Top tips for preparing a robust impairment test
Top tips for preparing a robust impairment test
This article highlights five common pitfalls we have observed over the last 12 months and crucially, how to avoid them so you can prepare a high quality, robust and reliable impairment test.
1. Identification of cash-generating units (CGUs)
Correct identification: A CGU is the smallest group of assets generating cash inflows independently. Incorrect identification can lead to inaccurate impairment tests through the incorrect inclusion or exclusion of certain cash flows.Factors to consider: Management must ensure the assessment of largely independent cash flows is accurate and that all relevant factors have been considered, for example: geographical independence, operational autonomy, financial segregation, inventory and supply and local market conditions.
2. Allocation of assets and liabilities to CGUs
Accurate allocation: Omitting or incorrectly including assets and liabilities in the CGU can misstate the carrying amount, leading to an incorrect conclusion. Ensure the calculation of the CGU carrying amount is consistent with the determination of the recoverable amount and that all directly attributable assets, goodwill, corporate assets, and liabilities (if appropriate) are included in the CGU's carrying amount. The carrying and recoverable amounts must be prepared on a consistent basis (ie either on an enterprise basis or an equity basis).
3. Selection of comparable companies
Best comparables: Selecting the most appropriate comparable companies is essential for determining the discount rate as the companies chosen will influence key inputs into the calculation of the cost of capital. It is more appropriate to select specific comparable companies over generic sector averages. Focus on selecting the ‘best’ comparable companies as opposed to trying to find exact matches – and ensure you do not cherry-pick.Screening criteria: Consider business description, geography, size, margins, profitability, growth prospects, risk attributes and product mix when screening, and document and justify your selections. Regularly review the comparable companies to ensure that market changes are reflected in your selection.
4. Impact of IFRS 16 Leases
It is important to consider the impact of IFRS 16 leases on the carrying value and calculation of the recoverable amount, even when the audited entity reports under UK GAAP. An IFRS 16 discount rate is typically lower than a non-IFRS 16 discount rate, especially in sectors with a high proportion of leased assets, such as retail. Using an IFRS 16 discount rate on non-IFRS 16 cash flows, and vice versa, can lead to inappropriate conclusions.Correct discount rate: Use an IFRS 16 discount rate where the underlying forecasts are based on IFRS 16 cash flows and adjust for any non-IFRS 16 cash flows to avoid an incorrect assessment of the recoverable amount.
Cash flow impact: Lease expenses are not included in IFRS 16 cash flows for existing leases as these are financing cash flows. However, consideration must be given to cash flows relating to the renewal of leases, particularly into perpetuity, and the cash flows should be adjusted accordingly.
Composition of carrying amount: For entities that report under IFRS, include the carrying amount of the right of use assets as a directly attributable asset or a share of corporate assets.
5. Tax considerations
Consistent discount rates: Apply pre-tax discount rates to pre-tax cash flows and post-tax discount rates to post-tax cash flows to avoid inconsistencies and methodological errors in the calculation of the recoverable amount. Pre-tax discount rate inputs are not observable, so it is common practice to calculate the recoverable amount on a post-tax basis and then use iteration to determine the implied pre-tax discount rate for disclosure purposes.Tax losses: Do not use brought forward tax losses in a value in use calculation of the recoverable amount as this will overstate the recoverable amount. The use of brought forward tax losses is not permitted for the purpose of impairment testing, as the 'value' of them is in the deferred tax asset (IAS 12) and not in the CGU itself.
Additional reminders
- Cash flows: The risk of variability in cash flows should be reflected either in the cash flows themselves or in the discount rate. It is important not to count the same risks twice. Best practice is to risk adjust the cash flows as much as possible. Remember, the terminal value reflects the cash flows into perpetuity so should reflect a ‘steady state’.
- Documentation: Ensure all assumptions are well documented and consistently applied.
- Compliance: Confirm compliance with the latest regulatory and reporting standards. Ensure cash flows included in the value in use are allowed under IAS 36.
- Board approval: Ensure cash flows reflect board-approved budgets.
- Impairment: The recoverable amount is higher of value in use or fair value less costs to disposal. Consider both for determining the recoverable amount when concluding on the appropriate quantum of an impairment.
If you feel you need extra support to prepare the impairment test, or any part thereof, we recommend consulting an experienced valuation expert to ensure the test is prepared accurately and meets the required standards.
For more information please contact Charlotte Okninski or Viral Desai.