Common Errors in Accounting for Impairment – Part 2C: Errors in determining discount rate

Article:

Common Errors in Accounting for Impairment – Part 2C: Errors in determining discount rate

26 October 2021

The essence of this “common errors” series is to highlight instances where, despite the accounting standards being very clear on a particular accounting treatment, preparers regularly ignore the clear requirements, resulting in financial statements being potentially materially misstated.

In previous articles we have looked at the following “common errors” relating to impairment testing:

Not testing for impairment when NZ IAS 36 Impairment of Assets clearly requires it – Part 1
Basic errors in determining value in use – cash flows - Part 2a and Part 2b.

In this article we look at common errors when determining the discount rate to be used in a value in use (VIU) model.

Basic requirements

NZ IAS 36, paragraphs 55 and 56 summarise the requirements for the discount rate to be used when calculating value in use of an asset or cash-generating unit (CGU).

Some errors relating to the discount rate include:

Using a group weighted average cost of capital (WACC) to test a single asset or CGU
Double counting adjustments for variability in future cash flows
Applying bias (optimism) to discount rates
Using an unadjusted incremental borrowing rate as the discount rate
Not adjusting WACC for security over assets that are not being evaluated for impairment, or the impact of other revenue streams of the entity
Not using a pre-tax discount rate
Incorrectly calculating a pre-tax discount rate

Using a group WACC to test a single asset or CGU

The first type of common error you could make when determining the discount rate of a specific asset or CGU is using your unadjusted weighted average cost of capital (WACC) when your group has multiple assets and projects.

Although NZ IAS 36 does refer to WACC, this can only be used for a single asset company because NZ IAS 36 requires that the discount rate must reflect the risks specific to the asset.

Example

Entity A has three business lines:

Business line X is a steady annuity business that Entity A is a market leader in this area
Business line Y is a profitable business line three years into its estimated product lifecycle of ten years
Business line Z is in the start-up phase and represents the use of innovative and unproven technology to enter a new market sector.

It would be inappropriate to use Entity A’s WACC as the discount rate to test Business Z for impairment.

Double counting adjustments for variability in future cash flows

In Part 2a we discussed the two available methods used to address the risk of variations with cash flows, i.e. either:

Adjust the cash flows to reflect the uncertainty and ranges of cash flows, or
Use a discount rate that incorporates the risk of uncertainty.

A common error is to incorporate uncertainty into both the cash flow forecasts and adjust the discount rate for this uncertainty.

Applying bias (optimism) to discount rates

Appendix A expressly states that discount rates are to be free from bias.

Example

Entity B has a pre-tax WACC of 10%.

It has three business units, two profitable and in well-established sectors (X&Y), and a third business sector (Z) that is only marginally profitable, in a highly competitive market and in a sector that is experiencing declining demand.

It would be wrong to apply a 10% discount rate to business line Z.

Using an unadjusted incremental borrowing rate as the discount rate

In many cases, an entity’s borrowing rate will be reduced, either because the lender has security over assets that are not being evaluated for impairment, or because of the impact of other revenue streams of the entity. Unless an entity is a single asset entity, it is unlikely the incremental borrowing rate reflects an asset specific discount rate.

Not adjusting WACC for security over assets that are not being evaluated for impairment, or the impact of other revenue streams of the entity

Entity C has two operating businesses - one is to operate as an investment property business, renting out commercial buildings, and the other is a retail operation in the garden centre sector.

Entity C’s borrowings are fully secured against all of its properties and it therefore has a reduced cost of borrowings because of the security given to the lender.

It would be wrong to apply an unadjusted WACC to the garden centre business because of the impact on the borrowing rate of the security given on the investment properties.

Not using a pre-tax discount rate

Example

Entity D is a single asset business and has a WACC of 10%. Entity D uses 10% as the discount rate in the VIU model.

This is not in line with the requirements of NZ IAS 36 to use a pre-tax discount rate because WACC is a post-tax discount rate.

Incorrectly calculating a pre-tax discount rate

Example

Entity E is a single asset business and has a WACC of 10%.

Entity E calculates the pre-tax discount rate (assuming a corporate tax rate of 30%) to be 14.28% (10%/0.7) as the discount rate in the VIU model.

Unfortunately, calculating a pre-tax discount rate is not as simple as grossing up the post-tax discount rate. If a post-tax borrowing rate or WACC is used as a starting point for determining a pre-tax discount rate, a two-step process needs to be adopted, i.e.:

Determine the post-tax cash flows by modelling out the quantum and timing of tax payments to arrive at post-tax cash flows, which can then be discounted using the WACC (post-tax discount rate) to arrive at ‘recoverable amount’, and then
Use the ‘recoverable amount’ and pre-tax cash flows to determine the internal rate of return/pre-tax discount rate.

Next month

In next month’s article we look at common errors made when determining ‘fair value less costs of disposal’.

For more on the above, please contact your local BDO representative

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