Year 3  Year 4  (Years 1 to 4) Revenues 100,000 100,000 99,029 98,068 96,163 Raw material (35,000) (35,340) (35,683) (36,376) (37,435) Labor  (25,000)  (25,000) (25,000) (25,000) (25,000) Net cash flows  40,000  39,660 38,346 36,692 33,728 148,426 When these ‘real’ cash flows are discounted at the real interest rate, the outcome is as follows. Cash flows forecast in real terms discounted at the real interest rate (5.8252% per year) Total Year 1  Year 2  Year 3  Year 4  (Years 1 to 4) Revenues 94,495 88,427 82,748 76,675 Raw material (33,394) (31,863) (30,693) (29,849) Labor (23,624) (22,323) (21,095) (19,933) Value in use Net cash flows 37,477 34,241 30,960 26,893 129,571 Method 2 – nominal cash flows discounted using nominal rate of interest The following are the cash flows expected to be generated by the machine in nominal terms. Cash flows forecast in nominal terms Base Total (Year 0) Year 1  Year 2  Year 3  Year 4  (Years 1 to 4) Revenues 100,000 103,000 105,060 107,161 108,233 Raw material (35,000) (36,400) (37,856) (39,749) (42,134) Labor  (25,000)  (25,750)  (26,522)  (27,318)  (28,138) Net cash flows  40,000  40,850  40,682  40,094  37,961 159,587 When these nominal cash flows are discounted at the nominal interest rate, the outcome is as follows. Cash flows forecast in nominal terms discounted at the nominal interest rate (9% per year) Total Year 1  Year 2  Year 3  Year 4  (Years 1 to 4) Revenues 94,495 88,427 82,748 76,675 Raw material (33,394) (31,863) (30,693) (29,849) Labor (23,624) (22,323) (21,095) (19,933) Value in use Net cash flows 37,477 34,241 30,960 26,893 129,571 *Forecast real rate is calculated as follows. 1 + nominal interest rate – 1 = 1 + 0.09 – 1 = 0.058252 or 5.8252% 1 + inflation rate 1 + 0.03

Period for projecting cash flows when determining the value in use of a right-of-use asset (entities that have adopted IFRS 16) – example Entity A is a retail entity. Entity A has determined that each of its individual stores is a CGU for the purposes of impairment testing under IAS 36. Each CGU includes a right-of-use asset for the lease of the retail store, leasehold improvements and various other owned assets such as display units, cashier tills, fridges and freezers. Entity A identifies that Store S may be impaired due to an economic downturn in the city where it is located. Store S was established four years earlier when Entity A entered into the lease agreement. The original term of the lease was seven years, with a renewal option for an additional five years. Because Entity A was not reasonably certain to exercise the renewal option at the commencement date of the lease, it determined that the lease term under IFRS 16 was seven years. At the date of the impairment test, three years remain under the original lease. At the date of the impairment test, the average remaining useful life of the assets in the Store S CGU (apart from the right-of-use asset) is eight years. This reflects, in part, the fact that Entity A expects to exercise the renewal option under the lease agreement (even though this was not reasonably certain at commencement of the lease). This assumption remains valid because Entity A expects that the economy will improve in the short term. In determining the value in use of the Store S CGU under IAS 36, Entity A needs to consider whether the projected cash flows are constrained by the lease term as defined by IFRS 16. IAS 36 states that in measuring value in use, an entity should base cash flow projections 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. IAS 36 adds that when a CGU consists of assets with different useful lives, all of which are essential to the ongoing operation of the unit, the replacement of assets with shorter lives is considered to be part of the day-to-day servicing of the unit when estimating the future cash flows associated with the CGU. The definition of ‘useful life’ contained in IAS 36, which is taken from IAS 16, is the period over which the asset is expected to be available for use by the entity. In some circumstances, the useful life of assets that can only be used in conjunction with a leased asset may be longer than the lease term determined in accordance with IFRS 16. If, as contemplated in IAS 36, Entity A establishes that the Store S CGU includes assets that are essential to the ongoing operation of the store and have a useful life that is longer than the lease term, the value in use would be determined over this longer period. In such a case, Entity A would include in its cash flows the replacement of the right-of-use asset (for example, expected periodic lease payments for the period beyond the lease term or the cost of a replacement asset to be purchased, depending on Entity A’s intended course of action).

Relevance of climate change to a value in use calculation A growing number of scientific projections detail not only potential average increases in global temperatures, but also how such changes will translate into physical phenomena such as rising sea levels and more frequent extreme weather events. Economic forecasts are also increasingly reflecting the impact of such changes, together with related factors such as carbon pricing initiatives and changing demand for fossil fuels and renewable energy. As highlighted by organizations including the Intergovernmental Panel on Climate Change (IPCC) and the World Economic Forum (WEF), this could result in various effects (positive or negative) on business models across all industries. This is due to the physical effects of climate change and to related effects on regulation, technological developments and consumer preferences. Changes in market expectations and reputational risk might also result in entities choosing to amend their business models. These factors may result in changes to management’s cash flow projections (based on reasonable and supportable assumptions that represent management’s best estimate of economic conditions as required by IAS 36, or the level of risk associated with achieving those cash flows, in which case they should, as appropriate, form part of an entity’s value in use assessment. When climate change is discussed in an entity’s broader corporate reporting (for example, in terms of risks to which the entity is exposed or changes to its business model), consideration should be given to whether any changes referred to have been appropriately considered as part of the entity’s impairment testing.

Incorporation of changes expected to occur beyond the period covered by financial budgets and forecasts It some cases, the future cash flows generated by an asset or cash-generating unit are not expected to grow (or decline) at a constant rate between the end of the period covered by management approved financial budgets or forecasts and the end of the asset’s useful life (or, in the case of a cash-generating unit or group of cash-generating units to which goodwill or an indefinite life intangible has been allocated, to perpetuity). One factor that may, in various circumstances, be expected to have a medium to long-term effect on cash flows is climate change. For example: assets of a tourism business may become ‘stranded’ (either physically or commercially) in areas susceptible to sea-level rises or loss of natural resources that attract visitors; agricultural yields may be anticipated to fall in areas expected to experience more extreme weather events or a limitation in the availability of water; or a business producing single-use plastics might be expected to experience a reduction in demand due to consumer and/or government action. If management’s best estimate, based on reasonable and supportable assumptions, is that such an event will affect cash flows beyond the forecast or budget period, it would be inappropriate to exclude management’s expectation from a value in use calculation by simply extrapolating budgeted/forecast cash flows using an expected rate of general economic growth. Instead, in applying the extrapolation of budgeted or forecast cash flows required by IAS 36 management should consider the need for a modification to incorporate a curve reflecting the anticipated timing, profile and magnitude of the effect of climate change (or any other longer-term factors expected to affect the economic environment). Alternatively, a single terminal growth rate incorporating climate change (or other longer-term factors) can be applied if it results in a reasonable approximation to its expected effect on the present value of the asset (or cash-generating unit’s) future cash flows. As noted in IAS 36, the growth rate applied can be negative. When such an external factor indicates that an item of property, plant and equipment may become physically unavailable or commercially obsolete earlier than would otherwise be the case, this should be factored into the review of the asset’s useful life required by IAS 16. Similarly, the useful life of any intangible assets affected should be reviewed as required by .

Incorporation of expected government action into estimates of future cash flows Changes in government policy or legislation may affect the future cash flows generated by an asset or cash-generating unit. For example, some governments may be considering introducing legislation or setting policies such as: a levy on greenhouse gas emissions (‘carbon tax’); regulations requiring increased standards of energy efficiency for commercial or residential property; or a cap on the supply or use of natural resources. Prior to enacting detailed legislation, a government might set a target to achieve net zero emissions within a certain timescale demonstrating an intent to pass legislation in the future. If expected government action would affect the cash flows generated by an asset or cash-generating unit, it will be necessary to consider at what point this should be factored into cash flow forecasts. Judgement will be required in determining when expected government action affects cash flow projections. However, unlike for the recognition of a new liability under either IAS 12 or IFRIC 21, it is not necessary to wait for the enactment or substantive enactment of a change before it is incorporated into an estimate of future cash flows supporting the carrying amount of an existing asset or cash-generating unit. Management’s best estimate may be that, whilst the exact nature or form of the government legislative or regulatory action is not certain, there will nonetheless be an effect on the entity’s future cash flows. If this is the case, the expected changes in cash flows should be included in a value in use calculation, as long as they are based on reasonable and supportable assumptions as required by IAS 36. Government action in areas such as climate change might reinforce or combine with changes not resulting from legislation (for example, changing consumer attitudes to carbon intensive products). As discussed, expected changes of this nature should also be factored into value in use calculations.

Inclusion of corporate costs in the calculation of the value in use of a CGU All corporate costs that can be directly attributed to the use of a CGU (or group of CGUs to which goodwill has been allocated), or that can be allocated on a reasonable and consistent basis to that CGU (or group of CGUs) should be included in the calculation of the value in use. This will generally be the case for costs such as IT costs, human resource costs or certain direct marketing activities. However, there is no requirement that all corporate costs be included in management’s estimate of expected future cash flows used for the calculation of the value in use of a CGU (or group of CGUs to which goodwill is allocated). Some costs may be determined to be neither directly attributable nor capable of being allocated on a reasonable and consistent basis to a CGU (or group of CGUs). Based on facts and circumstances, examples of such costs might include payments to the non-executive directors of an entity or those related to investor relations.

Expenditure on maintaining and improving assets – example The assets of a CGU comprise a factory and plant and machinery. The factory is expected to last 50 years, but will need a new roof in 30 years, and the machinery needs to be replaced every 10 years. The entity expects to be able to reduce costs per unit of production by extending the factory to double production in a few years, but is not yet committed to such a restructuring. The replacement expenditure for the 50 years, including the new roof and new machinery, should be included in the cash flows. Neither the expenditure to increase the size of the factory nor the additional income and revenue expenditure consequent on that expansion should be included.

Charges for the use of corporate assets to be excluded from estimated cash flows The present value of the net cash inflows of a CGU is CU220 before charges for the use of corporate assets, and the carrying amount of the assets of the CGU (excluding corporate assets) is CU140. The present value of the cash outflows for the use of the corporate assets is CU50, and the carrying amount of the portion of the corporate assets allocated to the CGU is CU45. The corporate assets can be allocated to the CGU on a reasonable and consistent basis. In these circumstances, IAS 36 requires that the portion of the corporate assets allocated to the CGU should be included in its carrying amount. Therefore, the value in use of CU220 is compared to the CGU’s carrying amount of CU185 (CU140 + CU45). The headroom is CU35 and there is no impairment loss. The entity should not factor into the determination of recoverable amount both the portion of the corporate assets and the related outflows; if it does so, it will incorrectly recognize an impairment loss of CU15 (value in use of CU170 (CU220 – CU50) compared to carrying amount of CU185 (CU140 + CU45)).

Material change to the manner of operations excluded from the value in use calculation – example Entity A is assessing a cash-generating unit that consists of a site currently dedicated to coal-powered electricity generation for impairment. The impairment indicator which prompted the impairment test and identification of its cash-generating unit arose from the coal energy plant. In response to expected commercial pressures and government action, Entity A’s long-term strategy is to replace the assets at the site with renewable energy generating facilities. Although Entity A will keep producing energy at the site, the change of production from coal to renewable energy represents a material change to the manner in which Entity A operates the cash-generating unit. As such, the effects of replacement of the assets in the cash-generating unit, enabling transfer from coal to renewable energy production should not be included in the calculation of value in use until Entity A is committed (as described in IAS 37) to a specific restructuring programmed. Accordingly, until that point, projections of future cash flows over the current site’s useful life should consider the extent to which cash flows might be affected by consumer behavior and possible increased costs of operations. It may also be appropriate to review the useful life of the assets comprised in the cash-generating unit.

Refinement of a manufacturing process included in value in use calculation – example Entity B is testing a cash-generating unit consisting of a facility manufacturing disposable coffee cups for impairment. In response to consumer pressure, Entity B plans to replace an element of the manufacturing process with one that makes the cups produced more easily recyclable. Management’s judgement is that this will not lead to a major change of the disposable coffee cups which are sold, or of their production, and therefore, that it just constitutes a refinement of the manufacturing process, rather than a material change to the facility’s operations or output. Accordingly, the cost of the alteration to that element of the manufacturing process and its effect of maintaining revenues that would otherwise be lost to Entity B’s competitors are included in the calculation of the cash-generating unit’s value in use.

Impact of replacement assets on value in use calculation For the purchase of replacement assets to be considered maintenance expenditure, and therefore included in a value in use calculation, it is not necessary for forecast replacement assets to be identical to those currently in use. If a component of an asset, or asset forming part of a cash-generating unit, is expected to be replaced by a component or asset that does not significantly change the manner of operations, but instead is a technological upgrade fulfilling the same function then, unless that replacement enhances the economic output of the asset or cash-generating unit, the expenditure on the replacement (and resultant continuation of cash inflows) should be included in a value in use calculation. For example, a telecommunications provider might have an ongoing programmed of replacing its infrastructure with updated equipment, allowing it to continue to provide connection speeds in line with market expectations and to retain its customers (who would otherwise switch to competitors offering more up to date services). In these circumstances, although the replacement equipment is a technological upgrade it only maintains the economic output of the provider’s network and as such should be considered servicing of the cash-generating unit. Replacement of existing assets with a technologically different, but operationally consistent alternative might also be driven by factors other than technological obsolescence. For example, a fleet of diesel engine delivery vehicles forming part of a larger cash-generating unit might, due to expected emissions regulations or consumer pressure, be expected to be replaced by electric vehicles at the end of their useful lives. Again, although the electric vehicles may be different to the current fleet, the replacement programmed does not (unlike the change from coal powered to renewable energy generation) represent a material change to the manner of in which business is conducted and only maintains the output of the cash-generating unit of which the vehicles form a part. As such, the costs of the replacement programmed and revenues generated after its completion should be included in the cash-generating unit’s value in use. The expected timing of such a replacement programmed should also be factored in to the annual assessment of the useful economic life of individual assets (or significant components of larger assets) required by IAS 16.

Impact of cash flow hedges on the calculation of value in use When an entity has entered into derivative contracts to hedge cash flows related to the purchase and sale of goods within a specific CGU, and the contracts are designated and qualify as cash flow hedges, the entity may either include or exclude the cash flows on the hedging contracts in determining the value in use of the CGU, as long as the carrying amount of the CGU is established in a consistent manner. IAS 36 defines a CGU as “the smallest group of assets that includes the asset and generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets“. IAS 36 explains that “in identifying whether cash inflows from an asset (or group of assets) are largely independent of the cash inflows from other assets (or groups of assets), an entity considers various factors including how management monitors the entity’s operations (such as by product lines, businesses, individual locations, districts or regional areas) or how management makes decisions about continuing or disposing of the entity’s assets and operations” . Accordingly, the decision to include or exclude the effect of hedging instruments and associated cash flows for the purpose of testing the carrying amount of a CGU for impairment should reflect how management defines its CGUs. For example, Entity A has entered into derivative contracts to hedge the cash flows related to the purchase and sale of commodities in a specific CGU. These contracts are designated and qualify as cash flow hedges. Entity A may either include or exclude the cash flows on the hedging contracts in determining the value in use of the CGU, as long as the carrying amount of the CGU is established in a consistent manner. If Entity A includes the cash flows on the hedging contracts in determining the value in use of the CGU, it must also include the fair value of the hedging contracts in the carrying amount of the CGU. Conversely, if the cash flows on the hedging contracts are excluded, it would be appropriate also to exclude the hedging contracts from the carrying amount of the CGU. Entity A may define its CGU strictly based on the independence of cash flows (i.e., by including only those assets that may not be operated without other assets). When this approach is taken, Entity A may consider that the CGU could operate without the hedging instruments and that the hedging instruments generate their own independent cash flows. Therefore, it would exclude the hedging instruments and their cash flows in testing the CGU for impairment. Alternatively, Entity A may define its CGU based on the manner in which it operates the assets. When this approach is taken, Entity A may consider that the CGU should include the hedging contracts if they are acquired specifically for the operations of a specific CGU and have no other business purposes. Both approaches are acceptable.

Calculation of value in use – dividend discount models When calculating the value in use of a CGU in accordance with IAS 36, estimated future cash flows expected to arise from dividends calculated using dividend discount models (DDMs) represent an appropriate cash flow projection in some circumstances. IAS 36 provides guidance on the principles to be applied in calculating the value in use of a CGU. Calculations using a DDM that values share at the discounted value of future dividend payments may be appropriate when calculating the value in use of a single asset (e.g., when an entity applies IAS 36 in determining whether an investment is impaired in the separate financial statements of an entity). Some DDMs focus on future cash flows that are expected to be available for distribution to shareholders rather than future cash flows from dividends. Such a DDM could be used to calculate the value in use of a CGU in consolidated financial statements, if it is consistent with the principles and requirements in IAS 36. This was confirmed in an agenda decision of the IFRS Interpretations Committee published in the November 2010 IFRIC Update.

Calculating a pre-tax discount rate from a post-tax rate – asset is not deductible for tax purposes – example At the end of 20X0, an asset has a remaining useful life of five years. The asset is not deductible for tax purposes. The tax rate is 20 per cent. The discount rate for the asset can be determined only on a post-tax basis and is estimated to be 10 per cent. Therefore, the pre-tax discount rate grossed-up at the standard rate of tax is 12.5 per cent [10 per cent/ (100 per cent – 20 per cent)]. At the end of 20X0, cash flow projections determined on a pre-tax basis are as follows. 20X1 20X2 20X3 20X4 20X5 (1) Pre-tax cash flows (CF) 500 500 500 500 500 Value in use calculated using post-tax cash flows and post-tax discount rate 20X1 20X2 20X3 20X4 20X5 (2) Tax CF [(1) × 20 per cent] 100 100 100 100 100 (3) Post-tax CF [(1) – (2)] 400 400 400 400 400 (4) Post-tax CF discounted at 10% to the end of 20X0 364 331 300 273 248 Value in use [∑ (4)] = 1,516   Value in use calculated using pre-tax cash flows and the grossed-up pre-tax discount rate 20X1 20X2 20X3 20X4 20X5 (5) Pre-tax CF discounted at 12.5% to the end of 20X0 444 395 351 312 278 Value in use [∑ (5)] = 1,780 Calculating the ‘real’ pre-tax discount rate by iteration Using iterative computation (i.e., so that the value in use determined using pre-tax cash flows and a pre-tax discount rate equals the value in use determined using post-tax cash flows and a post-tax discount rate), the pre-tax discount rate would be 19.4 per cent. 20X1 20X2 20X3 20X4 20X5 (6) Pre-tax CF discounted at 19.4% to the end of 20X0 419 351 294 246 206 Value in use [∑ (6)] = 1,516 The ‘real’ pre-tax discount rate differs from the post-tax discount rate grossed up by the standard rate of tax depending on the tax rate, the post-tax discount rate and the useful life of the asset. Similar calculations to those outlined above were carried out, but with the asset assumed to have a 10-, 15- and 20-years life (and be worth nil at the end of that life). A post-tax discount rate of 10 per cent in these similar scenarios equated to the following ‘real’ pre-tax discount rates: Assumed life Pre-tax discount rate 10 years 15.5% 15 years 14.2% 20 years 13.5% The discount rate is independent of the capital structure of the entity and of the way in which the entity financed the purchase of the asset because the future cash flows expected to arise from an asset do not depend on the way in which the entity financed the purchase of the asset. Generally, a single discount rate is used to estimate the value in use of an asset. Separate discount rates for different future periods should be used, however, when value in use is sensitive to a difference in risks for different periods or to the term structure of interest rates.

Formulae for discounting and aggregating cash flows to arrive at value in use The formulae for calculating value in use are derived from the following formulae. Single cash flow Present value of a single cash flow occurring in n years = Cashflow (1 + d) n Series of equal cash flows Present value of n annual cash flows = Cashflow × 1 – (1 + d)-n d   Perpetuity Present value of fixed annual cash flow, in perpetuity = Cashflow d Where d = annual discount rate In the first (single cash flow) formula, the cash flow is an actual cash flow. The discount rate will therefore be a nominal rate, matching the cash flow by including a compatible estimate of the effect of inflation. In the second (series) and third (perpetuity) formulae, it is assumed that all cash flows are the same, with the first cash flow occurring at the end of Year 1. When these cash flows will increase due to growth and inflation, this effect can be achieved by using a cash flow for Year 1 and reducing the nominal discount rate by both growth and inflation rates. When the actual cash flow for the previous period is used, it will first be necessary to increase it by the first year’s growth and inflation in order to find the cash flow at the end of Year 1. (This adjustment of the discount rate for growth is a substitute for building growth into the cash flows. It should not be confused with a real rate of return that would adjust for inflation only.) At a discount rate of 10 per cent, perpetuity can be assumed to approximate to 35 years or more, since any amounts beyond that horizon will be immaterial.

Formulae for calculation of value in use – assumed steady growth in cash flows to perpetuity – example The calculation is based on the perpetuity formula. Cash flow is for Year 1. Thus, when the previous year’s actual cash flow is used, it is first necessary to increase it to reflect growth and inflation in Year 1. Value in use = CF0  (1 + g) (1 + i) da Where: CF0 = actual cash flow for previous period i = annual inflation rate g = annual growth rate in cash flows da = nominal pre-tax discount rate adjusted to reflect inflation and growth in cash flows.

Formulae for calculation of value in use – cash flows forecast for five years and assumed steady growth thereafter – example The calculation is the sum of individual present values for the first five years, plus a perpetuity from Year 6 onwards re-expressed from Year 5 back to present value at time 0. Value in use = Present value of each cash flow for Years 1 to 5 + Present value of cash flows from Year 6 onwards = CF1 + CF2 + CF3 + CF4 + CF5 + CF5(1 + g) (1 + i) 1 + dn (1 + dn)2 (1 + dn)3 (1 + dn)4 (1 + dn)5 da x (1 + dn)5 Where: CFn = Cash flow in nth year i = annual inflation rate after Year 5 g = annual growth rate in cash flows after Year 5 dn = nominal pre-tax discount rate da = nominal pre-tax discount rate adjusted to reflect growth and inflation in cash flows Note: The sixth term in the formula above, CF5(1 + g)(1 + i) da × (1 + dn)5 is a compound of two functions. CF5(1 + g)(1 + i) da is the present value of cash flows from Year 6 onwards expressed as a present value at the beginning of Year 6. Further adjustment to multiply by 1 (1 + dn)5 re-expresses this as a present value at the beginning of Year 1.

Formulae for calculation of value in use – cash flows forecast for two years and assumed steady growth thereafter – example Assume: Cash flow for Year 1 CU20m Cash flow for Year 2 CU24m Assumed steady growth thereafter 2.5% Inflation 2.5% Nominal pre-tax discount rate 15% Adjusted pre-tax discount rate 10% Value in use = CU20m + CU24m + CU24m × 1.025 × 1.025 = CU226 million 1.15 1.152 0.1 × 1.152

 

Calculating a pre-tax discount rate from a post-tax rate In practice, estimating a suitable pre-tax rate is far from straightforward. The pre-tax discount rate is the rate of return that will, after tax has been deducted, give the post-tax rate of return. However, the pre-tax discount rate is generally not the post-tax rate grossed up by a standard rate of tax – IAS 36 includes an example illustrating this point. Conceptually, discounting post-tax cash flows at a post-tax discount rate should give the same result as discounting pre-tax cash flows at a pre-tax discount rate, provided that 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. In the example set out in IAS 36, one of the reasons for the difference between the grossed-up post-tax discount rate and the ‘real’ pre-tax discount rate is that the tax deductions for the asset do not arise evenly over its life. In practice, in a CGU comprised of a group of assets acquired at different times, it is possible that the overall pattern of tax deduction for assets will be more even and that a simple grossed-up post-tax rate may give a reasonable approximation of the actual pre-tax rate of return.

Determining when the impact of a restructuring should be included in the estimates of future cash flows IAS 36 defines a restructuring in the same way as IAS 37, as “a programmed that is planned and controlled by management and materially changes either the scope of a business undertaken by an entity or the manner in which that business is conducted.” In the context of determining whether the effects of a forecast change in the business are required by IAS 36 to be excluded from a value in use calculation, it should be noted that: the effects of changes outside management’s control, such as those arising from expected changes to the physical or economic environment or from government action, should be included in the calculation of value in use when they form part of management’s forecasts based on reasonable and supportable assumptions; the assessment of whether any forecast change in the scope or manner of operations is material (and therefore meets the definition of a restructuring) should be considered at the level of the asset, cash-generating unit or (for the purposes of goodwill testing) group of cash-generating units being tested for impairment. This is consistent with the general principle of IAS 36:44 that cash flows are estimated for the asset in its current condition and should not include the effects of future restructuring. Determining whether a change in operations is material will require the application of judgement. In applying that judgement, it will often be necessary to consider whether either: the output from an asset or cash-generating unit or the process of producing that output will change significantly (indicating a material change that is excluded until the entity is committed to a restructuring); or whether the change is a refinement to that output or process (indicating that the change does not meet the definition of a restructuring).

Exclusion from estimates of cash flows of interest payments that will be included in the cost of the asset IAS 36 prohibits the inclusion of financing cash outflows or inflows in a value-in-use calculation and does not provide for any exceptions to this rule. Therefore, borrowing costs that will be capitalized as part of the cost of an asset under IAS 23 are excluded from estimates of future cash flows when testing an asset under development for impairment.

Testing an asset under construction for impairment – costs of construction not yet incurred – example Company D designs, develops and manufactures components for high-speed optical networks. The majority of Company D’s customers are building communication infrastructures. In December 20X1, Company D purchased a plot of land in an industrial complex with the intent to build a state-of-the-art production facility for its integrated circuit and module products. Construction of the new facility began in March 20X2 and is expected to be completed by the end of August 20X2. In June 20X2, a number of Company D’s customers announced plans to cut the level of capital expenditures related to their infrastructure development, and Company D received several order cancellations. At 30 June 20X2, due to the significant change in business climate, Company D identifies indications that the new production facility may be impaired. Company D should include the remaining costs associated with completing the production facility in its estimates of future cash flows when assessing the asset group for impairment. IAS 36 clearly states that when the carrying amount of an asset does not yet include all the cash outflows to be incurred before it is ready for use, the estimate of future cash outflows includes an estimate of any further cash outflow that is expected to be incurred before the asset is ready for use.

 

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Incorporation of expected changes in consumer behavior into estimates of future cash flows The future cash flows generated by an asset or cash-generating unit may be affected by changes in consumer behavior. For example, a number of consumer driven initiatives have affected the demand for products with an environmental impact, such as: initiatives to minimize the use of single use plastics; increased popularity of veganism or otherwise more plant-based diets; and awareness of ‘food miles’ in purchasing decisions. IAS 36 requires that the calculation of value in use should reflect the best estimate of the future cash flows that management expects to derive from the asset or cash-generating unit. Changes in consumer behavior are not dependent on any restructuring by the entity or change to the asset or cash-generating unit itself. As a result, management’s best estimate of any forecast changes in consumer behavior expected to result in changes (positive or negative) in either the volume or price of future sales should be included. The same approach should be applied to expected changes in the behavior of an entity’s suppliers or business customers, who may themselves react to changing expectations of society, resulting in changes to an entity’s cost base or revenues to the extent the estimates are based on reasonable and supportable assumptions.

Valuation models: Dividend discount model IAS 36 provides detailed guidance on the principles to be applied when calculating value in use. In some industries, specific valuation models are used for internal purposes. An example of this is the use of the dividend discount model in the financial services sector. There are numerous variations of the dividend discount model, some discounting only future expected dividend receipts and others based on a more detailed analysis of recoverable value. Regardless of the name, it is important to understand the basis for any valuation model used. Internal valuation models could be adopted, to calculate the value in use of a CGU for purposes of impairment testing, provided that they are consistent with the principles and requirements of IAS 36.

Calculating value in use involves the following processes:

• Estimating the future cash flows expected to be derived from the asset in its current condition.
• Estimating the potential variation in the amount and timing of the future cash flows.
• Taking account of the time value of money (discounting), using current market risk-free interest rates.
• Estimating the price for bearing the uncertainty inherent in the asset (for example, whether the asset will perform as intended).
• Taking account of other factors, such as illiquidity, which would be reflected by the market in pricing the future cash flows expected to be derived from the asset.

Risks related to expected variations in the amount or timing of cash flows, uncertainty inherent in the asset and other factors, such as illiquidity, might be reflected in the calculation, either by adjusting the cash flows or by adjusting the discount rate. A risk should be incorporated in either the cash flows or the discount rate, but not both, to avoid double counting.

Factors that influence cash flows Cash flows will be determined and influenced by the following factors: ·        Sales volumes: determined by current demand, market share, growth in market size, advertising effects, and competition. Growth in sales volumes should be restricted to existing capacity and should not anticipate future capital expenditure that might expand capacity. ·        Sales prices: determined by current prices, competition, promotions and inflation. ·        Operating costs: determined by prices of goods and service consumed, level of activity, discounts available, competition among suppliers, and inflation. ·        Other cash flows: decommissioning costs, disposal proceeds and costs necessary to get assets under construction ready for use. The above list is not exhaustive.

Basis for estimates of future cash flows

Reasonable and supportable

Relevant cash flow forecasts should be made on the basis of reasonable and supportable assumptions that represent management’s best estimate of the economic circumstances that will prevail over the assets or CGU’s remaining life.

Management should examine the causes of any differences between actual cash flows and past projections, to assess whether assumptions are reasonable. The current assumptions should be consistent with past actual outcomes, except where circumstances have changed or subsequent events have occurred that make this inappropriate.

Use of reasonable and supportable forecasts Entity E owns 90% of its subsidiary L. Entity E’s management has approved the group’s five-year business plan, which also includes information regarding entity L. Entity L’s management has prepared its own budgets, which are more aggressive than those approved by its parent entity’s management. In this situation, entity L should use the business plan approved by entity E, to determine its assets’ value in use. Estimated cash flows should be based on budgets approved by management. Where there are two sets of budget information, the question arises of which should be used for the purposes of impairment testing. In such a situation, it is important to understand the reason behind the differences in the two budgets. Entity E’s management might have included, in its assumptions, information that has not yet been disclosed to entity L’s management. Alternatively, entity L’s management might have prepared the more aggressive budget to try and set a challenging ‘stretch’ target for its workforce. The cash flows used in the impairment calculation should be those that represent the most reasonable and supportable forecast approved by management. Although entity L’s management has prepared its own budgets, the group’s official estimates are those included in entity E’s approved business plan. In this situation, we would expect entity E’s budget to be used, unless it could be supported that the budget set by entity L’s management was more in line with actual expectations of future cash flows.

Value in use is an entity-specific measure, but the assumptions used by management should be supportable; for example:

• Management assumptions should be consistent with market evidence, such as independent macro-economic forecasts, and analysis from industry commentators or analysts, brokers and other third-party experts. Greater weight should be given to any external evidence that is available.
• Any differences between the forecast’s underlying assumptions and market evidence should be analyzed and understood. Management might find it helpful to explain these differences in disclosures or other material accompanying the financial statements.
• Management should analyse any differences between fair value less costs of disposal and value in use, and it should ensure that they are supportable.

Based on most up-to-date budget

The cash flows should be based on the most up-to-date budgets and forecasts that have been formally approved by management, excluding cash inflows and outflows arising from future restructuring or enhancements. If budgets are revised, they should also be approved by management before they can be used in the value in use calculation.

Value in use: business plan not approved by management Entity A has determined that a CGU’s fair value less costs of disposal is lower than it carrying amount. However, based on its value in use, the CGU would not be impaired. The value in use was determined using a business plan that had not been finally approved by management. The value in use should not be calculated based on a non-approved business plan. This does not represent a reliable source of information. It might be subject to change, for example, because senior management disagrees with the figures presented and the assumptions used. The only reliable information available would be the CGU’s fair value less costs of disposal, if the business plan is not yet approved. An impairment loss should, therefore, be recognized.

Projections based on these budgets and forecasts should cover a maximum of five years. Management could use a longer period, where appropriate, but only where it can demonstrate its ability to forecast cash flows accurately for longer periods. For example, where a CGU is a power plant which is not yet completed, it might expect to incur losses for two or three years, followed by several years of significant growth. The cash flow forecasts with explicit growth assumptions might exceed five years. The circumstances for overriding the presumed five-year cut-off should be rare.

Length of forecast

The cash flow projections of a CGU with a defined life should be an estimate of the value for that defined life. For example, if the CGU has a finite life based on its principal operating asset (for example, a mine or a power plant), the cash flow projection period might need to be limited to the life of that asset. If it is reasonable to assume that an entity would replace the principal operating asset, it might be appropriate to consider a terminal value that is intended to project cash flows into perpetuity. [IAS 36 para 49].

The length of the projection period for the cash flow forecast, where a CGU has goodwill or intangible assets with indefinite lives, will, in most cases, be into perpetuity. This is typically achieved by identifying a ‘steady state’ set of assumptions for the cash flows in the last year of the forecasts and applying a terminal value multiple to those cash flows.

Terminal value could be calculated by applying a terminal value multiple to the cash flows expected in the last year (CF) covered by the entity’s explicit forecasts, by using the formula CF * (1 + g) / (r – g), where ‘r’ is the discount rate and ‘g’ is the estimated long-term annual rate of growth in the cash flows. The terminal value, calculated as at the end of the period covered by formal budgets and plans, is discounted to its present value.

There are no restrictions on growth rates in the period that is covered by formal budgets and plans. In that initial period, the cash flows will reflect the variability in growth rates that is included in the entity’s explicit forecasts. The cash flows for periods beyond those covered by formal budgets and plans (whether they cover the full five years or a shorter period) should assume a steady or declining growth rate. This rate will not exceed the long-term average growth rate for the product, industries, country or countries in which the business operates or for the market in which the asset is used. [IAS 36 para 33(c)].

A higher rate could be used only if it is justified (for example, by objective information about patterns over a product or industry life-cycle).

Asset in its current condition

Restructuring

The costs and benefits of a future restructuring should not be recognized in value in use cash flow forecasts, unless the entity is committed to the restructuring, and related provisions have been made. These restrictions could lead to entities using a fair value less costs of disposal basis for the calculation of recoverable amount, because it might be higher.

A restructuring is a programmed that is planned and controlled by management and that materially changes either the scope of the business undertaken by the entity or the manner in which the business is conducted. IAS 37 sets out the conditions that should be complied with before provisions for restructurings can be recognized in financial statements.

Impairment reviews should be based on the most recent budgets and forecasts that have been formally approved by management. These budgets might include costs and benefits of restructuring before they are recognized in the financial statements. If this is the case, the relevant costs and benefits must be removed from the value in use calculation. The costs and benefits can be included in value in use if the restructuring provision has been recognized on the balance sheet.

Future restructuring planned in a value in use model At 31 December 20X1, the assets of a CGU are being reviewed for impairment. The carrying value of the CGU’s net assets is C6.5 million (excluding any restructuring provision), and the recognized assets’ remaining useful economic life is eight years. Management’s approved budgets at 31 December 20X1 include restructuring costs of C350, 000 to be incurred in 20X2; the restructuring is expected to generate cost savings of C100, 000 per annum from 20X3 onwards. Formal budgets have been prepared for the three years to 31 December 20X4. A zero-growth rate is assumed, because market conditions are extremely competitive, and this is expected to continue for the foreseeable future. The future cash flow estimates are set out below. For example, in 20X2 the net cash flows without restructuring (C870,000) exceed the net cash flows with restructuring (C520,000) by the amount of the restructuring costs (C350,000). The future cash flows (which exclude inflation) have been discounted at a rate of 4%. For simplicity, it has been assumed that the cash flows arise at the end of each year; therefore, the figures in the ‘present value’ columns for the cash flows (CF) in ‘n’ years’ time from 31 December 20X1 are derived from the formula CFn / (1 + i) n, where i (the discount rate) is 0.04. With re-organization Without re-organization Year Future Net Cash Flows Present Value Future Net Cash Flows Present Value C’000 C’000 C’000 C’000 20X2 110 103 +7 836 20X3 223 214 +9 832 20X4 197 120 +77 845 20X5 134 121 +13 812 20X6 202 210 -8 781 20X7 24 20 +4 751 20X8 43 53 -10 722 20X9 3 11 -8 694 Value in Use 6514 6273 The impairment calculations at 31 December 20X1 differ, according to whether or not provision for the restructuring costs is recognized in the financial statements. This will depend on whether the requirements of IAS 37 have been met for recognition. A – Provision for restructuring costs recognized at 31 December 20X1 If provision has been made for restructuring costs, the costs and benefits of the restructuring are taken into account in determining the CGU’s value in use. In this example, the post-restructuring value in use (C6, 514,000) exceeds the CGU’s carrying value (C6, 500,000 less restructuring provision of C350, 000). Hence, there is no impairment of the CGU’s assets. In the year to 31 December 20X1, the financial statements reflect the following charges: Restructuring provision C350, 000 Impairment loss Nil B – No provision for restructuring costs recognized at 31 December 20X1 If no provision for restructuring costs is permitted by IAS 37, the costs and benefits of the restructuring have to be stripped out of the projections in determining the CGU’s value in use. In this example, the CGU’s carrying value (C6, 500,000) exceeds its pre-restructuring value in use (C6, 273,000). Therefore, there is an impairment loss of C227, 000. In the year to 31 December 20X1, the financial statements reflect the following charges: Restructuring provision Nil Impairment loss                              C227, 000

Future enhancements

The costs and benefits of future expenditure that is intended to improve or enhance the assets or business should not be taken into account in the cash flow forecasts, because future cash flows are estimated for assets in their current condition.

Estimates of future cash flows include those cash flows that are necessary to maintain the current level of economic benefits expected to arise from the asset in its current condition. An asset will usually deteriorate through use, or component parts will wear out. Cash outflows for servicing the asset, to maintain its current capability, are taken into account in the estimates.

Expenditure is included in the cash flows where it is necessary to replace or restore separate components of a single fixed asset that have shorter useful lives than the rest of the asset, such as the lining of a furnace. The expected future cost of replacement or restoration expenditure is treated as if it were part of the day-to-day servicing of the larger asset, and it is included in the cash flows used to assess the larger asset’s recoverable amount.

Treatment of components in value in use The carrying value of a furnace is being reviewed for impairment. The furnace has a useful life of 20 years, and it requires relining every five years. The lining is treated as a separate asset component under IAS 16. Thus, the cost of the lining is depreciated over five years; the remainder of the furnace is depreciated over 20 years. For calculating the furnace’s value in use, the net cash flows forecast for the remainder of the furnace’s 20-year useful life would include the costs relating to relining the furnace every five years, because that expenditure is necessary to maintain the current standard of performance.

Where a CGU consists of assets with different useful lives, all of which are essential to the ongoing operation of the CGU, the replacement of assets with shorter useful lives is considered to be part of the day-to-day servicing of the CGU when the future cash flows attributable to the CGU are estimated.

Improvement-type expenditure A cruise ship is being reviewed for impairment at 31 December 20X1. The ship is a CGU. It carrying value is C72 million, and its estimated remaining useful life is 10 years, with a residual value estimated at C6 million. Management has approved a major investment plan to increase the ship’s passenger capacity. The work will be carried out in 20X4 and is expected to result in a significant increase in passenger revenues and a decrease in running costs. The remaining useful life is expected to be extended by two years. The estimated cost of the new investment is C8 million. There will also be a period of inactivity for the ship while the upgrade is being carried out, resulting in a net cash outflow in 20X4. Management assesses the recoverable amount by determining the ship’s value in use. The future cash flow estimates for the value in use calculation are set out below, along with figures that exclude from those estimates the cost and benefits of the planned C8 millions of future expenditure to enhance the asset’s current level of performance (referred to below as ‘capex’). The future cash flows (which exclude inflation) have been discounted at a rate of 6%. For simplicity, it has been assumed that the cash flows arise at the end of each year; therefore, the figures in the ‘present value’ columns for the cash flows (CF) in ‘n’ years’ time from 31 December 20X1 are derived from the formula CFn / (1 + i) n, where i (the discount rate) is 0.06. Including new capex Excluding new capex Future net cash flows Present value                Future net cash flows Present value                C’000 C’000 C’000 C’000 20X2 8300 7830 8300 7830 20X3 8500 7565 8500 7565 20X4 (4000) (3358) 8500 7137 20X5 10500 8317 8500 6732 20X6 10800 8070 8285 6191 20X7 11050 7790 8078 5695 20X8 11250 7482 7876 5238 20X9 11450 7184 7679 4818 20Y0 10990 6505 7487 4431 20Y1 10550 5891 13300 7427 20Y2 10130 5336 20Y3 15725 7815 Value in use 76427 For the purpose of the impairment review at 31 December 20X1, the future expenditure and the related benefits should be excluded from the calculation of value in use, so the ship is tested for impairment in its present form and condition. On this basis, the ship’s estimated value in use in its existing state (C63, 064,000) is lower than it carrying value (C72, 000,000), and so an impairment loss of C8, 936,000 should be recognized (assuming the ViU is higher than FVLCOD.) The improvement work is carried out in the year to 31 December 20X4. Assuming that the cash flow projections at 31 December 20X4 are the same as those previously estimated at 31 December 20X1, the calculation of the ship’s value in use at 31 December 20X4 is as follows: Year Future Net Cash Flows Present Value C’000 C’000 20X5 10500 9906 20X6 10800 9612 20X7 11050 9278 20X8 11250 8911 20X9 11450 8556 20Y0 10990 7748 20Y1 10550 7016 20Y2 10130 6356 20Y3 15725 9307 Value in use 76690 The ship’s carrying value at 31 December 20X4 is as follows (straight-line depreciation at 10% per annum to the estimated residual value of C6 million has been assumed): Carrying Value (C’000) 31 December 20X1 63064 Depreciation (20X2 to 20X4) (17119) Capital expenditure in 20X4 8000 31 December 20X4 53945 The ship’s value in use, following the improvement, exceeds its impaired carrying value. In accordance with paragraphs IAS 36, an increase in the recoverable amount as a result of further improvement expenditure (the benefits of which had been excluded from the original measurement of value in use) should result in a reversal of the original impairment loss at 31 December 20X4. The amount of the reversal is restricted to the extent that the ship’s carrying value is increased to what it would have been if the original impairment had not occurred. This is calculated as follows, resulting in a reversal of C6, 255,000 (C60, 200,000 – C53, 945,000). Carrying Value C’000 31 December 20X1 72,000 Depreciation 20X2 to 20X4 ((72,000,000 – 6,000,000) × 10% × 3) (19,800) Capital expenditure in 20X4 8,000 31 December 20X4 60,200

Composition of estimates of future cash flows

The cash flows should include:

• Projections of cash inflows from the continuing use of the asset or the activities of the CGU.
• Projections of cash outflows necessarily incurred to generate the cash inflows from continuing use of the asset or CGU (including cash outflows to prepare the asset for use), and that are directly attributable to the asset or CGU.
• Projections of such cash outflows that are indirectly attributable (such as those relating to central overheads), but that can be allocated on a reasonable and consistent basis to the asset or CGU.
• Net cash flows expected to be received (or paid) for the disposal of assets or CGUs at the end of their useful lives.
• Cash outflows to maintain the operating capacity of existing assets, including, for example, cash flows for day-to-day servicing.

Asset not available for use

Cash flows that are to be incurred before an asset or CGU is ready for use or sale should be estimated and included in the forecast provided that the project is already in progress. Examples might be future cash flows relating to a building under construction or a development project that is not yet completed. For consistency, the expected cash inflows once the asset is complete should also be included.

Financing

The cash flows should exclude cash flows relating to financing (which include interest payments), since the related liabilities are excluded from the carrying amount and because the cost of capital is taken into account by discounting the cash flows.

Tax

Tax cash flows should also be excluded, because value in use is calculated on the basis of discounting pre-tax cash flows at a pre-tax discount rate.

Independence

Cash flows relating to assets that generate cash flows independently from the asset under review are excluded from the forecasts (because they are also excluded from the carrying amount of a CGU). Examples would include financial assets such as receivables, except for trade debtors included in the CGU for practical reasons.

Liabilities

Cash outflows relating to obligations that have already been recognized as liabilities would be excluded, because the related liability is excluded from the CGU, unless included as part of working capital. This ensures the comparison of like with like. Examples of such liabilities include payables, pensions or provisions.

There are two streams of cash flows for defined benefit pension obligations: the cash flows that will settle the liability that is recognized in the balance sheet, and the cash flows relating to future service. If the pension liability is excluded from the CGU’s carrying amount, the cash flows relating to settling the recognized liability should be excluded from the value in use calculation. The cash flows relating to future service should still be included in the value in use calculation, because these are part of the CGU’s ongoing employee costs.

Corporate overheads

The cash outflows attributable to a CGU should include sensible allocations of corporate overheads, in the same way that the carrying values of CGUs should, where practicable, include apportionments of corporate assets.

Disposal

The estimate of cash flows expected to be received (or paid) for the disposal of assets or CGUs at the end of their useful lives should be the amount of the expected disposal proceeds in an arm’s length transaction between knowledgeable, willing parties, reduced by the estimated costs of disposal.

The estimate of cash flows from the disposal of an asset at the end of its useful life is determined in a similar way to its fair value less costs of disposal, except that:

• The entity uses prices prevailing at the date of the estimate for similar assets or CGUs that have reached the end of their useful lives and that have operated under similar conditions to those in which the asset or CGU will be used.
• Those estimated selling prices are adjusted both for future inflation and for expected specific future price increases. (However, if the effect of future inflation is excluded from the estimates of future cash flows and from the discount rate, it is also excluded from the estimate of net cash flows on disposal.)

Inflation

Assumptions about inflation can be dealt with in one of two ways: One method is to forecast cash flows in current prices and not forecast future inflation. The cash flows are then discounted at a real discount rate (that is, a rate of return that excludes inflation). The second method is to forecast cash flows to include estimates of inflation in revenues and costs. The cash flows are then discounted at a nominal discount rate (that is, a rate of return that includes inflation). It is important that inflation is treated consistently in the cash flow projections and the choice of discount rate.

Foreign currency

Where future cash flows are expected to be denominated in a foreign currency, they should be estimated in that currency and then discounted at a rate appropriate for that currency. The entity then translates the present value (expressed in the foreign currency) at the spot rate of exchange at the date of the value in use calculation.

Forecasting future foreign cash flows and translating them at estimated spot exchange rates at future dates is prohibited, because such estimates cannot be reliably made.

Transfer pricing

Internal transfer pricing directly affects the cash inflows and operating cash outflows relating to separate CGUs – for example, a vertically integrated group where one CGU transfers part of its output to another CGU in the same group at a price that is lower than the market price for its output. The cash inflows of the transferor CGU and the cash outflows of the transferee CGU that are used in the value in use calculations should be adjusted to reflect arm’s length (usually market) prices rather than internal transfer prices.

Transfer pricing difficulties A subsidiary might be only breaking even because it sells its output to a fellow subsidiary at cost, yet they are part of the same CGU from a group perspective. Where subsidiaries are separate CGUs, one subsidiary might be unprofitable because it sells its output to a fellow subsidiary at below-market prices. Conversely, the transferee subsidiary might be profitable, because it buys goods and services from its fellow subsidiary at below-market prices. From a group’s perspective, the cash inflows of the transferor CGU and the cash outflows of the transferee CGU that are used in the value in use calculations should be adjusted to reflect market prices rather than internal transfer prices. If the subsidiary earns an economic return on its assets after adjusting for market prices, it might be possible to argue that no impairment is required. This would be on the basis that the subsidiary could obtain a market rate of return on its investment, and therefore the recoverable amount (being the higher of value in use and fair value less costs of disposal) is higher than the actual cash flows being generated. In such a situation, disclosure would be required to explain the basis on which the recoverable amount was determined. Where a subsidiary is not earning an economic return on its assets, even after adjusting to market prices in terms of its separate cash flows, the subsidiary should be booking an impairment on those assets in its entity financial statements.

Risk

Estimated cash flows or discount rates should reflect the range of possible outcomes rather than a single, most likely, minimum or maximum possible amount. Risk must be incorporated into the cash flow model, to reflect uncertainty. Risks include variations in amount and timing of cash flows, and uncertainty inherent in the asset. This can be reflected either in the discount rate or in the cash flows. An expected cash flow approach incorporates a majority of the risk in the cash flows, and a traditional approach incorporates a majority of the risk in the discount rate.

‘Traditional’ and ‘expected cash flow’ approaches to present value

There are two approaches to estimating cash flows: the traditional approach, and the expected cash flow approach. The traditional approach uses a single set of cash flows and a single discount rate. It assumes that a single discount rate can incorporate all of the expectations about the future cash flows and the appropriate risk premium, and so it places more emphasis on the selection of the discount rate.

The expected cash flow approach starts with cash flows that reflect the risks that management anticipates (for example, cash flows based on probability). Risk-adjusted probability cash flow projections are not certain, and so it is not appropriate to use a risk-free rate to discount such cash flows. The discount rate will be lower than the rate used in a traditional approach, but it will not be risk-free.

Advantages of the expected cash flow approach in times of higher uncertainty The expected cash flow approach has the following advantages over the traditional approach, in an environment of higher uncertainty: ·        The sensitivity of the recoverable amount to uncertainties is explicit in the measurement, compared with the ‘traditional’ approach where it is factored into the discount rate. ·        It enables management to assess the uncertain assumptions that might have the most significant impacts on the recoverable amount. ·        It calculates a range of expected cash flows, instead of only considering the most likely case. ·        It might be more aligned with the way in which management prepares forecasts. ·        It lessens the impact of the judgmental exercise inherent in choosing a single specific risk premium, which might be difficult to quantify and document.

Modelling of uncertainty in ViU Management has identified three crucial uncertainties that might affect the forecast: ·        market developments; ·        the success of a new product; and ·        Customer churn. For each uncertainty, three cash flow projections have been identified, with the probability that they will occur: The recoverable amount will equal the expected value resulting from the combination of the 27 (3 × 3 × 3) possible scenarios. *The percentages indicate Probability.

Discount rate

Projected future cash flows are discounted at a pre-tax rate that reflects both 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. This means that an asset is regarded as impaired if it is not expected to earn a current market-related rate of return on it carrying value.

The rate of return expected by the market is the return that investors would require if they chose an investment that would generate cash flows of the same amounts, timing and risk profile as those that the entity expects from the asset or CGU under review. The rate is independent of the way in which the asset is financed. It is estimated from current market transactions for similar assets or from the weighted average cost of capital (WACC) of a listed entity that has a single asset or portfolio of assets that are similar, in terms of service potential and risks, to the asset under review.

If an asset-specific rate is not available directly from the market, an entity should estimate an appropriate discount rate that reflects, as far as possible, a market assessment of: The time value of money to the end of the asset’s useful life. The risks that the future cash flows will differ in amount or timing from estimates. The price for bearing the uncertainty inherent in the asset. Other factors that market participants would reflect in the rate, such as illiquidity.

The entity might take into account the following factors in determining this rate: The WACC for the entity, determined using techniques such as the capital asset pricing model. The entity’s incremental borrowing rate. Other market borrowing rates.

The rates are adjusted to take into account the way in which the market would assess the specific risks associated with the estimated cash flows and to exclude risks that are not relevant to the estimated cash flows or for which the estimated cash flows have been adjusted. Factors to consider might include:

• Country risk, such as the risk of political unrest.

• Currency risk, such as the risk of devaluation.
• The nature of the asset being tested; intangible assets are higher risk.
• Whether the cash flows are optimistic or stretch targets.

• Price risk, such as the risk that prices might be forced down by competitive pressures.

Impact of country and currency risk on discount rate An Australian entity carries significant goodwill and indefinite-lived intangible asset balances in its consolidated balance sheet. These arose from multiple acquisitions in recent years. The entity manufactures goods in Australia that are sold locally and exported to Europe. The entity’s functional currency is the Australian dollar, and its financial statements are presented in Australian dollars. In carrying out its first impairment review under IAS 36, management proposes to use a discount rate based on the local Australian dollar risk-free rate, the local market risk premium and a country risk premium. This discount rate will be applied to the Australian dollar-denominated cash flow projections for each CGU. Management’s approach is incorrect. The Australian dollar risk-free rate will include the perceived risks associated with investing in the country and in the local currency. To add a country risk premium is, therefore, double counting. A separate country risk premium is only usually relevant where cash flow projections are prepared in a different currency, such as the Euro. It is always important to ensure consistency between the assumptions underlying the projected cash flows and the discount rate.

Rates vary to reflect specific risk factors Rates applicable to different business units within a group might vary, to reflect any risk factors that are specific to those units. Trading activities and investments in different countries are likely to have different risks (for example, currency and political risks). The rate should be appropriate to the country in which the CGU operates (or in whose currency it derives its major cash flows), rather than the country in which the finance is sourced. Different business sectors also attract different risks – for example, a biotechnology entity will carry a greater market risk than a regulated utility. In general, the more uncertain the cash flows are, the riskier the investment is, and the greater the risk adjustment is to increase the discount rate.

The discount rate is independent of the entity’s capital structure and the way in which the purchase of the asset or CGU was financed. The future cash flows from the asset do not depend on how the asset was purchased.

The discount rate should not reflect risks for which the estimates of future cash flows have already been adjusted, to avoid double counting. Discount rates should reflect assumptions that are consistent with those inherent in the estimated cash flows.

Avoiding double counting when determining a discount rate If contractual cash flows are adjusted to incorporate the risk of default in order to derive expected (as opposed to contractual) cash flows for impairment testing, to avoid double counting, the rate used to discount those expected cash flows to present value should not include a factor for default risk. This means that the rate used to determine the risk-adjusted expected cash flows is not the same as the rate used to discount those expected cash flows to present value terms.

An entity normally uses a single discount rate for estimating an asset’s value in use. Separate discount rates are used for different future periods if the value in use is sensitive to risks for different periods or to the structure of interest rates over the asset’s life.

Inflation should also be treated consistently in the present value calculations. The discount rate is a real rate (inflation should be excluded) if the future cash flows are estimated at current values. The discount rate is a nominal rate (including inflation) if the estimated future cash flows include inflation.

Pre-tax rate

The discount rate for value in use calculations should be calculated on a pre-tax basis.

Observable market rates of return are generally post-tax rates (for example, an entity’s WACC). A post-tax rate should be adjusted to a pretax rate. The pre-tax discount rate is not always the post-tax discount rate grossed up by a standard rate of tax.

Calculating a pre-tax discount rate Entity A has calculated a weighted average cost of capital (WACC) of 8%, based on market assumptions. Management is aware that this is a post-tax rate and, therefore, wants to determine a pre-tax discount rate, by grossing up the 8% by the statutory tax rate in entity A’s country, which is 35%. The result is 12.3% (8% / 0.65). The 12.3% is the correct pre-tax discount rate only if the specific amount and timing of the future tax cash flows are reflected by this rate. So, a grossed-up discount rate works only if there is no deferred tax. As soon as there is deferred tax, an iterative calculation needs to be done that considers the fact that a carrying amount after impairment would trigger new deferred taxes, and this would again change the carrying amount.

Discounting post-tax cash flows at a post-tax discount rate should lead to the same result as discounting pre-tax cash flows with a pre-tax discount rate, and so it can be used as a proxy. This only works 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. Significant deferred tax balances can cause discrepancies in this calculation.

Calculation process for iteratively deriving a pre-tax discount rate The implicit pre-tax discount rate can be derived iteratively, using the post-tax discount rates that are directly observable from capital markets, by using a two-step iterative calculation process to convert the post-tax discount rate into an implicit pre-tax rate. This is based on: ·        Step 1: discounting the post-tax cash flows using a post-tax discount rate; and ·        Step 2: determining the implicit pre-tax rate that needs to be applied to pre-tax cash flows to arrive at the same result. Post-tax cash flows should reflect the specific amount and timing of the future tax cash flows. Where deferred tax exists, this can complicate the situation. In step 1, the expected actual tax cash payments are calculated to arrive at post-tax cash flows from pre-tax cash flow projections. These post-tax cash flows are discounted at an appropriate post-tax discount rate, derived using information observable on the capital markets. As a starting point for the derivation of the post-tax discount rate, the entity’s weighted average cost of capital (WACC) could be taken into account (as opposed to the entity’s incremental borrowing rate or other market borrowing rates). This is because the WACC is usually a good reflection of the risk specific to the asset or CGU, provided that it is similar to the rate that a market participant would use. This WACC should be adjusted for specific risks associated with the assets or CGU’s estimated cash flows (for example, country, currency or price risk). If such a WACC for the entity is not available, it might be necessary to estimate a WACC using peer group data. In step 2, the pre-tax discount rate is derived by determining the rate required to be applied to the pre-tax cash flows to arrive at the result obtained in step 1. In practice, the rate is calculated using the same methodology as for the calculation of an internal rate of return. Upfront deferred tax causes a double-counting issue. Deferred tax is the way in which the future tax consequences of recovering assets are recorded on the balance sheet. Therefore, if more tax will be payable in the future in relation to a CGU (say, because all available tax deductions have already been taken), this future tax payable will be recognized as a deferred tax liability. If value in use is calculated with reference to post-tax cash flows, the higher future tax payments will be included as cash outflows in the value in use measure, reducing the value in use. The carrying value of the CGU will be higher, by excluding the deferred tax liabilities from the carrying amount of the CGU. This means that the test no longer compares like with like. If the higher CGU carrying value is compared to a value in use measure that is depressed by tax cash outflows, the result might show an impairment. Any such impairment would include the discounted impact of the future tax outflows. It would not seem appropriate to book this element of the impairment, because the future tax outflows have already been accounted for, on an undiscounted basis, as deferred tax. Where there is significant deferred tax upfront, due to this double-counting issue, an IAS 36 value in use test might not be the most appropriate method.

Iteratively deriving a pre-tax discount rate The required pre-tax rate is the rate of return that will, after tax has been deducted, give the required post-tax rate of return. The following calculation illustrates how the pre-tax rate could correctly be derived from the post-tax rate. A CGU is being tested for impairment at the end of 20X0. The CGU comprises a specific asset, which was purchased two years ago for C2, 400. The asset has a 10-year useful life for accounting purposes. Tax relief on the asset is available, on a straight-line basis, over the asset’s first three years of the life. The tax rate is 35%. The carrying value for tax purposes at the end of 20X0 is C800 (C2, 400 × 1/3 years), and the carrying value for accounting purposes is C1, 920 (C2, 400 × 8/10 years). Applying the tax rate of 35% to the difference gives a deferred tax liability with a carrying value of C392 ((C1, 920 − C800) × 35%). The post-tax discount rate, determined from the entity’s WACC, is 8%. There are two potential applications of the requirements of IAS 36 that are commonly seen. Neither of these gives the correct value in use according to the requirements of IAS 36. Common error 1: Discount an imputed ‘post-tax cash flow’ at a post-tax discount rate of 8%. The ‘post-tax cash flow’ is determined by assuming that cash outflow for tax will be equal to the pre-tax profit at the standard tax rate. This is illustrated in the table below. Pre-tax profits from the asset are expected to be C125 at the end of 20X1, increasing by C5 for each of the following seven years. The appropriateness of such an increasing rate has been considered and determined reasonable. The results for the seven years in question are, therefore, as follows: Currency (C) 20X1 20X2 20X3 20X4 20X5 20X6 20X7 20X8 Pre-tax profit 125 130 135 140 145 150 155 160 Add back depreciation 240 240 240 240 240 240 240 240 Pre-tax cash flow 365 370 375 380 385 390 395 400 Estimated tax on profit (pre-tax profit @ 35%) (44) (46) (47) (49) (51) (53) (54) (56) Estimated post tax cash flow 321 325 328 331 334 338 341 344 Applying the post-tax discount rate to the estimated cash flows above gives a value in use of C1, 904. Common error 2: Discount pre-tax cash flow at post-tax discount rate grossed up for the tax rate. This rate would be 8% / (1 − 0.35) = 12.3%. This gives a value in use of C1, 866. These applications fail to achieve the correct result, either by not accounting for varying period-on-period cash flows or by ignoring deferred tax. The correct value in use can be achieved by taking the value in use from common error 1 and adjusting for the discounted cash outflows related to deferred tax. This is a complex iterative calculation, because the discounted cash outflows in question relate to the pre-tax value in use – the result of the calculation feeds back into the calculation itself. The calculation is best solved with the aid of a computer, but the following summarizes the final calculation for the example above, once the iteration has been completed: Currency (C) 20X0 20X1 20X2 20X3 20X4 20X5 20X6 20X7 20X8 Pre-tax ViU (α) 1,729 1,513 1,296 1,080 864 648 432 216 0 Tax base (β) 800 α – β 929 1,513 1,296 1,080 864 648 432 216 0 Change in α – β 584 (216) (216) (216) (216) (216) (216) (216) (216) @ 35% (tax) 204 (76) (76) (76) (76) (76) (76) (76) (76) Discounted (8%) 175 Post-tax ViU 1,904 Pre-tax ViU 1,729   The ‘post-tax ViU’ number is as calculated in ‘common error 1’ above. The iterative process will complete when a set of figures for the first line have been derived which, when discounted at 8%, produce the same number as in the bottom ‘pre-tax ViU’ line. Having derived the correct pre-tax ViU and having the correct pre-tax cash flows, it is possible to ‘back-solve’ to obtain a pre-tax discount rate that discounts the latter to the former. It is logical that the pre-tax discount rate is higher, because a higher return would be required from the asset in order to cover the future tax payments to be made. The result of C1, 729 is a lower value in use than that originally calculated under common error 1. This is because the larger tax cash outflows for the remainder of the asset’s life were not taken into account in common error 1. The outcome of this test is a deficit of C191 (based on a carrying value of C1, 920 and a value in use of C1, 729). This implies that there might be an impairment to recognize. However, this is not necessarily the case, given the recoverable amount test in IAS 36 – that is, the asset’s fair value less costs of disposal also need to be considered. This is because part or all of the deficit arising under the value in use method might already be recognized in the balance sheet as a deferred tax liability, but this is not taken into account under that method. Therefore, management should also determine the asset’s fair value less costs of disposal, to assess if an impairment charge is necessary. In this situation, it would be a reasonable assumption that the asset’s tax base would re-set to cost if the asset were acquired by a market participant. Therefore, the impact of the tax cash flows in a fair value less costs of disposal calculation is unlikely to be as significant; and, as a result, an impairment might not be required.

Corporate overheads in value in use calculations It is important to ensure that corporate overheads are not omitted or double counted in the value in use calculations. For example, if part of the carrying value of head office property is allocated to CGUs for the purpose of impairment reviews, any internal management charges paid by the CGUs relating to the use of that property should be excluded from their cash outflows, where inclusion would result in double counting.

Transfer pricing difficulties A subsidiary might be only breaking even because it sells its output to a fellow subsidiary at cost, yet they are part of the same CGU from a group perspective. Where subsidiaries are separate CGUs, one subsidiary might be unprofitable because it sells its output to a fellow subsidiary at below-market prices. Conversely, the transferee subsidiary might be profitable, because it buys goods and services from its fellow subsidiary at below-market prices. From a group’s perspective, the cash inflows of the transferor CGU and the cash outflows of the transferee CGU that are used in the value in use calculations should be adjusted to reflect market prices rather than internal transfer prices. If the subsidiary earns an economic return on its assets after adjusting for market prices, it might be possible to argue that no impairment is required. This would be on the basis that the subsidiary could obtain a market rate of return on its investment, and therefore the recoverable amount (being the higher of value in use and fair value less costs of disposal) is higher than the actual cash flows being generated. In such a situation, disclosure would be required to explain the basis on which the recoverable amount was determined. Where a subsidiary is not earning an economic return on its assets, even after adjusting to market prices in terms of its separate cash flows, the subsidiary should be booking an impairment on those assets in its entity financial statements.

Advantages of the expected cash flow approach in times of higher uncertainty The expected cash flow approach has the following advantages over the traditional approach, in an environment of higher uncertainty: The sensitivity of the recoverable amount to uncertainties is explicit in the measurement, compared with the ‘traditional’ approach where it is factored into the discount rate. It enables management to assess the uncertain assumptions that might have the most significant impacts on the recoverable amount. It calculates a range of expected cash flows, instead of only considering the most likely case. It might be more aligned with the way in which management prepares forecasts. It lessens the impact of the judgmental exercise inherent in choosing a single specific risk premium, which might be difficult to quantify and document.

Modelling of uncertainty in ViU Management has identified three crucial uncertainties that might affect the forecast: market developments; the success of a new product; and customer churn. For each uncertainty, three cash flow projections have been identified, with the probability that they will occur: The recoverable amount will equal the expected value resulting from the combination of the 27 (3 × 3 × 3) possible scenarios.

Impact of country and currency risk on discount rate An Australian entity carries significant goodwill and indefinite-lived intangible asset balances in its consolidated balance sheet. These arose from multiple acquisitions in recent years. The entity manufactures goods in Australia that are sold locally and exported to Europe. The entity’s functional currency is the Australian dollar, and its financial statements are presented in Australian dollars. In carrying out its first impairment review under IAS 36, management proposes to use a discount rate based on the local Australian dollar risk-free rate, the local market risk premium and a country risk premium. This discount rate will be applied to the Australian dollar-denominated cash flow projections for each CGU. Management’s approach is incorrect. The Australian dollar risk-free rate will include the perceived risks associated with investing in the country and in the local currency. To add a country risk premium is, therefore, double counting. A separate country risk premium is only usually relevant where cash flow projections are prepared in a different currency, such as the Euro. It is always important to ensure consistency between the assumptions underlying the projected cash flows and the discount rate.

Rates vary to reflect specific risk factors Rates applicable to different business units within a group might vary, to reflect any risk factors that are specific to those units. Trading activities and investments in different countries are likely to have different risks (for example, currency and political risks). The rate should be appropriate to the country in which the CGU operates (or in whose currency it derives its major cash flows), rather than the country in which the finance is sourced. Different business sectors also attract different risks – for example, a biotechnology entity will carry a greater market risk than a regulated utility. In general, the more uncertain the cash flows are, the riskier the investment is, and the greater the risk adjustment is to increase the discount rate.

Avoiding double counting when determining a discount rate If contractual cash flows are adjusted to incorporate the risk of default in order to derive expected (as opposed to contractual) cash flows for impairment testing, to avoid double counting, the rate used to discount those expected cash flows to present value should not include a factor for default risk. This means that the rate used to determine the risk-adjusted expected cash flows is not the same as the rate used to discount those expected cash flows to present value terms.

Calculating a pre-tax discount rate Entity A has calculated a weighted average cost of capital (WACC) of 8%, based on market assumptions. Management is aware that this is a post-tax rate and, therefore, wants to determine a pre-tax discount rate, by grossing up the 8% by the statutory tax rate in entity A’s country, which is 35%. The result is 12.3% (8% / 0.65). The 12.3% is the correct pre-tax discount rate only if the specific amount and timing of the future tax cash flows are reflected by this rate. So, a grossed-up discount rate works only if there is no deferred tax. As soon as there is deferred tax, an iterative calculation needs to be done that considers the fact that a carrying amount after impairment would trigger new deferred taxes, and this would again change the carrying amount.

Calculation process for iteratively deriving a pre-tax discount rate The implicit pre-tax discount rate can be derived iteratively, using the post-tax discount rates that are directly observable from capital markets, by using a two-step iterative calculation process to convert the post-tax discount rate into an implicit pre-tax rate. This is based on: step 1: discounting the post-tax cash flows using a post-tax discount rate; and step 2: determining the implicit pre-tax rate that needs to be applied to pre-tax cash flows to arrive at the same result. Post-tax cash flows should reflect the specific amount and timing of the future tax cash flows. Where deferred tax exists, this can complicate the situation. In step 1, the expected actual tax cash payments are calculated to arrive at post-tax cash flows from pre-tax cash flow projections. These post-tax cash flows are discounted at an appropriate post-tax discount rate, derived using information observable on the capital markets. As a starting point for the derivation of the post-tax discount rate, the entity’s weighted average cost of capital (WACC) could be taken into account (as opposed to the entity’s incremental borrowing rate or other market borrowing rates). This is because the WACC is usually a good reflection of the risk specific to the asset or CGU, provided that it is similar to the rate that a market participant would use. This WACC should be adjusted for specific risks associated with the assets or CGU’s estimated cash flows (for example, country, currency or price risk). If such a WACC for the entity is not available, it might be necessary to estimate a WACC using peer group data. In step 2, the pre-tax discount rate is derived by determining the rate required to be applied to the pre-tax cash flows to arrive at the result obtained in step 1. In practice, the rate is calculated using the same methodology as for the calculation of an internal rate of return. Upfront deferred tax causes a double-counting issue. Deferred tax is the way in which the future tax consequences of recovering assets are recorded on the balance sheet. Therefore, if more tax will be payable in the future in relation to a CGU (say, because all available tax deductions have already been taken), this future tax payable will be recognized as a deferred tax liability. If value in use is calculated with reference to post-tax cash flows, the higher future tax payments will be included as cash outflows in the value in use measure, reducing the value in use. The carrying value of the CGU will be higher, by excluding the deferred tax liabilities from the carrying amount of the CGU. This means that the test no longer compares like with like. If the higher CGU carrying value is compared to a value in use measure that is depressed by tax cash outflows, the result might show an impairment. Any such impairment would include the discounted impact of the future tax outflows. It would not seem appropriate to book this element of the impairment, because the future tax outflows have already been accounted for, on an undiscounted basis, as deferred tax. Where there is significant deferred tax upfront, due to this double-counting issue, an IAS 36 value in use test might not be the most appropriate method.

Iteratively deriving a pre-tax discount rate The required pre-tax rate is the rate of return that will, after tax has been deducted, give the required post-tax rate of return. The following calculation illustrates how the pre-tax rate could correctly be derived from the post-tax rate. A CGU is being tested for impairment at the end of 20X0. The CGU comprises a specific asset, which was purchased two years ago for C2,400. The asset has a 10-year useful life for accounting purposes. Tax relief on the asset is available, on a straight-line basis, over the asset’s first three years of the life. The tax rate is 35%. The carrying value for tax purposes at the end of 20X0 is C800 (C2,400 × 1/3 years), and the carrying value for accounting purposes is C1,920 (C2,400 × 8/10 years). Applying the tax rate of 35% to the difference gives a deferred tax liability with a carrying value of C392 ((C1,920 − C800) × 35%). The post-tax discount rate, determined from the entity’s WACC, is 8%. There are two potential applications of the requirements of IAS 36 that are commonly seen. Neither of these gives the correct value in use according to the requirements of IAS 36. Common error 1: Discount an imputed ‘post-tax cash flow’ at a post-tax discount rate of 8%. The ‘post-tax cash flow’ is determined by assuming that cash outflow for tax will be equal to the pre-tax profit at the standard tax rate. This is illustrated in the table below. Pre-tax profits from the asset are expected to be C125 at the end of 20X1, increasing by C5 for each of the following seven years. The appropriateness of such an increasing rate has been considered and determined reasonable. The results for the seven years in question are, therefore, as follows: Currency (C)                                                    20X1      20X2      20X3      20X4      20X5      20X6                20X7      20X8 Pre-tax profit                                                  125        130        135        140        145        150                155        160 Add back depreciation                                                   240        240        240        240        240        240                240        240 Pre-tax cash flow                                          365        370        375        380        385        390                395        400 Estimated tax on profit (pre-tax profit @ 35%)                                (44)        (46)        (47)        (49)        (51)        (53)                (54)        (56) Estimated post-tax cash flow                    321        325        328        331        334        338                341        344 Applying the post-tax discount rate to the estimated cash flows above gives a value in use of C1,904. Common error 2: Discount pre-tax cash flow at post-tax discount rate grossed up for the tax rate. This rate would be 8% / (1 − 0.35) = 12.3%. This gives a value in use of C1,866. These applications fail to achieve the correct result, either by not accounting for varying period-on-period cash flows or by ignoring deferred tax. The correct value in use can be achieved by taking the value in use from common error 1 and adjusting for the discounted cash outflows related to deferred tax. This is a complex iterative calculation, because the discounted cash outflows in question relate to the pre-tax value in use – the result of the calculation feeds back into the calculation itself. The calculation is best solved with the aid of a computer, but the following summarizes the final calculation for the example above, once the iteration has been completed: Currency (C)                      20X0      20X1      20X2      20X3      20X4      20X5      20X6      20X7                20X8 Pre-tax ViU (α)                 1,729     1,513     1,296     1,080     864        648        432        216        0 Tax base (β)                      800 α – β                                   929        1,513     1,296     1,080     864        648        432        216        0 Change in α – β                               584        (216)     (216)     (216)     (216)     (216)     (216)                (216)     (216) @ 35% (tax)                      204        (76)        (76)        (76)        (76)        (76)        (76)        (76)                (76) Discounted (8%)                             175 Post-tax ViU                      1,904 Pre-tax ViU                       1,729 The ‘post-tax ViU’ number is as calculated in ‘common error 1’ above. The iterative process will complete when a set of figures for the first line have been derived which, when discounted at 8%, produce the same number as in the bottom ‘pre-tax ViU’ line. Having derived the correct pre-tax ViU and having the correct pre-tax cash flows, it is possible to ‘back-solve’ to obtain a pre-tax discount rate that discounts the latter to the former. It is logical that the pre-tax discount rate is higher, because a higher return would be required from the asset in order to cover the future tax payments to be made. The result of C1,729 is a lower value in use than that originally calculated under common error 1. This is because the larger tax cash outflows for the remainder of the asset’s life were not taken into account in common error 1. The outcome of this test is a deficit of C191 (based on a carrying value of C1,920 and a value in use of C1,729). This implies that there might be an impairment to recognize. However, this is not necessarily the case, given the recoverable amount test in IAS 36 – that is, the asset’s fair value less costs of disposal also need to be considered. This is because part or all of the deficit arising under the value in use method might already be recognized in the balance sheet as a deferred tax liability, but this is not taken into account under that method. Therefore, management should also determine the asset’s fair value less costs of disposal, to assess if an impairment charge is necessary. In this situation, it would be a reasonable assumption that the asset’s tax base would re-set to cost if the asset were acquired by a market participant. Therefore, the impact of the tax cash flows in a fair value less costs of disposal calculation is unlikely to be as significant; and, as a result, an impairment might not be required.

Identifying potential impairment losses and estimating the pre-tax impact Deriving a pre-tax discount rate is a complex exercise. There are some practical methods to use, to identify potential impairment losses and estimate the pre-tax impact. One method is to calculate the post-tax cash flow discounted at the post-tax discount rate. This calculation should give a reasonable indication, using readily available data, of whether there has been an impairment. If no impairment is identified, a judgement can be made with regard to the headroom above carrying value. If the headroom is considered sufficiently high, it might be possible to infer that the likelihood of an impairment arising on a pre-tax calculation is remote. The pre-tax rate can be estimated for disclosure purposes. If there is not significant headroom in the post-tax calculation, a pre-tax analysis will be required, to identify the correct pre-tax value in use from which the pre-tax impairment loss and the related deferred tax effects (and the pre-tax discount rate for disclosure purposes) can be derived.

Deriving a pre-tax rate from a post-tax rate The required pre-tax rate is the rate of return that will, after tax has been deducted, give the required post-tax rate of return. The following example illustrates how the pre-tax rate might be derived from the post-tax rate: Step 1: Post-tax Actual Plan Plan Plan Plan Plan Plan Plan Plan Currency in thousands 20X0 20X1 20X2 20X3 20X4 20X5 20X6 20X7 20X8 EBIT       125 30 135 140 145 150 155 160 Depreciation/ amortization 240 240 240 240 240 240 240 240 EBITDA                365 370 375 380 385 390 395 400 Tax deduction* (800) − − − − − − − Taxable earnings (435) 370 375 380 385 390 395 400 Tax CF × (tax rate) 152 (130) (131) (133) (135) (137) (138) (140) Post-tax CF discount 517 240 244 247 250 253 257 260 factor 8.00% 0.9259 0.8573 0.7938 0.7350 0.6806 0.6302 0.5835 0.5403 Discounted cash flow 479 206 194 182 170 160 150 140 479 Post-Tax Value in use 1,681 Step 2: Pre-tax discount rate is derived by iteration using the post-tax value in use Pre-tax Actual Plan Plan Plan Plan Plan Plan Plan Plan Currency in thousands 20X0 20X1 20X2 20X3 20X4 20X5 20X6 20X7 20X8 Pre-tax CF 365 370 375 380 385 390 395 400 discount factor** 15.4% 0.867 0.752 0.652 0.565 0.490  0.424 0.368 0.319 Discounted cash flow 316 278 244 215 188 166 146 128 Pre-tax Value in use 1,681 * The asset’s historical cost was C2,400 and the tax amortization period are three years. 20X1 was the final year for which the entity was entitled to claim tax amortization for the asset. ** Discount factor of 15.4% is computed using the goal seek function (that is, an Excel function to derive IRR). (Based on the pre-tax cash flow and value in use.) This example demonstrates that it is possible to obtain the same value in use result from a post-tax cash flow approach as from a pre-tax approach. It was possible as the post-tax cash flow was adjusted to reflect the actual amount and timing of the actual tax cash flows, as adjusted for deferred tax and not based on assumptions about tax cash flows. However, the above example is quite straightforward, given that it is calculating the value in use for a single asset and was impacted by taxation only in year 20X1.

Goodwill

Goodwill acquired in a business combination represents future economic benefits arising from assets that are not capable of being individually identified and separately recognized, such as a skilled workforce.

Goodwill does not generate cash inflows independently from other assets or groups of assets, and so the recoverable amount of goodwill as an individual asset cannot be determined. Goodwill acquired in a business combination should be allocated, from the acquisition date, to each of the acquirer’s CGUs or groups of CGUs that are expected to benefit from the synergies of the business combination. This is done irrespective of where the other acquired assets and liabilities are allocated.

Goodwill should be allocated on a reasonable basis. The allocation of goodwill to a CGU, or groups of CGUs, is made based on the synergies expected to be derived from the combination.

Goodwill allocated to new and existing businesses An entity acquires a group of entities. Acquired subsidiary A is a competitor of one of the entity’s existing operations. Subsidiary A will be closed, and its customers will be served by the entity’s existing operation. The goodwill relating to subsidiary A will be allocated to a CGU or group of CGUs of the entity’s existing operation. The other assets and liabilities of subsidiary A might not be allocated to those CGUs.

Methods for allocation of goodwill Given the lack of guidance on acceptable methods of allocation, an appropriate basis needs to be selected by an entity’s management. Discounted cash flow-based methods are, in general, likely to be appropriate for most acquisitions, because asset-based methods do not generally reflect the relative profitability of different businesses. A cash flow approach is also consistent with the principles for subsequent impairment calculations.

Goodwill sometimes cannot be allocated on a non-arbitrary basis to individual CGUs, and so it is allocated to groups of CGUs. Each CGU (or group of CGUs) to which goodwill is allocated from the date of acquisition should:

• represent the lowest level within the entity at which management monitors goodwill for internal purposes; and
• not be larger than an operating segment (as defined by IFRS 8) before aggregation.

Goodwill can then be monitored and tested for impairment in a way that is consistent with management’s internal management systems, thus avoiding development of additional systems specifically to deal with goodwill.

Testing a segment for impairment Entity A manufactures and sells envelopes, and it commenced operations in Melbourne in 19X6. In January 20X0, entity A purchased the assets and liabilities of entity B, a business located in Sydney, and it recorded goodwill of C6 million on acquisition. One year later, in 20X1, entity A purchased the assets and liabilities of entity C, a business located in Perth, and it recorded goodwill of C11 million on acquisition.   Entities B and C also manufacture and sell envelopes. The goodwill arose from the value attributed by entity A to the assembled workforce in each business and the benefit of combining the back-office functions with those functions already carried out by entity A. All pricing, purchasing, marketing, advertising and human resource decisions are made centrally, except for hiring operational staff. Management has assigned responsibility for this function to the local management of entities B and C. The three business units – entities A, B and C – have different customer bases and are located in different states. Management has identified each business as a separate CGU for the purpose of testing assets, other than goodwill, for impairment. Entities A, B and C are one operating segment for the purpose of segment reporting. The carrying amount of goodwill in entity A’s financial statements is C14 million. Management cannot allocate the goodwill to each of the three CGUs, except on an arbitrary basis. Internal management reporting is organized to measure performance at the corporate level. Goodwill should be tested for impairment by aggregating entities A, B and C. All three CGUs benefit from the synergies ascribed to each business combination. The combination of the three CGUs represents the lowest level at which management captures information, for internal management reporting purposes, about the benefits of the goodwill. The combined CGUs are not larger than an operating segment.

Non-arbitrary basis A ‘non-arbitrary’ basis for the allocation of goodwill to CGUs (or groups of CGUs) is a matter of judgement, depending on the relevant facts. An example that would be considered ‘arbitrary’ is allocating goodwill to four individual CGUs on the basis of 25% to each CGU, simply because there are four CGUs. One approach, in practice, for goodwill allocation is a relative fair value approach.

Allocation of goodwill after acquisition An international chemicals business, entity D, acquired another chemicals business, entity E, with 80 factories operating in 10 countries. There is an external market for each factory’s output, and each factory maintains its own accounting records and cash flow information. Entity E is managed by reference to geographical segments. Management decided that the lowest level to which goodwill could be allocated, on a reasonable and consistent basis, was each of the 10 countries. The compensation scheme of the territory management in each of the 10 countries includes certain financial ratios. These ratios take into account allocation of goodwill on the acquisition among operations in the 10 countries. Entity D did not operate in these 10 countries prior to entity E’s acquisition. Two years after the acquisition, entity D decides to restructure the acquired business in two countries and, as a result, decides to close five factories in those countries. Each factory is a separate CGU, so entity D should calculate the recoverable amount of the five factories that it has decided to close, for the purposes of impairment testing the factories, and record the impairment. Goodwill cannot be allocated to the individual factories, on a reasonable and consistent basis, so a second test is performed. The smallest CGU to which goodwill can be allocated, on a reasonable and consistent basis, is each of the countries in which the factories are located. Entity D calculates the recoverable amount of entity E’s business in the two countries in which factories will be closed. The recoverable amount of those businesses is compared to the carrying amount of the business, including goodwill. Any impairment identified is applied first to reduce the goodwill’s carrying amount, and then to other non-monetary assets on a pro rata basis. Four years after the acquisition, new products introduced by competitors supersede some of the products that entity E manufactures. Although all of the individual factories remain profitable, there is an indication that the goodwill on entity E’s acquisition as a whole is impaired. There are no indicators of impairment at individual factories, so it is not necessary to test for impairment at a factory level. There is an indication that goodwill is impaired, so goodwill should be tested for impairment at the level of the smallest CGU to which goodwill can be allocated on a reasonable and consistent basis. The smallest CGU to which goodwill can be allocated, on a reasonable and consistent basis, is entity E’s business in each of the 10 countries. Entity D calculates the recoverable amount of entity E’s business in each country. The recoverable amount of those businesses is compared to the carrying amount of the business, including goodwill. Any impairment identified is applied first to reduce the goodwill’s carrying amount, and then to other non-monetary assets on a pro rata basis.

Allocating goodwill to CGUs for impairment purposes might not coincide with how it is allocated for the purpose of IAS 21 and measuring foreign currency gains and losses. If goodwill is allocated at relatively low levels for the purpose of IAS 21, that does not mean that it has to be reviewed for impairment at those low levels, unless management monitors the goodwill at that level for internal management purposes.

The allocation of goodwill should normally be completed before the end of the financial year in which the combination takes place. If the initial allocation of goodwill cannot be completed within the year of acquisition, that initial allocation is completed before the end of the first financial year beginning after the acquisition date. In accordance with IAS 36, the reasons why a portion has not been allocated, and the amount of unallocated goodwill, should be disclosed. We would not expect an entity can avoid an impairment charge simply as a result of goodwill not being allocated. Generally, entities should allocate the goodwill, even if provisionally, and perform impairment testing if indications of impairment exist.

Maximum period allowed for allocating goodwill A group with a December year-end acquires a business in March 20X8. The goodwill should be tested for impairment by 31 December 20X8. IFRS 3 allows an entity 12 months from the acquisition date to complete the purchase accounting. The entity has not completed its purchase accounting by 31 December 20X8. It cannot allocate goodwill until the amount is known. There have been no trigger events suggesting that the acquired goodwill might be impaired. For this acquisition, the entity should complete the purchase accounting by March 20X9. At this time, the goodwill amount is known, so the goodwill should be allocated to CGUs or groups of CGUs by 31 December 20X9 for the annual impairment review. Goodwill should be tested for impairment where there has been a triggering event, even if the allocation process is not complete.

Where a CGU to which goodwill has been allocated is disposed of, the goodwill is included in the CGU’s assets and liabilities used in calculating the profit or loss on disposal. Goodwill should be apportioned to the disposed operation by measuring it on the basis of the relative values of the operation disposed of and the portion of the CGU retained. This method is to be used, unless the entity can demonstrate that some other method better reflects the goodwill associated with the operation disposed of.

Relative value is usually based on recoverable amounts of the operation disposed of and the operation retained at the date of disposal. The recoverable amount of the operation disposed will be the fair value less costs of disposal. The recoverable amount of the operation retained might be based on the latest estimate of recoverable amount of the whole CGU. This latest estimate would have to be updated for any events or circumstances up to the date of disposal of the operation that formed part of the CGU. Any consequential effects of the disposal on the remaining part of the CGU would have to be taken into account. If such a process is impracticable or unreliable, a new calculation of the recoverable amount of the retained part of the CGU might be necessary.

Allocation of goodwill on part-disposal of a CGU A CGU was reviewed for impairment at 31 December 20X4, and recoverable amount was estimated at C3 million. Recoverable amount was based on the fair value less costs of disposal. Goodwill of C600,000 has previously been allocated to the CGU and is not impaired at 31 December 20X4. In 20X5, part of the CGU is disposed of for C2 million net of disposal costs. The entity has to allocate the goodwill of C600,000 between the portion of the CGU that is retained and the portion disposed of. Assuming no change in the CGU’s recoverable amount up to the date of disposal and no other special effects of the disposal, using a relative fair value approach the allocation of the goodwill to the operation disposed of would be two-thirds of total goodwill. That is, the value of the business disposed of, C2 million, divided by the whole CGU’s recoverable amount of C3 million. Therefore, C400,000 of goodwill would be apportioned to the business disposed of. Another method of allocation could be used for the goodwill if it could be demonstrated that this better reflected the goodwill disposed of and the goodwill retained.

Goodwill might need to be reallocated if a group restructures or reorganizes. The entity should reallocate the goodwill amongst the units affected. Reallocation should be based on a relative value approach, as for disposal. Relative values should be adopted, unless the entity can demonstrate that some other method better reflects the goodwill attributable to the reorganized CGUs.

Alternative to relative fair value approach Goodwill might need to be reallocated if a group restructures or disposes of a CGU. Reallocation is usually done based on relative fair values. The relative fair value approach assumes that all CGUs or parts of CGUs contain a similar proportion of goodwill to one another. This might not be the case. Example Group S is a multi-national group with a presence in various continents. In 20X6, group S acquired a South American sub-group. Goodwill of C1 million was generated on acquisition, and it was allocated across three CGUs (A, B and C), based upon geographical locations. In 20X9, a restructuring exercise was carried out. The new CGUs in South America (X, Y and Z) are determined on a product basis. The group manufactures two products in South America and, in addition, has a consultancy business. Prior to the restructuring, the goodwill of C1 million was assessed for impairment, and it was determined to be fully recoverable. The fair value of identifiable net assets and the full fair value of each CGU are given in the table below: CGU X CGU Y CGU Z Total C’m C’m C’m C’m Fair value of identifiable net assets 3.8 6 5 14.8 Fair value in total 4 6 10 20 If the goodwill of C1 million is reallocated across CGUs X, Y and Z on a relative fair value basis, C200,000 would be allocated to CGU X, C300,000 to CGU Y and C500,000 to CGU Z. This would result in the immediate impairment of goodwill allocated to CGU Y. This is because the relative fair value model does not take into account the difference between the businesses in question. CGUs X and Y, being manufacturing businesses, are highly asset-intensive, whereas CGU Z, the consultancy business, has a smaller asset base. In this situation, an acceptable alternative to the relative fair value approach would be to ‘perform a purchase price allocation’ exercise for each CGU. The fair value of each CGU as a business would be compared to the identifiable net assets’ fair value, to calculate a notional goodwill amount. The recognized goodwill is then reallocated across the new CGUs, based on the relative values of this notional goodwill. In this case, there is notional goodwill of C200,000 in CGU X, Cnil in CGU Y and C5,000,000 in CGU Z. Thus C40,000 of goodwill would be allocated to CGU X (C200,000/C5,200,000 * C1,000,000), and C960,000 would be allocated to CGU Z. A similar situation to that above could occur on a partial disposal of a CGU, if the part of the CGU disposed of was more or less asset-intensive than that retained.

Allocation of goodwill after change in management structure Entity A has previously allocated goodwill to CGUs A, B and C. Following a change in management team, the managers of CGUs A, B and C have all been replaced by one manager, who is in charge of the three businesses. In this situation, it will be necessary to understand whether there has truly been a change in the way in which goodwill is monitored internally. If the internal reporting for each of CGUs A, B and C has been replaced with one report covering the combined businesses, we would consider it acceptable to reallocate the goodwill to the combination of the CGUs, for the purposes of impairment testing. However, if the new manager is receiving disaggregated information for each CGU, it is likely that goodwill is still being monitored in the same way as before, and so the allocation should not be changed.

Restructuring of an operation is an impairment indicator if it has an adverse effect on the entity. An impairment review should be performed prior to any restructuring, to ensure that the reallocation process does not mask any pre-existing impairments.

Goodwill might be allocated to a group of CGUs. So, individual CGUs within the group might not have goodwill directly allocated to them. A CGU with no goodwill allocated is tested where there is an indication of impairment. The impairment test compares the unit’s carrying amount (excluding any goodwill) with its recoverable amount, and any impairment loss is recognized.

Goodwill might be allocated to individual CGUs or to groups of CGUs. Any CGU or group of CGUs to which goodwill has been allocated should be tested for impairment annually. It should also be tested where there is an indication of impairment. The impairment test compares the carrying amount of the CGU or group of CGUs, including the allocated goodwill, with the recoverable amount of the CGU or group of CGUs. If the recoverable amount is less than the carrying amount, an impairment loss is recognized.

Test CGUs with goodwill annually Groups need to keep detailed records of the composition of the aggregate amount of purchased goodwill, to avoid having to carry out impairment tests of all CGUs annually. The records should explain the parts of the group to which the goodwill relates, and the CGUs and groups of CGUs to which it has been allocated. CGUs or groups of CGUs to which goodwill is allocated should be tested for impairment annually and whenever there are indications of impairment. Other CGUs to which goodwill has not been allocated only need to be tested when there are indications of impairment. Records of the allocation of goodwill to CGUs are also necessary, to account for subsequent disposals (to determine how much goodwill should be written off when a business is sold or reorganized).

The annual impairment test for CGUs containing goodwill can be carried out at any time in the financial year, but it should be done at the same time each year. Different CGUs can be tested for impairment at different times in the year. However, if some or all of the goodwill allocated to a CGU was acquired in the current financial year, the CGU should be tested for impairment before the end of that financial year.

There might be an indication of impairment of an asset within a CGU to which goodwill has been allocated. The asset should be tested for impairment before the CGU is tested. This also applies to a CGU within a group of CGUs to which goodwill has been allocated. The impairment test is a two-step process:

• Step 1: Test the individual asset or CGU for impairment. An impairment should be recorded, to reduce the carrying amount to the recoverable amount.
• Step 2: Test the CGU or group of CGUs including goodwill. This second stage is a comparison of the recoverable amount with the restated carrying amount after the step 1 impairment.

The two-stage approach ensures that other assets excluding goodwill are tested separately for impairment at the level of the individual asset or (for groups of CGUs) at the individual CGU level and goodwill allocated to the CGU or group of CGUs is tested at the CGU (or at the combined group of CGUs) level.

Two-stage approach to impairment testing An entity acquired a group of entities some years ago. At the current year end, there is an indicator that one subsidiary, entity A, might be impaired. Entity A is a cash-generating unit (CGU). Value in use is assumed to be higher than fair value less costs of disposal, and so it is taken as the recoverable amount. A – Recognition of impairment where goodwill has been allocated to the CGU The carrying value of entity A and its recoverable amount are compared, as follows, to determine the impairment loss: Cash-generating unit      A C’m Net assets 220 Goodwill 40 Total net assets 260 Value in use 200 Impairment 60 Where purchased goodwill is allocated to the individual CGU, there is an impairment loss of C60 million in entity A, reducing the carrying value of its net assets and goodwill to C200 million. C40 million of the impairment loss is attributed to goodwill, and C20 million is attributed to other assets on a pro rata basis. The carrying values, after recognizing the impairment loss, are as follows: Carrying value after impairment A C’m Net assets 200 Goodwill – Total net assets 200 B – Recognition of impairment where goodwill has not been allocated to the individual CGU The entity first calculates impairment loss (if any), based on entity A’s net assets excluding goodwill. Cash-generating unit A C’m Net assets 220 Value in use 200 Impairment 20 Entity A’s net assets are reduced, by the impairment loss, to C200 million (allocation of the impairment loss is on a pro rata basis). In order to test goodwill, the entity then tests the group of CGUs that includes entity A and to which goodwill has been allocated. The group of CGUs consists of the operations of entities A and B combined. (The impairment test of this group of CGUs should be done annually, in any case, and at other times where there is an indication of impairment, because it contains goodwill.) The calculation of the impairment loss is then as follows: Cash-generating unit A B Goodwill Larger CGU C’m C’m C’m C’m Net assets 200 110 80 390 Value in use 200 180 380 Impairment – – 10 10   Carrying values after impairment A B Goodwill Larger CGU C’m C’m C’m C’m Net assets 200 110 70 380 The total impairment charge is thus C30 million, being C20 million from the first stage and C10 million from the second stage. This is the difference between the carrying amount of entity A’s assets of C220 million and their revised carrying amount of C200 million, plus the difference between the carrying amount of goodwill of C80 million and its revised carrying amount of C70 million.

Non-controlling interests

Where an entity acquires less than 100% of a business, goodwill could be one of the following two amounts, depending on the choice that an entity makes when it decides how to measure non-controlling interest. Non-controlling interest could be measured using the fair value method or the proportionate share method:

• Goodwill will only include amounts relating to the acquiring entity’s interest in the business acquired, where non-controlling interest is measured at the non-controlling interest’s proportionate shares in the acquiree’s identifiable net assets.
• Goodwill will include amounts relating to both the acquiring entity’s interest and the non-controlling interest in the business acquired, where non-controlling interest is measured at fair value.

The proportionate share method causes a mismatch in impairment testing. The carrying amount includes 100% of the assets and liabilities but only the parent’s share of goodwill. The recoverable amount will include 100% of the CGU, including 100% of goodwill. So, adjustments are needed, to compare like with like.

In carrying out an impairment test of a CGU with a non-controlling interest that has been accounted for using the proportionate share method, the following steps are taken:

• The CGU’s carrying amount is notionally adjusted to include goodwill attributable to the non-controlling interest. This is done by grossing up the carrying amount of goodwill allocated to the CGU, to include the goodwill attributable to the non-controlling interest.
• The CGU’s notional carrying amount is then compared with the CGU’s recoverable amount.
• If the recoverable amount is lower than the notional carrying amount, an impairment loss is recognized.
• This impairment loss will include a loss attributable to the noncontrolling interest’s notional share of goodwill. That element of the loss needs to be identified and excluded from the amount of the loss that is recognized. This is done in proportion to the amount of the loss that is attributable to the notional goodwill as a whole.
• The impairment loss (as adjusted for the non-controlling interest’s share) is first applied to write down the goodwill that has been recognized. This is the goodwill attributable to the parent’s interest that is actually recognized in the financial statements, and not the ‘notional’ goodwill that includes the non-controlling interest’s share. Any excess of impairment losses over the carrying amount of goodwill is then applied pro rata against the remaining non-monetary assets on the basis of their carrying amounts.

No adjustment is needed if the non-controlling interest is measured using the fair value approach.

Calculation of impairment when there is a non-controlling interest in the CGU Entity X acquires an 80% interest in entity A for C2.4 million on 1 January 20X6. The identifiable net assets and contingent liabilities (after fair valuing) of entity A are C1.8 million on that date. Entity X applies the partial goodwill method, recognizing goodwill only to the extent of its own 80% interest in entity A. Entity X, therefore, recognizes in its financial statements: ·        The fair value of net assets and contingent liabilities of C1.80 million. ·        Goodwill of C0.96 million (calculated as C2.40m – (C1.80m × 80%)). ·        Non-controlling interest (NCI) of C0.36 million (C1.80m × 20%). Entity A is a CGU. Goodwill has been allocated to entity A, so it should be tested annually for impairment, and more frequently whenever there is an indication of impairment. It should also be tested before the end of the accounting period in which the acquisition took place. At the end of 20X6, entity X assesses the CGU’s (entity A’s) recoverable amount as C1 million. Entity X uses straight-line depreciation and a 10- year useful life for entity A’s depreciable assets, and it anticipates no residual value. (It is assumed, for simplicity, that the depreciable assets are C1.8 million.) Part of the recoverable amount of C1 million is attributable to the non-controlling interest’s share of goodwill that has not been recognized. The carrying amount of entity A should first be notionally increased, for the purpose of the impairment test, by the goodwill attributable to the non-controlling interest. That notionally increased carrying amount is then compared with the recoverable amount of C1 million. This is shown in the following table: Carrying value of CGU C’m C’m Goodwill (attributable to parent’s interest) 0.96 Unrecognized non-controlling interest in goodwill * 0.24 Total goodwill (the starting point, if applying the gross NCI method) 1.20 Gross carrying amount of identifiable net assets 1.80 Accumulated depreciation (0.18) Carrying amount of identifiable net assets 1.62 Notionally adjusted carrying amount 2.82 Recoverable amount 1.00 Impairment loss (notional for partial NCI method and actual for gross NCI method) 1.82 *The goodwill attributable to entity X’s interest of 80% was C0.96 million at the acquisition date. Therefore, the goodwill attributable to the non-controlling interest’s 20% interest is one-quarter of that (C0.24 million). The impairment loss then needs to be allocated. This is first attributed to goodwill (of which only C0.96 million is in entity A’s balance sheet, as the 0.24 is attributable to the non-controlling interests), and then allocated to the net assets. Carrying value of CGU Allocation of impairment After impairment C’m C’m C’m Goodwill (attributable to parent’s interest) 0.96 (0.96) − Gross carrying amount of identifiable net assets 1.80 Accumulated depreciation 0.18 Carrying amount of identifiable net assets 1.62 (0.62) 1.00 1.00 Carrying amount (1) 2.58 Recoverable amount 1.00 Impairment loss (total booked) (1.58) (1.58) Note: (1) Excludes notional amount of non-controlling interest’s goodwill. If the gross NCI method had been used, C1.2 million of goodwill would have been recognized in the balance sheet, and all would be impaired. The balance of the impairment loss of C0.62 million is recognized in full, because it relates to net assets (including both parent and non-controlling interest’s share) that are also recognized in full in the financial statements. This remaining impairment loss is allocated pro rata to the identifiable assets (excluding goodwill) on the basis of their carrying amounts. The total impairment loss recognized in entity X’s consolidated financial statements is therefore C0.96m + C0.62m = C1.58m.

An entity with goodwill recognized under the fair value method and the proportionate method will need to track goodwill by transaction, so that the gross-up method can be applied, as necessary, to the relevant pieces of goodwill.

This diagram below outlines the process for determining whether goodwill needs to be grossed up for impairment testing, the calculation of impairment losses for goodwill, and the allocation of losses between the controlling and non-controlling interests, if the proportionate share method is chosen.

Goodwill arising from an acquisition with a non-controlling interest might be allocated to a group of CGUs which are wholly-owned. Any impairment loss would first be allocated between the wholly-owned portion of the group of CGUs and the portion with controlling and non-controlling interests according to the relative carrying amounts of goodwill. The impairment loss related to the goodwill for the wholly-owned CGUs is allocated to the controlling interest, while the impairment loss related to the partially-owned CGUs is allocated to the controlling interest and noncontrolling interest, based on their respective profit and loss allocations.

Allocation of an impairment loss to controlling and non-controlling interests with pre-existing goodwill An entity has previously recorded goodwill of C800, all arising from 100% acquisitions. It subsequently records goodwill of C500 in an 80% acquisition, and it applies the fair value method to the valuation of the non-controlling interest. The acquired business is a single CGU, but it is grouped with a number of wholly owned CGUs for impairment testing. The previously recorded goodwill of C800 is also allocated to that group of CGUs. There is no other non-controlling interest. Profit or loss of the acquired business is allocated on the basis of the relative equity interests of the parent and the non-controlling interest. The group of CGUs is tested for impairment annually. Two years later, the entity carries out the annual impairment test. The carrying value of the CGUs and the goodwill that is tested with them is less than the recoverable amount by C500, resulting in an impairment loss. How should the impairment loss be allocated? Goodwill gross-up is not required, because all existing goodwill arose in 100% acquisitions and the 80% acquisition used the fair value method. The impairment loss is first allocated between the wholly-owned portion of the group of CGUs and the portion with controlling and non-controlling interests, by the relative carrying amounts of goodwill. A goodwill impairment loss of C307 (C500 × C800 ÷ C1,300) is allocated to the wholly-owned portion of the group of CGUs. All of this loss is allocated to the controlling interest. A goodwill impairment of C193 (C500 × C500 ÷ C1,300) is allocated to the CGU that includes the controlling and non-controlling interests. This is further allocated between the controlling and non-controlling interests on the same basis as profit and loss. So, the amount of impairment loss attributed to the controlling interest is C154 (C193 × 80%), and the amount allocated to the non-controlling interest is C39 (C193 × 20%). The total impairment loss allocated to the controlling interest is C461 (C307 + C154). The total impairment loss allocated to the non-controlling interest is C39, and the impairment charge in the income statement is the full C500.

Corporate assets

Corporate assets, such as head office buildings, are defined as “… assets other than goodwill that contribute to the future cash flows of both the cash-generating unit under review and other cash-generating units”.

Corporate assets do not generate cash inflows independently of other assets or groups of assets, and their carrying amount cannot be fully attributed to the CGU that is being reviewed for impairment.

A corporate asset is usually tested for impairment only if there is an indicator that it is impaired, unless it is an indefinite-lived asset (such as a brand) that should be tested annually. If there is an impairment indicator, the corporate asset should be tested as part of a CGU, because it does not generate independent cash flows, and so its stand-alone value in use cannot be estimated.

A fair value might be established for corporate assets, such as a brand or corporate headquarters. If the fair value less costs of disposal is higher than the carrying amount, the corporate asset is not impaired and a test at the CGU level will not be necessary.

The following approach should be used to allocate corporate assets to CGUs:

• Allocate corporate asset to a CGU on a reasonable and consistent basis, if possible. The entity should compare the CGU’s recoverable amount with the carrying amount of the CGU including the allocated portion of corporate assets. Any impairment loss arising is then recognized.
• If corporate assets cannot be allocated on a reasonable and consistent basis to the CGU, the entity should apply a two-stage test:
• first, it compares the CGU’s recoverable amount with the carrying value of its net assets (excluding any allocation of corporate assets), and recognizes any impairment loss; and
• second, it identifies the next smallest group of CGUs to which corporate assets can be allocated on a reasonable and consistent basis; it then compares the recoverable amount of that group of CGUs with the carrying amount of their net assets (including the allocation of corporate assets), and recognizes any further impairment loss.

Allocating corporate assets within CGUs An entity should ensure that the carrying values of all CGUs in a group add up to the carrying value of the group’s assets in aggregate. No assets should escape the impairment review. By including allocations of corporate assets within the CGU’s carrying amount, the impairment review checks whether or not the CGU’s net cashes flows (excluding any cash outflows relating to the CGU’s use of those corporate assets) will recover the carrying amounts of the CGU’s own assets and the allocated portion of corporate assets. Any internal charges that are payable relating to the use of the corporate assets would need to be excluded from the CGU’s cash flows; otherwise, the consumption of corporate asset resources would be double counted, because the carrying amount would be increased and the value in use decreased by the same item.

A reasonable basis of allocation could be carrying amounts of the CGUs’ net assets, weighted according to the CGUs’ expected useful lives. This is an appropriate basis where the relative carrying amounts of the net assets are a reasonable indication of the proportion of the corporate assets that are devoted to each CGU. Other bases might be appropriate, depending on the entity’s structure and type of corporate asset. For example, the corporate assets in a central personnel department might be allocated on the basis of headcount in individual CGUs, rather than by reference to their net assets.

Testing corporate assets for impairment An entity has 3 CGUs (A, B and C) and some corporate assets. The corporate assets include a headquarters with a carrying value of C200 and a computer center at C100. The computer center cannot be reasonably allocated, but an allocation is made of the remaining C200 between the three CGUs, based on the carrying amounts of the three units, weighted by reference to the CGUs’ remaining useful lives, as follows: CGU A B C Total C C C C Carrying amount 200 200 300 700 Useful life 10 years 20 years 20 years Weighting based on useful life 1 2 2 Carrying amount after weighting 200 400 600 1,200 Pro-rata allocation of the headquarter building 16.7% 33.3% 50% 100% Allocation of carrying amount of building 33 67 100 200 Carrying amount after allocation 233 267 400 900 The computer center is not allocated.

Two-stage test (corporate assets) An entity has 3 CGUs (A, B and C) and some corporate assets. The corporate assets include a headquarters with a carrying value of C200 and a computer center at C100. The computer center cannot be reasonably allocated, but an allocation is made of C200 for the headquarters. The entity first determines the recoverable amount and carrying amount of each CGU, excluding the computer center, and carries out the impairment test for each CGU (assuming that there are indications of impairment for each CGU). The recoverable amounts are determined as 250, 230 and 350 respectively for CGUs A, B and C. Normal impairment (first-stage) test CGU A B C Total C C C C Directly attributable net assets 200 200 300 700 Headquarter building 33 67 100 200 Total net assets 233 267 400 900 Value in use (recoverable amount) 250 230 350 830 Impairment loss – 37 50 87 Net assets after impairment 233 230 350 813 The impairment loss is then allocated between the CGU’s assets and the headquarter building, on a pro rata basis, as follows: CGU B C C C To headquarter building 9 (37 × 67/267) 12 (50 × 100/400) To assets in CGU 28 (37 × 200/267) 38 (50 × 300/400) 37 50 Second-stage test CGU A B C Headquarter building Subtotal Computer center Total C C C C C C C Directly attributable net assets 200 200 300 200 900 100 1,000 Impairment loss arising from normal impairment test – (28) (38) (21) (87) – (87) Carrying amount after normal impairment test 200 172 262 179 813 100 913 Value in use (recoverable amount) 830 Impairment loss from second stage test 83 The impairment loss of C83, arising on the second stage, should be allocated pro rata to the assets of the total unit (that is, the CGUs, the headquarter building and the computer center). This is provided that the impairment loss does not reduce the carrying amount of an asset below the highest of: ·        its fair value less costs of disposal (if determinable); ·        its value in use (if determinable); and ·        zero. The value in use for CGUs A, B and C and the headquarters is known, and it amounts to C830. In accordance with IAS 36, the CGUs’ carrying amount cannot be further reduced below its value in use (C830), and so the entire impairment of C83 should be allocated to the computer center.