Continuing on from last month’s article on common errors in accounting for impairment we continue to highlight instances where, despite the accounting standards being very clear on a particular accounting treatment, Tier 1 and Tier 2 preparers regularly ignore the clear instructions in the standard, resulting in their financial statements being potentially materially misstated.
While estimating an asset’s recoverable amount requires a great degree of judgement and estimation, in a number of cases there are a set of very clear rules, which are commonly overlooked. These include:
- Not testing for impairment when the standard clearly requires it
- Not testing for impairment at the correct ‘unit of account’
- Not including the correct assets in the impairment test
- Basic errors in determining recoverable amount Basic errors in determining ‘value in use’
- Basic errors in determining ‘fair value less cost of disposal’.
In last month’s article, we dealt with errors preparers make by not performing an impairment test when NZ IAS 36 Impairment of Assets clearly requires impairment testing to be performed.
While many preparers of financial statements consider the determination of an asset’s ‘value in use’ (VIU) to involve a great deal of professional judgement, they would be wrong to believe that very basic errors cannot be made, i.e. where VIU is not determined using the very clear requirements of NZ IAS 36 Impairment of Assets.
Unfortunately, there are just too many errors dealing with VIU calculations to deal with in one article. This month, we deal with ‘Part A’, and include discussion on the following areas where VIU errors may occur:
- Not addressing the risks associated with cash flows – quantum and timing
- Which method is being used to address the risk of variations with cash flows?
- Basis for estimates of future cash flows
- Are your cash flow projections consistent with past actual outcomes?
- Use of cash flow projections for periods longer than five years
- Including cash flows from post Year 5 to the end of the asset’s useful life
- Projections of cash inflows from the continuing use of the asset – inflation
- Cash flow projections must include outflows of servicing the asset and future overheads that can be allocated on a reasonable and consistent basis.
Not addressing risks associated with cash flows – quantum and timing
NZ IAS 36, paragraph 31 clearly sets out the two steps involved in determining VIU:
This article does not consider complex areas of budgeting cash flows. Rather, it looks at the clear requirements of the standard that should be followed.
NZ IAS 36, paragraph 30 acknowledges that there are uncertainties associated with the possible variations in the amount and timing of forecasted cash flows. Specifically the requirement in ‘(b) expectations about possible variations in the amount or timing of those future cash flows’ to be included in the VIU model in turn leads to the need for the VIU calculation to also include ‘(d) the price for bearing the uncertainty inherent in the asset’.
NZ IAS 36, paragraph 32 goes onto say that the potential variances in expected cash flows (both amount and timing) can be reflected either as adjustments to the future cash flows, or as adjustments to the discount rate.
A fundamental error is not to address the risk associated with forecast net cash flows, both in terms of the quantum of these cash flows, and the timing of these cash flows.
Entity A has the following cash flow predictions:
Entity A determines that its pre-tax discount rate based on weighted average cost of capital (WACC) is 7%, and for the purpose of the VIU calculation, it will use the most likely cash forecast of $6,000,000.
Error: Entity A has not applied a weighted average adjustment to its cash flow predictions.
If Entity A intends to use a discount rate of 7% it should use the weighted average cash flow forecast of $5,600,000, or it should adjust the discount rate to reflect the risk of the $6,000,000 forecast cash flow not being achieved.
Entity A prepares a five year cash flow forecast and determines the weighted average forecast cash flow to be $5,600,000. It predicts that the potential pattern of cash inflows will be as follows:
Entity A determines that its pre-tax discount rate based on weighted average cost of capital (WACC) is 7% and intends to use a discount rate of 7% on the most likely forecast timing prediction.
Even though Entity A is using the weighted average cash flow forecast, it cannot simply use the 7% discount rate unless it makes an adjustment for the risk associated with the timing of the forecast cash flows.
Which method is being used to address the risk of variations with cash flow?
The elements identified in paragraph 30(b), (d) and (e) can be reflected either as adjustments to the future cash flows or as adjustments to the discount rate. Whichever approach an entity adopts to reflect expectations about possible variations in the amount or timing of future cash flows, the result shall be to reflect the expected present value of the future cash flows, i.e. the weighted average of all possible outcomes. Appendix A provides additional guidance on the use of present value techniques in measuring an asset’s value in use.
NZ IAS 36, paragraph 32
NZ IAS 36, paragraph 32 refers preparers to APPENDIX A of the standard for guidance on how to reflect the potential variances in amounts and timing of forecasted cash flows, and the price associated with this risk.
Appendix A sets out two models that can be used:
- Traditional approach or
- Expected cash flow approach.
Under the ‘traditional’ approach, adjustments for NZ IAS 36, paragraph 30 factors, ‘(b) expectations about possible variations in the amount or timing of those cash flows’, ‘(d) the price for bearing the uncertainty inherent in the asset’ and ‘(e) other, sometimes unidentifiable, factors (such as illiquidity) that market participants would reflect in pricing the future cash flows the entity expects to derive from the asset’, are embedded in the discount rate.
Under the ‘expected cash flow’ approach, these factors result in adjustments in arriving at risk-adjusted expected cash flows.
Error 2 – Traditional approach
If using the ‘traditional’ approach to determine VIU (cash flows have not had a weighted average probability applied to them, both in respect of amount and timing), the discount rate has not been appropriately adjusted for the price of the risk of uncertainties around the amount and timing of cash flows.
Error 3 – Expected value approach
If using the ‘expected value’ approach to determine VIU (discount rate does not reflect the uncertainties around the amount and timing of cash flow), an appropriate weighted probability factor has not been applied to forecast cash flows.
Basis for estimates of future cash flows
Although forecasting cash flows is very much an area of professional judgement, NZ IAS 36, paragraph 33 sets out very clear requirements in respect of estimating future cash flows that can lead to some mistakes, namely:
- Cash flow projections must be based on reasonable and supportable assumptions
- Cash flow projections must be based on the most recent financial budgets/forecasts
- Projections shall cover a maximum period of five years
- Projections beyond five years shall apply a steady or declining growth rate for subsequent years.
In measuring value in use an entity shall:
- 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. Greater weight shall be given to external evidence.
- base cash flow projections on the most recent financial budgets/ forecasts approved by management, but shall exclude any estimated future cash inflows or outflows expected to arise from future restructurings or from improving or enhancing the asset’s performance. Projections based on these budgets/forecasts shall cover a maximum period of five years, unless a longer period can be justified.
- estimate cash flow projections beyond the period covered by the most recent budgets/forecasts by extrapolating the projections based on the budgets/forecasts using a steady or declining growth rate for subsequent years, unless an increasing rate can be justified. This growth rate shall not exceed the long-term average growth rate for the products, industries, or country or countries in which the entity operates, or for the market in which the asset is used, unless a higher rate can be justified.
NZ IAS 36, paragraph 33
Entity B has the following results and forecasts for the performance of its CGU X.
It is very common for entities to use ‘hockey stick’ forecasts, whereby the asset’s performance is always forecast to improve towards the end of the forecast horizon. It is unlikely that these types of forecasts will meet the requirements of paragraph 33 for the forecast to be supportable.
Error 4 – Cash flow forecasts
Cash-flow forecasts are not reasonable or supportable.
Are your cash flow projections consistent with past actual outcomes?
NZ IAS 36, paragraph 34 requires that ‘Management shall ensure that the assumptions on which its current cash flow projections are based are consistent with past actual outcomes…’
Entity C has the following results and forecasts for the performance of its CGU X.
The above table demonstrates that Entity C has a history of being overoptimistic when determining its VIU, with the forecast constantly being pushed out to future years, despite actual results showing poorer results than original forecasts. Again, it is unlikely that Company C will be able to meet the requirements of paragraph 33 for the forecast to be supportable.
Errors 5 – Cash flow forecasts
Assumptions on which its current cash flow projections are based are not consistent with past actual outcomes
Use of cash flow projections for periods longer than five years
NZ IAS 36, paragraph 35 clearly expresses concerns over management being able to predict over periods greater than five years. It states:
- Detailed, explicit and reliable financial budgets/forecasts of future cash flows for periods longer than five years are generally not available
- Management should base their estimates of future cash flows on the most recent budgets/forecasts for a maximum of five years
- Forecasts longer than five years can be used if management are both confident that these projections are reliable and can demonstrate its ability, based on past experience, to forecast cash flows accurately over that longer period.
Entity D determines its VIU model using the above seven year forecast. The cash flow forecast shows significant growth in years 6 and 7. This is not in line with the requirements of NZ IAS 36, paragraph 35.
Error 6 – Using cash flows beyond five years
Management uses cash flow projections over a period greater than five years and cannot demonstrate its ability, based on past experience, to forecast cash flows accurately over that longer period.
Including cash flows from post Year 5 to the end of the asset’s useful life
The restrictions on forecasting cash flows beyond Year 5 does not mean that cash flow forecasts cannot include the period post year 5 to the end of an asset’s useful life. For example, if a ship is purchased with an expected commercial life of 15 years, the VIU impairment model would include cash flows from year 6 to 15, however, the revenue generated from the asset in the forecast period would be based on extrapolating forecasts made in the short term, using a steady or declining growth rate.
Entity E operates a facility that is forecast to have a 10 year useful life, supplying electricity to the local grid. The CGU has a carrying value of $6,000,000. Entity E has a risk-adjusted discount rate of 10% and forecast net cash flows are as follows:
Entity E only uses the first five year’s cash flows and determines the VIU to be $3,791,000 and records an impairment loss of $2,209,000 ($6,000,000- 3,791,000).
Entity E is wrong to exclude the forecast cash flows from years 6 to 10, which are based on a steady revenue forecast. The recoverable amount of the asset should be $6,144,570, and no impairment charge should have been recorded.
Error 7 – Not using cash flows beyond five years
Projections wrongly exclude cash flows for the asset after Year 5.
Projections of cash inflows from the continuing use of the asset – inflation
NZ IAS 36, paragraph 40 sets out a number of requirements when determining the projected cash flows.
Inflation assumptions in the discount rate are not consistent with the inflation rate used in the cash flows used in the VIU calculation
Cash flow projections must include outflows of servicing the asset and future overheads that can be allocated on a reasonable and consistent basis
Entity F operates a manufacturing CGU.
Carrying value is $17,000,000, all support functions (sales, marketing, etc.) are performed by head office.
Cost of sales represents all direct factory costs, e.g. material, labour, direct overhead, indirect factory overhead, etc.
The five year budget is as follows:
In determining the CGU’s recoverable amount, Entity F uses the profit forecast from the factory and a discount rate of 10%.
Entity F determines that the recoverable amount is $18,953,930 and there is no impairment charge (carrying value is $17 million).
However, Entity F should have included the cash outflows in respect of the indirect costs associated with running the operation (support costs) as follows:
The above calculation shows that the recoverable amount is actually $13,646,830, and an impairment charge of $3,353,170 should have been recognised ($17,000,000- $13,646,830).
Error 9 – Omitting cash outflows for overheads that can be allocated on a reasonable and consistent basis
Cash outflows exclude cash outflows from future overheads that can be allocated on a reasonable and consistent basis, e.g. head office and other support function overheads that are necessary to service the asset.
Entity G operates a manufacturing CGU.
Carrying value is $13,000,000. Entity G bases its VIU calculation on its EBITDA forecast using a 10% discount rate.
Based on the above calculation, Entity G determines the recoverable amount of the CGU to be $13,646,830 and that no impairment charge should be recognised (carrying value is $13 million).
Entity G has an accounting policy of capitalising all capital expenditure on items over $10,000, including tooling, etc. Some of these capital items are depreciated (and replaced) over two years.
Cash outflows associated with these short-lived capital items is forecast as follows:
The correct VIU calculation should be:
Error 10 – Omitting cash outflows for servicing the asset
Cash outflows exclude the cash outflows from day-to-day servicing of the asset because EBITDA forecasts are used for the basis of a VIU cash flow forecasts. In these situations, relatively short-lived fixed assets can be erroneously excluded from the effective maintenance cash outflows because their cost (as depreciation/amortisation) is excluded from cash outflow projections.
The recoverable amount, correctly including the cost of short-lived assets, is $12,113,800, Entity G should therefore have recognised an impairment charge of $886,200 ($13,000,000-12,113,800).
Next month we will discuss more errors when determining value in use (Part 2B).
For more on the above, please contact your local BDO representative.