2.1.1 Market capitalisation

If market capitalisation is lower than the carrying value of equity, this is a powerful indicator of impairment as it suggests that the market considers that the business value is less than the carrying value. However, the market may have taken account of factors other than the return that the entity is generating on its assets. For example, an individual entity may have a high level of debt that it is unable to service fully. A market capitalisation below equity will not necessarily be reflected in an equivalent impairment loss. An entity's response to this indicator depends very much on facts and circumstances. Most entities cannot avoid examining their CGUs in these circumstances unless there was sufficient headroom in a previous impairment calculation that would not have been eroded by subsequent events or none of the assets or CGUs is sensitive to market capitalisation as an indicator. If a formal impairment review is required when the market capitalisation is below equity, great care must be taken to ensure that the discount rate used to calculate VIU is consistent with current market assessments. IAS 36 does not require a formal reconciliation between market capitalisation of the entity, FVLCD and VIU. However, entities need to be able to understand the reason for the shortfall and consider whether they have made sufficient disclosures describing those factors that could result in an impairment in the next periods. [IAS 36.134(f)].

2.1.2 (Future) performance

Another significant element is an explicit reference in (b), (c) and (d) above to internal evidence that future performance will be worse than expected. Thus IAS 36 requires an impairment review to be undertaken if performance is or will be significantly below that previously budgeted. In particular, there may be indicators of impairment even if the asset is profitable in the current period if budgeted results for the future indicate that there will be losses or net cash outflows when these are aggregated with the current period results.

2.1.3 Individual assets or part of CGU?

Some of the indicators are aimed at individual fixed assets rather than the CGU of which they are a part, for example a decline in the value of an asset or evidence that it is obsolete or damaged. Such indicators may also imply that a wider review of the business or CGU is required. However, this is not always the case. For example, if there is a slump in property prices and the market value of the entity's new head office falls below its carrying value this would constitute an indicator of impairment and trigger a review. At the level of the individual asset, as FVLCD is below carrying amount, this might indicate that a write-down is necessary. However, the building's recoverable amount may have to be considered in the context of a CGU of which it is a part. This is an example of a situation where it may not be necessary to re-estimate an asset's recoverable amount because it may be obvious that the CGU has suffered no impairment. In short, it may be irrelevant to the recoverable amount of the CGU that it contains a head office whose market value has fallen.

2.1.4 Interest rates

Including interest rates as indicators of impairment could imply that assets are judged to be impaired if they are no longer expected to earn a market rate of return, even though they may generate the same cash flows as before. However, it may well be that an upward movement in general interest rates will not give rise to a write-down in assets because they may not affect the rate of return expected from the asset or CGU itself. The standard indicates that this may be an example where the asset's recoverable amount is not sensitive to a particular indicator.

The discount rate used in a VIU calculation should be based on the rate specific for the asset. An entity is not required to make a formal estimate of an asset's recoverable amount if the discount rate used in calculating the asset's VIU is unlikely to be affected by the increase in market rates. For example the recoverable amount for an asset that has a long remaining useful life may not be materially affected by increases in short-term rates. Further an entity is not required to make a formal estimate of an asset's recoverable amount if previous sensitivity analyses of the recoverable amount showed that it is unlikely that there will be a material decrease in the recoverable amount because future cash flows are also likely to increase to compensate for the increase in market rates. Consequently, the potential decrease in the recoverable amount may simply be unlikely to result in a material impairment loss. [IAS 36.16].

Events in the financial crisis of 2008/2009 demonstrated that this may also be true for a decline in market interest rates. A substantial decline in short-term market interest rates did not lead to an equivalent decline in the (long term) market rates specific to assets.

3.1.1 Intangible assets as corporate assets

As discussed in 3.1 above, many intangible assets do not generate independent cash inflows as individual assets and should therefore be tested for impairment with other assets of the CGU of which they are part. However, one question an entity would need to assess beforehand, is whether the intangible assets in question meet the corporate assets definition ‘…assets other than goodwill that contribute to the future cash flows of both the cash-generating unit under review and other cash-generating units’ or whether the intangible assets should be considered in determining cash-generating units? The judgement made in this respect can have a significant impact on the level at which cash-generating units are identified and therefore at which level assets are assessed for impairment. A careful consideration of all facts and circumstances is required to avoid carrying out impairment tests at a level that is too high with the result of masking potential impairments.

Assume a scenario where entity A acquires entity B. Entity B operates in a different industry to A. The reason for the acquisition was diversification with no expected cross synergies between A's and B's operations. Entity B sells product X under a European wide well-known brand and operates across Europe. Each country has its own manufacturing site from which mainly small local companies in the same country are served. Before the acquisition, entity B concluded that every manufacturing site in each country is a separate CGU. On acquisition of entity B an intangible asset for the brand is recorded in entity's A group financial statements. No goodwill was recorded. At which level should entity A set the cash-generating units for the acquired business? In our view in this specific example, the single brand would not result in a determination that the cash-generating unit(s) of entity B's business are at the overall level of B. There are individual production sites in each European country from which customers in the same country are served and there is no cross selling of products to customers in other European countries, therefore independent cash inflows can be identified on a country level resulting in the identification of cash-generating units on a country level. The treatment of the brand would follow the guidance as set out in 4.2 below for corporate assets, either because the brand is considered to be a corporate asset or by analogy.

On the other hand, if in the example above B was a professional services company operating European wide and entity B's brand identifies entity B as one integrated pan-European service provider and markets itself to customers as such, the determination of cash-generating unit(s) of entity B's business at an overall level of B including the brand may be appropriate, particularly where a majority of the customers have a presence in multiple European countries and are looking for one supplier that can serve each local presence.

As explained above, the identification of CGUs involves judgement and a careful consideration of all facts and circumstances is required.

4.1.1 Environmental provisions and similar provisions and liabilities

Paragraph 78 of IAS 36 illustrates liabilities that should be deducted from the carrying amount of the assets of a CGU because a buyer would assume the liability using an example of a mine in a country in which there is a legal obligation to restore the site by replacing the overburden. The restoration provision, which is the present value of the restoration costs, has been provided for and deducted from the carrying value of the assets of the CGU. It will be taken into account in the estimation of FVLCD but must also be deducted in arriving at VIU so that both methods of estimating recoverable amount are calculated on a comparable basis that aligns with the carrying amount of the CGU.

There are other provisions for liabilities that would be taken over by the purchaser of a CGU, e.g. property dilapidations or similar contractual restoration provisions. The provision will be accrued as the ‘damage’ is incurred and hence expensed over time rather than capitalised. If the provision is deducted from the assets of the CGU then it must also be deducted in arriving at VIU and it has to be taken into account in the estimation of FVLCD.

Indeed, many provisions made in accordance with IAS 37 – Provisions, Contingent Liabilities and Contingent Assets – may be reflected in the CGU's carrying amount as long as they will be treated appropriately in arriving at the recoverable amount of the CGU.

Including the cash outflows that will be paid to settle the contractual obligation in the VIU discounted cash flow calculation bears the danger of distortion as the cash flows for impairment purposes will be discounted using a different rate to the rate used to calculate the provision itself. The carrying amount of this class of liability will reflect a discount rate suitable for provisions, based on the time value of money and the risks relating to the provisions. This is likely to be considerably lower than a suitable discount rate for an asset and the distortion caused by this would have to be considered and adjusted if the effect is significant. A simple illustration is that the present value of a cash outflow of €100 in 10 years’ time is €39 discounted at 10% but €68 if a discount rate of 4% is used. Deducting the respective cash flows discounted at the asset discount rate could result in an overstatement of the CGU's recoverable amount.

Therefore, to avoid the danger of distortion and to allow for a meaningful comparison between the carrying amount of the CGU and the recoverable amount, IAS 36 requires the carrying amount of the provision to be deducted in determining both the CGU's carrying amount and its VIU. [IAS 36.78].

In 2015 the Interpretations Committee received a request to clarify the application of paragraph 78 of IAS 36. The submitter observed that the approach of deducting the liability from both the VIU and the CGU's carrying amount would produce a null result and therefore asked whether this was really the intention or whether an alternative approach was required.

In its November 2015 meeting the Interpretations Committee observed that when the CGU's fair value less costs of disposal (FVLCD) considers a recognised liability then paragraph 78 of IAS 36 requires both the CGU's carrying amount and its VIU to be adjusted by the carrying amount of the liability. In the Interpretations Committee's view this approach provides a straightforward and cost-effective method to perform a meaningful comparison of the recoverable amount and the carrying amount of the CGU. Moreover, it observed that this approach is consistent with the requirement in IAS 36 to reflect the risks specific to the asset in the present value measurement of the assets in the CGU and the requirements in IAS 37 to reflect the risk specific to the liability in the present value calculation of the liability.

The Interpretations Committee therefore decided that neither an interpretation nor an amendment to a Standard was necessary and did not add this issue to its agenda.

As mentioned at 4.1 above from a practical point of view an entity could calculate the VIU of a CGU without deducting the liability cash outflow and compare that to the CGU excluding the liability. As long as the calculated VIU is above the CGU's carrying amount no impairment would be required and the lack of comparability to the FVLCD would not cause an issue.

4.1.2 Lease liabilities under IFRS 16

A CGU may include a right-of-use asset recorded under IFRS 16. Right-of-use assets are assessed for impairment by applying IAS 36.

When it comes to lease arrangements, in most cases a CGU would be disposed of together with the associated lease arrangements. FVLCD for the CGU would consider the associated lease arrangements and therefore the need to make the contractual lease payments. This would require deducting the carrying amount of the lease liabilities when determining the carrying amount of the CGU.

It is important to note that lease payments reflected in the lease liability recorded in the statement of financial position will have to be excluded from the VIU calculation. If the carrying amount of the lease liabilities is deducted to arrive at the carrying amount of the CGU, the same carrying amount of the lease liabilities would need to be deducted from the VIU. IAS 36 does not allow the calculation of the VIU on a net basis directly, through reducing the future cash flows by the lease payments as this bears the risk of distortion that will arise due to the difference in the discount rate used for the VIU calculation and the discount rate used to calculate the carrying amount of the lease liability. [IAS 36.78]. Please see 7.1.8 for further discussion around VIU and lease payments.

4.1.3 Trade debtors and creditors

Whether an entity includes or excludes trade debtors and creditors in the assets of the CGU, it must avoid double counting the cash flows that will repay the receivable or pay those liabilities. This may be tricky because cash flows do not normally distinguish between cash flows that relate to working capital and other items. A practical solution often applied is to include working capital items in the carrying amount of the CGU and include the effect of changes in the working capital balances in the cash flow forecast.

The following simplified example is based on a finite life CGU and illustrates the effects of including and excluding initial working capital items.

In some industries it is common for companies to operate on a negative working capital basis. Negative working capital provides a cash flow benefit in earlier years that reverses in later years, and at the latest at the end of its life for a limited life CGU. This increases the value of the CGU in question. For a CGU for which the value in use calculation includes a terminal value, effectively assuming a perpetual life, careful consideration is required in determining the extent to which negative working capital balances are expected to continue into perpetuity and in determining a sustainable level of negative working capital balances to avoid overstating the value in use for the CGU in question.

4.1.4 Pensions

As mentioned at 4 above, recognised liabilities are in general not included in arriving at the recoverable amount or carrying amount of a CGU.

Paragraph 79 of IAS 36 mentions pension obligations as items that might for practical reasons be included in calculating the recoverable amount of a CGU. In such a case, the carrying amount of the CGU is decreased by the carrying amount of those liabilities. [IAS 36.79].

In practice, including cash flows for a pension obligation in the recoverable amount could be fraught with difficulty, especially if it is a defined benefit scheme, as there can be so many differences between the measurement basis of the pension liability and the cash flows that relate to pensions. Deducting the carrying amount of the pension obligation from both the value in use and the carrying amount of the CGU avoids this issue. If the pension liability is excluded from the carrying amount of the CGU, then any cash flows in relation to it should not be considered in the value in use calculation and the pension liability should not be deducted from the VIU.

Cash flows in relation to future services on the other hand, whether for defined contribution or defined benefit arrangements, should always be included in calculating the recoverable amount as these are part of the CGU's ongoing employee costs. In practice, it can be difficult to distinguish between cash flows reflecting repayment of the pension liability and cash flows that are future employee costs of the CGU.

4.1.5 Cash flow hedges

In the case of a cash flow hedge in relation to highly probable forecasted transactions, it often makes no significant difference for short term hedging arrangements if the hedging asset or liability and the hedging cash flows are included in the calculation of recoverable amount. The result is to gross up or net down the assets of the CGU and the relevant cash flows by an equivalent amount, after taking account of the distorting effects of differing discount rates. However, some entities argue that they ought to be able to take into account cash flows from instruments hedging their sales or purchases that are designated as cash flow hedges under IFRS 9 because not to do so misrepresents their economic position. In order to do this, they may wish to include the cash flows and either exclude the derivative asset or liability from the CGU or, alternatively, include the derivative asset or liability and reflect the related cash flow hedge reserve in the CGU as well (this latter treatment would not be a perfect offset to the extent of ineffectiveness). They argue that the cash flow hedges protect the fair value of assets through their effect on price risk. They also note that not taking cash flows from instruments hedging their sales or purchases introduces a profit or loss mismatch by comparison with instruments that meet the ‘normal purchase/normal sale’ exemption under which the derivative remains off balance sheet until exercised.

Although logical from an income perspective, IAS 36 does not support these arguments. The derivative asset or liability can only be included in the CGU as a practical expediency and the hedge reserve is neither an asset nor liability to be reflected in the CGU. As the carrying amount of the hedge instrument is a net present value, any impairment loss might be similar to that calculated by excluding the derivative financial instrument and its cash flows. However, there may be a difference between the two due to different discount rates being applied in the determination of the derivative's fair value and the determination of the VIU. IFRS 9 would not permit an entity to mitigate the effects of impairment by recycling the appropriate amount from the hedging reserve. Finally, entities must be aware that cash flow hedges may have negative values as well as positive ones.

4.2.1 Leased corporate assets

Companies frequently enter into lease arrangements on a corporate level, such as a leased corporate headquarters or leased IT equipment. Under IFRS 16 these lease arrangements will result in the recognition of right-of-use assets. Similar to other corporate assets, the right-of-use assets carrying values have to be tested for impairment along with the CGUs they serve. An entity will frequently need to allocate the carrying amount of corporate right-of-use assets to (groups of) CGUs when performing the impairment test. As discussed under 4.2 above, some entities include a charge for the use of corporate assets rather than allocating the assets to CGUs and CGU groups. This is an acceptable approximation as long as entities ensure that the allocation is reasonable and that the total charge has the same NPV as the carrying amount of those assets and there is no impairment. Otherwise, there could be double counting or the omission of assets or cash outflows from CGUs or the misallocation of impairment to the assets of the CGU.

6.1.1 FVLCD and the unit of account

In determining FVLCD it is critical to determine the relevant unit of account appropriately.

IFRS 13 does specify the unit of account to be used when measuring fair value in relation to a reporting entity that holds a position in a single asset or liability that is traded in an active market (including a position comprising a large number of identical assets or liabilities, such as a holding of financial instruments). In this situation, IFRS 13 requires an entity to measure the asset or liability based on the product of the quoted price for the individual asset or liability and the quantity held (P×Q).

This requirement is generally accepted when the asset or liability being measured is a financial instrument in the scope of IFRS 9. However, when an entity holds an investment in a listed subsidiary, joint venture or associate, some believe the unit of account is the entire holding and the fair value should include an adjustment (e.g. a control premium) to reflect the value of the investor's control, joint control or significant influence over their investment as a whole.

Questions have also arisen as to how this requirement applies to cash-generating units that are equivalent to listed investments. Some argue that, because IAS 36 requires certain assets and liabilities to be excluded from a CGU, the unit of account is not identical to a listed subsidiary, joint venture or associate and an entity can include adjustments that are consistent with the CGU as a whole. Some similarly argue that approach is appropriate because, in group financial statements, an entity is accounting for the assets and liabilities of consolidated entities, rather than the investment. However, others argue that if the CGU is effectively the same as an entity's investment in a listed subsidiary, joint venture or associate, the requirement to use P×Q should apply.

IFRS 13 requires entities to select inputs that are consistent with the characteristics of the asset or liability being measured and would be considered by market participants when pricing the asset or liability. Apart from block discounts (which are specifically prohibited), determining whether a premium or discount applies to a particular fair value measurement requires judgement and depends on specific facts and circumstances.

The standard indicates that premiums or discounts should not be incorporated into fair value measurements unless all of the following conditions are met:

• the application of the premium or discount reflects the characteristics of the asset or liability being measured;
• market participants, acting in their economic best interest, would consider these premiums or discounts when pricing the asset or liability; and
• the inclusion of the premium or discount is not inconsistent with the unit of account in the IFRS that requires (or permits) the fair value measurement.

Therefore, when an entity holds an investment in a listed subsidiary, joint venture or associate and if the unit of account is deemed to be the entire holding, it seems to be appropriate to include, for example, a control premium when determining fair value, provided that market participants would take this into consideration when pricing the asset. If, however, the unit of account is deemed to be the individual share of the listed subsidiary, joint venture or associate, the requirement to use P×Q (without adjustment) to measure the fair value would override the requirements in IFRS 13 that permit premiums or discounts to be included in certain circumstances. In September 2014, in response to these questions regarding the unit of account for an investment in a listed subsidiary, joint venture or associate, the IASB proposed amendments to clarify that:

• The unit of account for investments in subsidiaries, joint ventures and associates be the investment as a whole and not the individual financial instruments that constitute the investment.
• For investments that are comprised of financial instruments for which a quoted price in an active market is available, the requirement to use P×Q would take precedence, irrespective of the unit of account. Therefore, for all such investments, the fair value measurement would be the product of P×Q, even when the reporting entity has an interest that gives it control, joint control or significant influence over the investee.
• When testing CGUs for impairment, if those CGUs correspond to an entity whose financial instruments are quoted in an active market, the fair value measurement would be the product of P×Q.

The comment period for this exposure draft ended on 16 January 2015 and the Board began redeliberations in March 2015. During redeliberations, additional research was undertaken on fair value measurements of investments in subsidiaries, associates and joint ventures that are quoted in an active market and on the measurement of the recoverable amount of cash-generating units on the basis of fair value less costs of disposal when the cash-generating unit is an entity that is quoted in an active market.

Following the redeliberations, in its January 2016 meeting, the IASB concluded that the research would be fed into the Post-implementation Review (PIR) of IFRS 13. As part of its PIR of IFRS 13, the IASB issued a Request for Information (RFI) and specifically asked about prioritising Level 1 inputs in relation to the unit of account. The feedback was discussed at the IASB's March 2018 meeting. In respect of the valuation of quoted subsidiaries, associates and joint ventures, the PIR found that there were continued differences in views between users and preparers over whether to prioritise Level 1 inputs or the unit of account. The issue is not pervasive in practice according to the PIR findings. However, respondents noted it can have a material effect when it does occur. Some stakeholders said that there are material differences between measuring an investment using the P×Q and a valuation using a method such as discounted cash flows. Respondents indicated the reasons for such differences include that share prices do not reflect market liquidity for the shares or that they do not reflect the value of control and/or synergies. A few respondents also noted that markets may lack depth and are, therefore, susceptible to speculative trading, asymmetrical information and other factors.

The IASB has decided not to conduct any follow-up activities as a result of findings from the PIR and stated, as an example, that it will not do any further work on the issue of unit of account versus P×Q because the costs of such work would outweigh the benefits.

The IASB has released its Report and Feedback Statement on the PIR in the last quarter of the 2018 calendar year.

This issue is discussed in more detail in Chapter 14 at 5.1.

6.1.2 Depreciated replacement cost or current replacement cost as FVLCD

Cost approaches, e.g. depreciated replacement cost (DRC) or current replacement cost, are one of the three valuation approaches that IFRS 13 considers to be appropriate for establishing FVLCD. Yet, the Basis for Conclusions of IAS 36 indicates that DRC is not suitable:

‘Some argue that the replacement cost of an asset should be adopted as a ceiling for its recoverable amount. They argue that the value of an asset to the business would not exceed the amount that the enterprise would be willing to pay for the asset at the balance sheet date.

‘IASC believed that replacement cost techniques are not appropriate to measuring the recoverable amount of an asset. This is because replacement cost measures the cost of an asset and not the future economic benefits recoverable from its use and/or disposal.’ [IAS 36.BCZ28-BCZ29].

We do not consider that this means that FVLCD cannot be based on DRC. Rather, this means that DRC can only be used if it meets the objective of IFRS 13 by being a current exit price and not the cost of an asset. If the entity can demonstrate that the price that would be received for the asset is based on the cost to a market participant buyer to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence, then (and only then) is DRC an appropriate basis for FVLCD. See Chapter 14 at 14.3.

7.1.1 Budgets and cash flows

The standard describes in some detail the responsibilities of management towards the estimation of cash flows. Management is required to ensure that the assumptions on which its current cash flow projections are based are consistent with past actual outcomes by examining the causes of differences between past cash flow projections and actual cash flows. If actual cash flows have been consistently below projected cash flows then management has to investigate the reason for it and assess whether the current cash flow projections are realistic or require adjustment. [IAS 36.34].

IAS 36 states that the cash flows should be based on the most recent budgets and forecasts for a maximum of five years because reliable forecasts are rarely available for a longer period. If management is confident that its projections are reliable and can demonstrate this from past experience, it may use a longer period. [IAS 36.35]. In using budgets and forecasts, management is required to consider whether these really are the best estimate of economic conditions that will exist over the remaining useful life of the asset. [IAS 36.38]. It may be appropriate to revise forecasts where the economic environment or conditions have changed since the most recent financial budgets and forecasts were approved by management.

Cash flows for the period beyond that covered by the forecasts or budgets assume a steady, declining or even negative rate of growth. An increase in the rate may be used if it is supported by objective information. [IAS 36.36].

Therefore, only in exceptional circumstances should an increasing growth rate be used, or should the period before a steady or declining growth rate be assumed to extend to more than five years. This five year rule is based on general economic theory that postulates above-average growth rates will only be achievable in the short-term, because such above-average growth will lead to competitors entering the market. This increased competition will, over a period of time, lead to a reduction of the growth rate, towards the average for the economy as a whole. IAS 36 suggests that entities will find it difficult to exceed the average historical growth rate for the products, countries or markets over the long term, say twenty years. [IAS 36.37].

This stage of the impairment review illustrates the point that it is not only fixed assets that are being assessed. The future cash flows to be forecast are all cash flows – receipts from sales, purchases, administrative expenses, etc. It is akin to a free cash flow valuation of a business with the resulting valuation then being compared to the carrying value of the assets in the CGU.

The cash flow forecast should include three elements:

• cash inflows from the continuing use of the asset;
• the cash outflows necessary to generate these cash inflows, including cash outflows to prepare the asset for use, that can either be directly attributed, or allocated on a reasonable and consistent basis; and
• the net cash flows, if any, that the entity may receive or pay for the disposal of the asset at the end of its useful life. [IAS 36.39].

Cash flows can be estimated by taking into account general price changes caused by inflation, or on the basis of stable prices. If inflation is excluded from the cash flow then the discount rate selected must also be adjusted to remove the inflationary effect. [IAS 36.40]. Generally, entities will use whichever method is most convenient to them that is consistent with the method they use in their budgets and forecasts. It is, of course, fundamental that cash flows and discount rate are both estimated on a consistent basis.

To avoid the danger of double counting, the future cash flows exclude those relating to financial assets, including receivables and liabilities such as payables, pensions and provisions. [IAS 36.43]. However, 4 above notes that paragraph 79 allows the inclusion of such assets and liabilities for practical reasons, in which case the cash flows must be reflected as well, and includes a discussion of some of the assets and liabilities that may or may not be reflected together with the implications of so doing. [IAS 36.79].

The expected future cash flows of the CGU being assessed for impairment should not include cash inflows or outflows from financing activities or tax receipts or payments. This is because the discount rate used represents the financing costs and the future cash flows are themselves determined on a pre-tax basis. [IAS 36.50, 51].

7.1.2 Cash inflows and outflows from improvements and enhancements

Whilst a part-completed asset must have the costs to complete it included in the cash flows, [IAS 36.42], the general rule is that future cash flows should be forecast for CGUs or assets in their current condition. Forecasts should not include estimated future cash inflows or outflows that are expected to arise from improving or enhancing the asset's performance. [IAS 36.44]. Projections in the cash flow should include costs of day-to-day servicing that can be reasonably attributed to the use of the asset (for overheads see 7.1.7 below). [IAS 36.41].

While the restriction on enhanced performance may be understandable, it adds an element of unreality that is hard to reconcile with other assumptions made in the VIU process. For example, the underlying forecast cash flows that the standard requires management to use will obviously be based on the business as it is actually expected to develop in the future, growth, improvements and all. Producing a special forecast based on unrealistic assumptions, even for this limited purpose, may be difficult.

Nevertheless, paragraph 48 explicitly states that improvements to the current performance of an asset may not be included in the estimates of future cash flows until the entity incurs the expenditure that provides those improvements. The treatment of such expenditure is illustrated in Example 6 in the standard's accompanying section of illustrative examples. [IAS 36.48]. The implication of this requirement is that if an asset is impaired, and even if the entity is going to make the future expenditure to reverse that impairment, the asset will still have to be written down. Subsequently, the asset's impairment can be reversed, to the degree appropriate, after the expenditure has taken place. Reversal of asset impairment is discussed at 11.4 below.

IAS 36 makes it clear that for a part-completed asset, all expected cash outflows required to make the asset ready for use or sale should be considered in the estimate of future cash flows, and mentions a building under construction or a development project as examples. [IAS 36.42]. The standard is also clear that the estimate of future cash flows should not include the estimated future cash inflows that are expected to arise from the increase in economic benefits associated with cash outflows to improve or enhance an asset's performance until an entity incurs these cash outflows. [IAS 36.48]. This raises the question of what to do once a project to enhance or improve the performance of an asset or a CGU has commenced and it has started to incur cash outflows. In our view, once a project has been committed to and has substantively commenced, an entity should consider future cash inflows that are expected to arise from the increase in economic benefits associated with the cash outflows to improve or enhance the asset. Important to note is that it must take into consideration all future cash outflows required to complete the project and any risks in relation with the project, reflected either in the cash flows or the discount rate.

An assumption of new capital investment is in practice intrinsic to the VIU test. What has to be assessed are the future cash flows of a productive unit such as a factory or hotel. The cash flows, out into the far future, will include the sales of product, cost of sales, administrative expenses, etc. They must necessarily include capital expenditure as well, at least to the extent required to keep the CGU functioning as forecast. This is explicitly acknowledged as follows:

‘Estimates of future cash flows include future cash outflows necessary to maintain the level of economic benefits expected to arise from the asset in its current condition. When a cash-generating unit consists of assets with different estimated 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 unit. Similarly, when a single asset consists of components with different estimated useful lives, the replacement of components with shorter lives is considered to be part of the day-to-day servicing of the asset when estimating the future cash flows generated by the asset.’ [IAS 36.49].

Accordingly, some capital expenditure cash flows must be built into the forecast cash flows. Whilst improving capital expenditure may not be recognised, routine or replacement capital expenditure necessary to maintain the function of the asset or assets in the CGU has to be included. Entities must therefore distinguish between maintenance, replacement and enhancement expenditure. This distinction may not be easy to draw in practice, as shown in the following example.

Further examples indicate another problem area – the effects of future expenditure that the entity has identified but which the entity has not yet incurred. An entity may have acquired an asset with the intention of enhancing it in future and may, therefore, have paid for future synergies which will be reflected in the calculation of goodwill. Another entity may have plans for an asset that involve expenditure that will enhance its future performance and without which the asset may be impaired.

Examples could include:

• a TV transmission company that, in acquiring another, would expect to pay for the future right to migrate customers from analogue to digital services; or
• an aircraft manufacturer that expects to be able to use one of the acquired plants for a new model at a future point, a process that will involve replacing much of the current equipment.

In both cases the long-term plans reflect both the capital spent and the cash flows that will flow from it. There is no obvious alternative to recognising an impairment when calculating the CGU or CGU group's VIU as IAS 36 insists that the impairment test has to be performed for the asset in its current condition. This means that it is not permitted to include the benefit of improving or enhancing the asset's performance in calculating its VIU.

In the TV example above, it does not appear to matter whether the entity recognises goodwill or has a separable intangible right that it has not yet brought into use.

An entity in this situation may attempt to avoid or reduce an impairment write down by calculating the appropriate FVLCD, as this is not constrained by rules regarding future capital expenditure. As discussed above, these cash flows can be included only to the extent that other market participants would consider them when evaluating the asset. It is not permissible to include assumptions about cash flows or benefits from the asset that would not be available to or considered by a typical market participant.

7.1.3 Restructuring

The standard contains similar rules with regard to any future restructuring that may affect the VIU of the asset or CGU. The prohibition on including the results of restructuring applies only to those plans to which the entity is not committed. Again, this is because of the general rule that the cash flows must be based on the asset in its current condition so future events that may change that condition are not to be taken into account. [IAS 36.44, 45]. When an entity becomes committed to a restructuring (as set out in IAS 37 – see Chapter 26), IAS 36 then allows an entity's estimates of future cash inflows and outflows to reflect the cost savings and other benefits from the restructuring, based on the most recent financial budgets/forecasts approved by management. [IAS 36.46, 47]. Treatment of such a future restructuring is illustrated by Example 5 in the standard's accompanying section of illustrative examples. The standard specifically points out that the increase in cash inflows as a result of such a restructuring may not be taken into account until after the entity is committed to the restructuring. [IAS 36.47].

Entities will sometimes be required to recognise impairment losses that will be reversed once the expenditure has been incurred and the restructuring completed.

7.1.4 Terminal values

In the case of non-current assets, a large component of value attributable to an asset or CGU arises from its terminal value, which is the net present value of all of the forecast free cash flows that are expected to be generated by the asset or CGU after the explicit forecast period. IAS 36 includes specific requirements if the asset is to be sold at the end of its useful life. The disposal proceeds and costs should be based on current prices and costs for similar assets, adjusted if necessary for price level changes if the entity has chosen to include this factor in its forecasts and selection of a discount rate. The entity must take care that its estimate is based on a proper assessment of the amount that would be received in an arm's length transaction. [IAS 36.52, 53].

Whether the life of an asset or CGU is considered to be finite or indefinite will have a material impact on the terminal value. It is therefore of the utmost importance for management to assess carefully the cash generating ability of the asset or CGU and whether the period over which this asset or CGU is capable of generating cash flows is defined or not. While many CGUs containing goodwill will have an indefinite life, the same is not necessarily true for CGUs without allocated goodwill. For example, if a CGU has one main operating asset with a finite life, as in the case of a mine, the cash flow period may need to be limited to the life of the mine. Whether it would be reasonable to assume that an entity would replace the principal assets of a CGU and therefore whether it would be appropriate to calculate the terminal value under consideration of cash flows into perpetuity will depend on the specific facts and circumstances.

In the case of assets or CGUs with indefinite useful lives, the terminal value is calculated by having regard to the forecast maintainable cash flows that are expected to be generated by the assets or CGUs in the final year of the explicit forecast period (‘the terminal year’). It is essential that the terminal year cash flows reflect maintainable cash flows as otherwise any material one-off or abnormal cash flows that are forecast for the terminal year will inappropriately increase or decrease the valuation.

The maintainable cash flow expected to be generated by the asset or CGU is then capitalised by a perpetuity factor based on either:

• the discount rate if cash flows are forecast to remain relatively constant; or
• the discount rate less the long term growth rate if cash flows are forecast to grow.

Care is required in assessing the growth rate to ensure consistency between the long term growth rate used and the assumptions used by the entity generally in its business planning. IAS 36 requires an entity to use in the VIU calculation a steady or declining growth rate for subsequent years, unless an increasing rate can be justified. This growth rate must 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. [IAS 36.33].

7.1.5 Foreign currency cash flows

Foreign currency cash flows should first be estimated in the currency in which they will be generated and then discounted using a discount rate appropriate for that currency. An entity should translate the present value calculated in the foreign currency using the spot exchange rate at the date of the value in use calculation. [IAS 36.54]. This is to avoid the problems inherent in using forward exchange rates, which are based on differential interest rates. Using such a rate would result in double-counting the time value of money, first in the discount rate and then in the forward rate. [IAS 36.BCZ49]. However, the method requires an entity to perform, in effect, separate impairment tests for cash flows generated in different currencies but make them consistent with one another so that the combined effect is meaningful. This is an extremely difficult exercise. Many different factors need to be taken into account including relative inflation rates and relative interest rates as well as appropriate discount rates for the currencies in question. Because of this, the possibility for error is great and the greatest danger is understating the present value of cash outflows by using too high a discount rate. In practice, valuers may assist entities to obtain a sufficiently accurate result by assuming that cash flows are generated in a single currency even though they may be received or paid in another. Significantly, the rate used to translate the cash flows could well be different from that used to translate the foreign currency assets, goodwill and liabilities of a subsidiary at the period end. For example, a non-monetary asset such as an item of property, plant and equipment may be carried at an amount based on exchange rates on the date on which it was acquired but generates foreign currency cash flows. In order to determine its recoverable amount if there are indicators of impairment, IAS 21 – The Effects of Changes in Foreign Exchange Rates – states that the recoverable amount will be calculated in accordance with IAS 36 and the present value of the cash flows translated at the exchange rate at the date when that value was determined. [IAS 21.25]. IAS 21 notes that this may be the rate at the reporting date. The VIU is then compared to the carrying value and the item is then carried forward at the lower of these two values.

7.1.6 Internal transfer pricing

If the cash inflows generated by the asset or CGU are based on internal transfer pricing, the best estimate of an external arm's length transaction price should be used in estimating the future cash flows to determine the asset's or CGU's VIU. [IAS 36.70]. Note that this applies to any cash inflow once a CGU has been identified; it is not restricted to CGUs that have been identified because there is an active market for their outputs, which are described at 3.2 above.

In practice, transfer pricing may be based on estimated market values, perhaps with a discount or other adjustment, be a cost-based price or be based on specific negotiation between the group companies. Transfer prices will reflect the taxation consequences to the transferring and acquiring companies and the prices may be agreed with the relevant taxation authorities. This is especially important to multinational companies but may affect transfer prices within a single jurisdiction.

Transfer pricing is extremely widespread. The following example describes a small number of bases for the pricing and the ways in which it might be possible to verify whether they approximate to an arm's length transaction price (and, of course, even where the methodology is appropriate, it is still necessary to ensure that the inputs into the calculation are reasonable). An arm's length price may not be a particular price point but rather a range of prices.

7.1.7 Overheads and share-based payments

When calculating the VIU, entities should include projections of cash outflows that are:

1. necessarily incurred to generate the cash inflow from continuing use of the asset (or CGU); and
2. can be directly attributed, or allocated on a reasonable and consistent basis to the asset (or CGU). [IAS 36.39(b)].

Projections of cash outflows include those for the day-to-day servicing of the asset/CGU as well as future overheads that can be attributed directly, or allocated on a reasonable and consistent basis, to the use of the asset/CGU. [IAS 36.41].

In principle, all overhead costs should be considered and most should be allocated to CGUs when testing for impairment, subject to materiality.

Judgements might however be required to determine how far down to allocate some overhead costs and in determining an appropriate allocation basis, in particular when it comes to stewardship costs and overhead costs incurred at a far higher level in a group to the CGU/asset assessed for impairment. Careful consideration of the entity's specific relevant facts and circumstances and cost structure is needed.

Generally, overhead costs that provide identifiable services to a CGU (e.g. IT costs from a centralised function) as well as those that would be incurred by a CGU if it needed to perform the related tasks when operating on a ‘stand-alone basis’ (e.g. financial reporting function) should be allocated to the CGU being tested for impairment.

Conversely, overhead costs that are incurred with a view to acquire and develop a new business (e.g. costs for corporate development such as M&A activities) would generally not be allocated. These costs are similar in nature to future cash inflows and outflows that are expected to arise from improving or enhancing a CGU's performance which are not considered in the VIU according to paragraph 44 of IAS 36. [IAS 36.44].

The selection of a reasonable and consistent allocation basis of overhead costs will require analysis of various factors including the nature of the CGU itself. A reasonable allocation basis for identifiable services may be readily apparent, for example in some cases volume of transaction processing for IT services or headcount for human resource services may be appropriate. However, a reasonable allocation basis for stewardship costs that are determined to be necessarily incurred by the CGU to generate cash inflows may require more analysis. For example, an allocation basis for stewardship costs such as revenue or headcount may not necessarily be reasonable when CGUs have different regulatory environments, (i.e. more regulated CGUs may require more governance time and effort) or maturity stages (i.e. CGUs in mature industries may require less governance effort). The allocation basis may need to differ by type of cost and in some cases may need to reflect an average metric over a period of time rather than a metric for a single period or may need to reflect future expected, rather than historic, metrics.

Overheads not fully pushed down to the lowest level of CGUs might need to be included in an impairment test at a higher level group of CGUs if it can be demonstrated that the overhead costs are necessarily incurred and can be attributed directly or allocated on a reasonable and consistent basis at that higher level. After a careful analysis, there could be instances when certain overhead costs are excluded from cash flow projections on the basis that they do not meet the criteria under paragraph 39(b) of IAS 36.

Many entities make internal charges, often called ‘management charges’, which purport to transfer overhead charges to other group entities. Care must be taken before using these charges as a surrogate for actual overheads as they are often based on what is permitted, (e.g. by the taxation authorities), rather than actual overhead costs. There is also the danger of double counting if a management charge includes an element for the use of corporate assets that have already been allocated to the CGU being tested, e.g. an internal rent charge.

In certain situations it may be argued that some stewardship costs are already included in the impairment test through the discount rate used. This would among other factors depend on the way the discount rate has been determined, and whether the relevant stewardship cost should be regarded more as a shareholder cost covered in the shareholders’ expected return rather than a cost necessarily incurred by the CGU to generate the relevant cash flows. Due to the complexity of such an approach it would need to be applied with appropriate care.

In many jurisdictions employees’ remuneration packages include share-based payments. Share-based payments may be cash-settled, equity-settled or give the entity or the counterparty the choice of settlement in equity or in cash. In practice, many share-based payment transactions undertaken by entities are awards of equity-settled shares and options. This gives the entity the possibility of rewarding employees without incurring any cash outflows and instead the cash costs are ultimately borne by the shareholders through dilution of their holdings.

When it comes to impairment assessment, a question that often faces entities is whether and how to consider share-based payments in the recoverable amount, in particular the VIU calculation. IAS 36 itself does not provide any specific guidance as to whether or how share-based payments should be considered in determining the recoverable amount.

As IAS 36 focuses on cash flows in determining VIU, it seems that expected cash outflows in relation to cash-settled share-based payments would need to be reflected in the VIU calculation. The future expected cash outflow could, for example, be reflected by the fair value of the award at the balance sheet date, through including the amount of that fair value expected to vest and be paid out in excess of the liability already recognised at that date in the VIU calculation. In such a case the liability already recognised at the date of the VIU determination would not form part of the carrying value of the CGU.

While theoretically this seems to be straight forward, in practice it can be quite a challenging and judgemental task, in particular when the entity consists of a large number of CGUs. Share-based payments are in general awarded by the parent to employees within the group. There may be no correlation between any change in the value of share-based payments after the grant date and the performance of the employing CGU. This may be relevant in assessing whether and how such changes in value and the ultimate expected cash flows are allocated to a specific CGU.

What is even less clear is whether an entity should reflect in the VIU calculation equity-settled share-based payments. Such share-based payment transactions will never result in any cash outflows for the entity, and therefore a literal reading of IAS 36 may indicate that they can be ignored in determining the recoverable amount. However, some might argue an entity should appropriately reflect all share-based payments in the VIU calculation, whether or not these result in a real cash outflow to the entity. Such share-based payments are part of an employee's remuneration package and therefore costs (in line with the treatment under IFRS 2 – Share-based Payment) incurred by the entity for services from the employee are necessary as part of the overall cash flow generating capacity of the entity. Others may argue that they need to be considered through adjusting the discount rate in order to reflect a higher return to equity holders to counter the dilutive effects of equity settled share-based payment awards.

The time span over which the recoverable amount is calculated is often much longer than the time period for which share-based payments have been awarded. Companies and their employees would often expect that further share-based payment awards will be made in the future during the time period used for the recoverable amount calculation. Depending on the respective facts and circumstances an entity would need to consider whether to include the effect of share-based payments over a longer period, considering the discussion above.

7.1.8 Lease payments

7.1.9 Events after the reporting period

Events after the reporting period and information received after the end of the reporting period should be considered in the impairment assessment only if changes in assumptions provide additional evidence of conditions that existed at the end of the reporting period. Judgement of all facts and circumstances is required to make this assessment.

Information available after the year end might provide evidence that conditions were much worse than assumed. Whether an adjustment to the impairment assessment would be required or not would depend on whether the information casts doubts on the assumptions made in the estimated cash flows for the impairment assessment.

Competitive pressures resulting in price reductions after the year end do not generally arise overnight but normally occur over a period of time and may be more a reaction to conditions that already existed at the year-end in which case management would reflect this in the year end impairment assessment.

IAS 10 – Events after the Reporting Period – distinguishes events after the reporting period between adjusting and non-adjusting events (see Chapter 38). IAS 10 mentions abnormally large changes after the reporting period in asset prices or foreign exchange rates as examples of non-adjusting events and therefore these changes would in general not be a reason to update year end impairment calculations. The standard implies that abnormally large changes must be due to an event that occurred after the period end and therefore more or less assumes that the cause of such abnormally large changes are not conditions that already existed at the year-end. However, management would need to carefully assess the reason for the abnormally large change and consider whether it is due to conditions which already existed at the period end.

As stated under 7.1 above, cash flow projections used for the impairment test should be based on recent financial budgets/forecasts approved by management. This begs the question – what an entity should do if a new budget/forecast is approved by management after the reporting period end but before the accounts are authorised for issue? A similar question arises in group scenarios where subsidiaries’ accounts might be authorised for issue a significant time after the group accounts were authorised for issue. In both scenarios the same general considerations as explained above would apply. An entity would need to assess whether the revised budget/forecast is due to conditions that already existed at the reporting period end and therefore would need to be considered in the impairment assessment, or whether the change in budget/forecast is due to circumstances that arose after the end of the reporting period and therefore would only be considered in subsequent impairment tests. In a group scenario, this could lead to a situation where the revised budget/forecast would need to be considered on a subsidiary level when the subsidiaries’ accounts are authorised for issue after the revised budget was approved, despite the fact that the group accounts were already authorised for issue based on the previous budget.

7.1.10 ‘Traditional’ and ‘expected cash flow’ approach to present value

The elements that must be taken into account in calculating VIU are described at 7 above. IAS 36 requires an estimate of the future cash flows the entity expects to derive from the asset and the time value of money, represented by the current market risk-free rate of interest, to be reflected in the VIU calculation. However, the other elements that must be taken into account, all of which measure various aspects of risk, may be dealt with either as adjustments to the discount rate or to the cash flows. These elements are:

• expectations about possible variations in the amount or timing of those future cash flows;
• the price for bearing the uncertainty inherent in the asset; and
• other factors, such as illiquidity that market participants would reflect in pricing the future cash flows the entity expects to derive from the asset. [IAS 36.30].

Adjusting for these factors in the discount rate is termed the ‘traditional approach’ in Appendix A to IAS 36. Alternatively, under the ‘expected cash flow’ approach these adjustments are made in arriving at the risk-adjusted cash flows. Either method may be used to compute the VIU of an asset or CGU. [IAS 36.A2].

The traditional approach uses a single set of estimated cash flows and a single discount rate, often described as ‘the rate commensurate with the risk’. This approach assumes that a single discount rate convention can incorporate all expectations about the future cash flows and the appropriate risk premium and therefore places most emphasis on the selection of the discount rate. [IAS 36.A4].

Due to the problems and difficulties around capturing and reflecting all of the variables into a single discount rate, IAS 36 notes that the expected cash flow approach may be the more effective measurement tool. [IAS 36.A6, A7].

The expected cash flow approach is a probability weighted net present value approach. This approach uses all expectations about possible cash flows instead of a single most likely cash flow and assigns probabilities to each cash flow scenario to arrive at a probability weighted net present value. The use of probabilities is an essential element of the expected cash flow approach. [IAS 36.A10]. The discount rate then considers the risks and variability for which the cash flows have not been adjusted. Appendix A notes some of the downsides of this approach, e.g. that the probabilities are highly subjective and that it might be inappropriate for measuring a single item or one with a limited number of outcomes. Nonetheless, it considers the most valid objection to the method to be the costs of obtaining additional information when weighed against its ‘greater reliability’. [IAS 36.A10‑13].

Whichever method is used, an entity needs to ensure that consistent assumptions are used for the estimation of cash flows and the selection of an appropriate discount rate in order to avoid any double-counting or omissions.

7.2.1 Discount rates and the weighted average cost of capital

The WACC is often used in practice. It is usually acceptable to auditors as it is supported by valuation experts and is an accepted methodology based on a well-known formula and widely available information. In addition, many entities already know their own WACC. However, it can only be used as a starting point for determining an appropriate discount rate and some of the issues that must be taken into account are as follows:

1. a)the WACC is a post-tax rate and IAS 36 requires VIU to be calculated using pre-tax cash flows and a pre-tax rate. In the majority of cases, converting the former into the latter is not simply a question of grossing up the post-tax rate by the effective tax rate;
2. b)an entity's own WACC may not be suitable as a discount rate if there is anything atypical about the entity's capital structure compared with ‘typical’ market participants;
3. c)the WACC must reflect the risks specific to the asset and not the risks relating to the entity as a whole, such as default risk; and
4. d)the entity's WACC is an average rate derived from its existing business, yet entities frequently operate in more than one sector. Within a sector, different types of projects may have different levels of risk (e.g. a start-up as against an established product).
5. These issues are discussed further below.

One of the most difficult areas in practice is the effect of taxation on the WACC. In order to determine an appropriate pre-tax discount rate it is likely to be necessary to adjust the entity's actual tax cash flows.

Ultimately, the appropriate discount rate to select is one that reflects current market assessments of the time value of money and the risks specific to the asset in question, including taxation. Such a rate is one that reflects ‘the return that investors would require if they were to choose an investment that would generate cash flows of amounts, timing and risk profile equivalent to those that the entity expects to derive from the asset’. [IAS 36.56].

7.2.2 Calculating a pre-tax discount rate

VIU is primarily an accounting concept rather than a business valuation of the asset or CGU. One fundamental difference is that IAS 36 requires pre-tax cash flows to be discounted using a pre-tax discount rate. Why not calculate VIU on a post-tax basis? The reason is the complexities created by tax losses carried forward, temporary tax differences and deferred taxes.

The standard explains in the Basis for Conclusions that, future income tax cash flows may affect recoverable amount. It is convenient to analyse future tax cash flows into two components:

1. the future tax cash flows that would result from any difference between the tax base of an asset (the amount attributed to it for tax purposes) and its carrying amount, after recognition of any impairment loss. Such differences are described in IAS 12 as ‘temporary differences’; and
2. the future tax cash flows that would result if the tax base of the asset were equal to its recoverable amount. [IAS 36.BCZ81].

The concept is complex but refers to the following issues.

An impairment test, say at the end of 2016, takes account of estimated future cash flows. The tax that an entity will pay in future years that will be reflected in the actual tax cash flows that it expects may depend on tax depreciation that the entity has already taken (or is yet to take) in respect of the asset or CGU being tested for impairment. The value of the asset to the business on a post-tax basis must take account of all tax effects including those relating to the past and not only those that will only arise in future.

Although these ‘temporary differences’ are accounted for as deferred taxation, IAS 12:

1. does not allow entities to recognise all deferred tax liabilities or deferred tax assets;
2. does not recognise deferred tax assets using the same criteria as deferred tax liabilities; and
3. deferred tax is not recognised on a discounted basis.

Therefore, deferred taxation as provided in the income statement and statement of financial position is not sufficient to take account of the actual temporary differences relating to the asset or CGU.

At the same time, an asset valuation implicitly assumes that the carrying amount of the asset is deductible for tax. For example, if the tax rate is 25%, an entity must receive pre-tax cash flows with a present value of 400 in order to recover a carrying amount of 300. [IAS 36.BCZ88]. In principle, therefore, VIU on a post-tax basis would include the present value of the future tax cash flows that would result if the tax base of the asset were equal to its value in use. Hence, IAS 36 indicates that the appropriate tax base to calculate VIU in a post-tax setting, is the VIU itself. [IAS 36.BCZ84]. Therefore, the calculated VIU should also be used to derive the pre-tax discount rate. It follows from this that the ‘tax cash flows’ to be taken into account will be those reflected in the post-tax VIU, so they will be neither the tax cash flows available in relation to the asset (based on its cost) nor the actual tax cash flows payable by the entity.

For these reasons, the (then) IASC decided to require an enterprise to determine value in use by using pre-tax future cash flows and a pre-tax discount rate.

This means that there is a different problem, calculating an appropriate pre-tax discount rate because there are no observable pre-tax discount rates. Two important points must be taken into account:

• The pre-tax discount rate is not always the post-tax discount rate grossed up by a standard rate of tax. There are some circumstances in which a gross-up will give a reasonable approximation, discussed further at 7.2.4 below.
• The pre-tax discount rate is not the post-tax rate grossed up by the effects of the entity's actual tax cash flows. As discussed above, a post-tax discount rate such as the WACC is based on certain assumptions about the tax-deductibility of the asset and not the actual tax cash flows experienced by the entity.

Recognising this, paragraph BCZ85 of IAS 36 states that ‘in theory, discounting post-tax cash flows at a post-tax discount rate and discounting pre-tax cash flows at a pre-tax discount rate should give the same result, as long as 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’. [IAS 36.BCZ85].

Therefore, the only accurate way to calculate a pre-tax WACC is to calculate the VIU by applying a post-tax rate to post-tax cash flows, tax cash flows being based on the allowances and charges available to the asset and to which the revenue is subject (see discussion at 7.2.3 below). The effective pre-tax rate is calculated by removing the tax cash flows and, by iteration, one can identify the pre-tax rate that makes the present value of the adjusted cash flows equal the VIU calculated using post tax cash flows.

Paragraph BCZ85 includes an example of how to calculate a pre-tax discount rate where the tax cash flows are irregular because of the availability of tax deductions for the asset's capital cost. See also the calculations in Example 20.14 below – (a) illustrates a calculation of a pre-tax discount rate. This is a relatively straightforward calculation for a single asset at the inception of the relevant project.

It may be far more complex at a later date. This is because entities may be attempting to calculate a discount rate starting with post-tax cash flows and a post-tax discount rate at a point in time when there are already temporary differences relating to the asset. A discount rate based on an entity's prospective tax cash flows may under- or overstate IAS 36's impairment charge unless it reflects these previous allowances or disallowances. This is the same problem that will be encountered if an entity attempts to test VIU using post-tax cash flows as described at 7.2.3 below.

A notional adjustment will have to be made if the entity is not paying tax because it is making, or has made, tax losses. It is unwarranted to assume that the post- and pre-tax discount rates will be the same if the entity pays no tax because of its own tax losses as this will be double counting. It is taking advantage of the losses in the cash flows but excluding that value from the assets of the CGU.

Entities may attempt to deal with the complexity of determining a pre-tax rate by trying to calculate VIU on a post-tax basis but this approach means addressing the many difficulties that have been identified by the IASB and the reasons why it mandated a pre-tax approach in testing for impairment in the first place.

Some approximations and short cuts that may give an acceptable answer in practice are dealt with at 7.2.4 below.

7.2.3 Calculating VIU using post-tax cash flows

Because of the challenges in calculating an appropriate pre-tax discount rate and because it aligns more closely with their normal business valuation approach, some entities attempt to perform a VIU calculation based on a post-tax discount rate and post-tax cash flows.

In support of the post-tax approach, the example in paragraph BCZ85 of IAS 36, which explains how to calculate a pre-tax discount rate, is mistakenly understood as a methodology for a post-tax VIU calculation using an entity's actual tax cash flows.

Entities that try a post-tax approach generally use the year-end WACC and estimated post-tax cash flows for future years that reflect the actual tax that they expect to pay in those years. A calculation on this basis will only by chance correspond to an impairment test in accordance with IAS 36 because it is based on inappropriate assumptions, i.e. it does not take account of the temporary differences that affect the entity's future tax charges and will not be based on the assumption that the VIU is tax deductible. Some include in the post-tax calculation the benefit of tax deductions or tax losses by bringing them into the cash flows in the years in which the tax benefit is expected to be received. In these cases the calculation will not correctly take account of the timing differences reflected in the tax cash flows and may not accurately reflect the differences created by the assumption that the VIU is tax deductible.

In order to calculate a post-tax VIU that is the equivalent to the VIU required by IAS 36, an entity will usually have to make adjustments to the actual tax cash flows or otherwise adjust its actual post-tax cash flows.

There are two approaches that can give a post-tax VIU that is equivalent to IAS 36's pre-tax calculation:

1. Post-tax cash flows based on notional tax cash flows. The assumptions that need to be made are the same as those used in calculating a pre-tax discount rate as described in paragraph BCZ85. Therefore, there must be no temporary differences associated with the asset which means including only the future cash flows that would result if the tax base of the asset were equal to its VIU. In addition, no account is taken of the existing tax losses of the entity. Both of these assumptions will probably mean making appropriate notional adjustments.
2. Post-tax cash flows reflecting actual tax cash flows. The relevant deferred tax asset or liability, discounted as appropriate, should be treated as part of the net assets of the relevant CGU.

It is very important to note that these are methodologies to determine IAS 36's required VIU and they will only be acceptable if the result can be shown to be materially the same as a pre-tax impairment calculation as required by IAS 36.

Note that for illustrative purposes all of the following examples assume that there is no headroom, i.e. the NPV of the relevant cash flows is exactly equal to the carrying value of the asset. This is to make it easier to observe the relationship between pre- and post-tax calculations. See 7.2.5 below for worked examples including headroom.

It will rarely be practicable to apply this methodology to calculate a discount rate for a CGU, as so many factors need to be taken into account. Even if all assets within the CGU are individually acquired or self-constructed, they may have a range of lives for depreciation and tax amortisation purposes, up to and including indefinite lives.

If goodwill is being tested it has an indefinite life whilst the underlying assets in the CGU or CGU group to which it has been allocated will usually have finite lives. It is likely that a reasonable approximation to the ‘true’ discount rate is the best that can be achieved and this is discussed further below.

7.2.4 Approximations and short cuts

The illustrations in Example 20.14 at 7.2.3 above are of course simplified, and in reality it is unlikely that entities will need to schedule all of the tax cash flows and tax consequences in order to calculate a pre-tax discount rate every time they perform an impairment review. In practice, it will probably not be possible to obtain a rate that is theoretically perfect – the task is just too intractable for that. The objective, therefore, must be to obtain a rate which is sensible and justifiable. Some of the following may make the exercise a bit easier.

An entity may calculate a pre-tax rate using adjusted tax cash flows based on the methods and assumptions described above and then apply that rate to discount pre-tax cash flows for the VIU calculation. This pre-tax rate will only need to be reassessed in following years when there is an external factor that affects risks, relevant market rates or the taxation basis of the asset or CGU.

The market may conclude that the risks relating to a particular asset are higher or lower than had previously been assumed. The market might consider risks to have reduced if, for example, a new project, process or product proves to be successful; the converse would also be true if there were previously unforeseen problems with an activity. Relevant changes in market rates are those for instruments with a period to maturity similar to the expected life of the assets being reviewed for impairment, so these will not necessarily need to be recalculated every time an impairment review is carried out. Short-term market rates may increase or decrease without affecting the rate of return that the market would require on long-term assets. Significant changes in the basis of taxation could also affect the discount rate, e.g. if tax deductions are applied or removed for all of a class of asset or activity. The discount rate will not necessarily be affected if the entity ceases to make taxable profits.

Valuation practitioners often use approximations when computing tax cash flows that may also make the task more straightforward. It may often be a valid approximation to assume that the tax amortisation of assets equals their accounting depreciation. Tax cash flows will be based on the relevant corporate tax rate and the forecast earnings before interest and taxation to give post-tax ‘cash flows’ that can then be discounted using a post-tax discount rate. The circumstances in which this could lead to a material distortion (perhaps in the case of an impairment test for an individual asset) will probably be obvious. This approach is consistent with the overall requirement of IAS 36, which is that the appropriate discount rate to select is one that reflects current market assessments of the risks specific to the asset in question.

The circumstances in which a standardised gross up at the corporation tax rate will give the relevant discount rate are:

• no growth in cash flows;
• a perpetuity calculation; and
• tax cash flows that are a constant percentage of total cash flows.

As long as these conditions remain unchanged, it will be straightforward to determine the discount rate for an impairment review at either the pre- or post-tax level.

There may be a close approximation to these criteria for some CGUs, particularly if accounting and tax amortisation of assets is similar. This is illustrated in Example 20.15 below – see the comparison of discount rates at the end of the example. A simple gross up may be materially correct. The criteria are unlikely to apply to the VIU of individual assets because these are rarely perpetuity calculations and the deductibility for tax purposes may not resemble accounting depreciation. If it is inappropriate to make such a gross up, an iterative calculation may be necessary to compute the appropriate pre-tax discount rate.

7.2.5 Disclosing pre-tax discount rates when using a post-tax methodology

If an entity calculates impairment using a post-tax methodology, it must still disclose the appropriate pre-tax discount rate. [IAS 36.134(d)(v)]. There is a widely-held view that the relevant pre-tax discount rate is the rate that will discount the pre-tax cash flows to the same VIU as the post-tax cash flows discounted using the post-tax discount rate. This will not necessarily give an answer that is consistent with IAS 36, which makes it clear that pre- and post-tax discount rates will only give the same answer 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’. [IAS 36.BCZ85]. It is no different in principle whether grossing up for a pre-tax rate or grossing up for disclosure purposes.

IAS 36 indicates that the appropriate tax base to calculate VIU in a post-tax setting, is the VIU itself. Therefore, the calculated (post-tax) VIU should also be used to derive the pre-tax discount rate. Depreciation for tax purposes must also be based on the calculated VIU.

Assuming that there is no impairment, the post-tax VIU will be higher than the carrying value of the asset. To calculate the pre-tax rate, the tax amortisation must be based on this figure. If tax amortisation is based on the cost of the asset, the apparent pre-tax discount rate will show a rising trend over the life of the asset as the ratio of pre- to post-tax cash flows changes and the effect of discounting becomes smaller. These effects can be very marked.

A rate based on actual post-tax cash flows will also vary from year to year depending on the tax situation.

Neither of these distortions is consistent with the principle that the pre-tax discount rate is the rate that reflects current market assessments of the time value of money and the risks specific to the asset. [IAS 36.55].

7.2.6 Determining pre-tax rates taking account of tax losses

A common problem relates to the effect of tax losses on the impairment calculation, as they may reduce the total tax paid in the period under review or even eliminate it altogether. As noted above, however, a post-tax discount rate is based on certain assumptions about the tax-deductibility of the asset and not the actual tax cash flows. It is therefore unwarranted to assume that the post- and pre-tax discount rates will be the same if the entity pays no tax because of its own tax losses. The pre-tax rate should not include the benefit of available tax benefits and any deferred tax asset arising from tax losses carried forward at the reporting date must be excluded from the assets of the CGU if the impairment review is based on VIU. Similarly, if the entity calculates a post-tax VIU (see 7.2.3 above), it will also make assumptions about taxation and not base the calculation on the actual tax cash flows.

In many circumstances, the past history of tax losses affects the level of risk in the cash flows in the period under review, but one must take care not to increase the discount rate to reflect risks for which the estimated cash flows have been adjusted. [IAS 36.A15]. To do so would be to double count.

7.2.7 Entity-specific WACCs and different project risks within the entity

The entity's WACC is an average rate derived from its existing business, yet entities frequently operate in more than one sector. Within a sector, different types of projects may have different levels of risk, e.g. a start-up against an established product. Therefore, entities must ensure that the different business risks of different CGUs are properly taken into account when determining the appropriate discount rates.

It must be noted that these areas of different risk will not always coincide with the assets or CGUs that are being tested for impairment as this is a test for impairment and not necessarily a determination of business value.

Many sectors generate many new products but have a high attrition rate as most of their new products fail (pharmaceuticals and biotechnology, for example) and this is likely built into industry WACCs. If the risk of failure is not reflected in the industry WACC because the entity is not typical of the industry then either the WACC or the cash flows ought to be adjusted to reflect the risk (but not so as to double count).

7.2.8 Entity-specific WACCs and capital structure

The discount rate is a pre-tax rate that reflects 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. [IAS 36.55]. An entity's own WACC may not be suitable as a discount rate if there is anything atypical about the entity's capital structure compared with ‘typical’ market participants. In other words, would the market assess the cash flows from the asset or unit as being riskier or less risky than the entity-wide risks reflected in the entity-wide WACC? Some of the risks that need to be thought about are country risk, currency risks and price risk.

Country risk will reflect the area in which the assets are located. In some areas assets are frequently nationalised by governments or the area may be politically unstable and prone to violence. In addition, the potential impact of physical instability such as weather or earthquakes, and the effects of currency volatility on the expected return from the asset, must be considered.

Two elements of price risk are the gearing ratio of the entity in question (if, for example, it is much more or less geared than average) and any default risk built into its cost of debt. However, IAS 36 explicitly notes that the discount rate is independent of the entity's capital structure and the way the entity financed the purchase of the asset, because the future cash flows expected to arise from an asset do not depend on these features. [IAS 36.A19].

Ultimately, it might be acceptable to use the entity's own WACC, but an entity cannot conclude on this without going through the exercise of assessing for risk each of the assets or units and concluding on whether or not they contain additional risks that are not reflected in the WACC.

7.2.9 Use of discount rates other than the WACC

IAS 36 allows an entity to use rates other than the WACC as a starting point in calculating the discount rate. These include:

1. the entity's incremental borrowing rate; and
2. other market borrowing rates. [IAS 36.A17].

If borrowing rates (which are, of course, pre-tax) were used as a starting point, could this avoid some of the problems associated with adjusting the WACC for the effects of taxation? Unfortunately, this is unlikely. Debt rates reflect the entity's capital structure and do not reflect the risk inherent in the asset. A pure asset/business risk would be obtained from an entity funded solely by equity and equity risk premiums are always observed on a post-tax basis. Therefore, the risk premium that must be added to reflect the required (increased) return over and above a risk free rate by an investor will always have to be adjusted for the effects of taxation.

It must be stressed that the appropriate discount rate, which is the one that reflects current market assessments of the time value of money and the risks specific to the asset in question, ought to be the same whatever the starting point for the calculation of the rate.

Vodafone in its description of its pre-tax discount rate starts from the relevant bond (i.e. debt) rate (Extract 20.2 at 13.3 below). However, this note also describes many of the elements of the WACC calculation and how Vodafone has obtained these; it does not suggest that Vodafone has used anything other than an adjusted WACC as a discount rate for the purposes of the impairment test.

7.2.10 Impact of IFRS 16 adoption on the discount rate

With adoption of IFRS 16, the carrying amount of the CGU will increase, reflecting the right-of-use assets added to the carrying value of the CGU. On the other hand, the VIU of the CGU will increase by the net present value of the future lease payments discounted at the discount rate used under IAS 36 due to the removal of lease payments reflected in the lease liabilities from the VIU calculation. The transition method selected on the adoption of IFRS 16, will impact the amount of the right-of-use assets recorded. If under the modified retrospective approach an entity selects to record the right-of-use assets at an amount equal to the lease liabilities, then the addition of the right-of-use assets in the carrying amount of the CGU and the removal of the lease payments from the VIU calculation will usually have an offsetting effect. As a result, generally, there will be a limited effect on the impairment test, i.e. the amount of headroom or impairment calculated will not be substantially different. However, if the IAS 36 discount rate (for example, a discount rate based on the WACC) exceeds the IFRS 16 discount rate (for example, the lessees’ incremental borrowing rate), this will have a net negative impact on the results of the impairment test as the carrying amount of the CGU will increase by more than the increase in the VIU of the CGU. This effect could result in what could appear to be an impairment, or an increase in a previous impairment charge. However, from an economic perspective, the underlying business and cash flows have not changed, thus, it is difficult to justify why there would be an effect on the impairment test as a result of the discounting.

As a result of the adoption of IFRS 16, the composition of the asset base being tested for impairment (see 3 above), and the associated cash flows included in the VIU calculation (see 7.1.8 above) have changed. Therefore, the discount rate used in determining VIU should, in our view, be recalculated to ensure consistency. In theory, we would expect that such discount rate would generally be somewhat lower than the IAS 36 discount rate used when operating leases were off-balance sheet under IAS 17 – Leases. Such a decrease does not result from any future anticipated change in behaviour or risk perception of market participants, but, instead, remains based on market conditions at the measurement date and results from the change in composition of the assets (recognition of right-of-use assets with lower inherent risks) and change in cash flows (lease payments as financing cash flows instead of operating cash flows which reduces the relative volatility of cash flows in the VIU calculation).

From a practical point of view, generally an entity might in early years of IFRS 16 adoption, use an alternative approach where, instead of adjusting the discount rate and excluding the lease cash flows reflected in the recognised lease liability from the VIU calculation as discussed in 7.1.8.A above, it continues to include the cash outflows in the VIU calculation, includes the right-of-use assets together with the lease liability in the carrying amount of the CGU and uses the unadjusted pre-IFRS 16 discount rate. As always, it will be of upmost importance to ensure that the discount rate used for the VIU calculation is reflective of the approach used, the cash flows included in the VIU calculation and the composition of the carrying amount of the CGU. We expect that observable debt/equity ratios in the market will, over time, reflect the move from a pre-IFRS 16 to a post-IFRS 16 basis. This might make it difficult to obtain appropriate discount rates on a pre-IFRS 16 basis for later years and this alternative approach might then no longer be appropriate.

8.1.1 The composition of goodwill

IAS 36 requires an entity to allocate goodwill to the CGUs that are expected to benefit from the synergies of the business combination, a challenging task because, in accounting terms, goodwill is measured as a residual (see Chapter 9). This means that in most cases goodwill includes elements other than the synergies on which the allocation to CGUs is based.

The IASB and FASB argue that what it refers to as ‘core goodwill’ is an asset. [IFRS 3.BC323].

Core goodwill, conceptually, comprises two components: [IFRS 3.BC313]

1. the fair value of the going concern element of the acquiree's existing business. ‘The going concern element represents the ability of the established business to earn a higher rate of return on an assembled collection of net assets than would be expected if those net assets had to be acquired separately. That value stems from the synergies of the net assets of the business, as well as from other benefits (such as factors related to market imperfections, including the ability to earn monopoly profits and barriers to market entry – either legal or because of transaction costs – by potential competitors)’; and
2. the fair value of the expected synergies and other benefits from combining the acquirer's and acquiree's net assets and businesses. Those synergies and other benefits are unique to each combination, and different combinations would produce different synergies and, hence, different values.

The problem for the allocation process is, firstly, that (a) relates to the acquired business taken as a whole and any attempt to allocate it to individual CGUs or CGU groups in the combined entity may well be futile. IFRS 3 refers to part of element (a) above, the value of an assembled workforce, which may not be recognised as a separate intangible asset. This is the existing collection of employees that permits the acquirer to continue to operate an acquired business from the acquisition date without having to hire and train a workforce. [IFRS 3.B37]. This has to be allocated to all the CGUs and CGU groups that benefit from the synergies.

Secondly, synergies themselves fall into two broad categories, operating synergies, which allow businesses to increase their operating income, e.g. through economies of scale or higher growth, or financial synergies that may result in a higher cash flow or lower cost of capital and includes tax benefits. Some financial synergies are quite likely to relate to the combined business rather than individual CGUs or CGU groups. Even though the expected future cash flows of the CGU being assessed for impairment should not include cash inflows or outflows from financing activities or tax receipts, [IAS 36.50, 51], there is no suggestion in IAS 36 that these synergies cannot be taken into account in allocating goodwill.

In addition, goodwill measured as a residual may include amounts that do not represent core goodwill. IFRS 3 attempts to minimise these amounts by requiring an acquirer:

• to measure the consideration accurately, thus reducing any overvaluation of the consideration paid;
• to recognise the identifiable net assets acquired at their fair values rather than their carrying amounts; and
• to recognise all acquired intangible assets meeting the relevant criteria so that they are not subsumed into the amount initially recognised as goodwill. [IFRS 3.BC317].

However, this process is not perfect. The acquirer might for example attribute value to potential contracts the acquiree is negotiating with prospective customers at the acquisition date but these are not recognised under IFRS 3 and neither are contingent assets, so their fair value is subsumed into goodwill. [IFRS 3.B38, IFRS 3.BC276]. Employee benefits and share-based payments are not recognised at their fair value. [IFRS 3.26, 30]. In practice, the most significant mismatch arises from deferred taxation, which is not recognised at fair value and can lead to the immediate recognition of goodwill. This is discussed at 8.3.1 below.

In summary, this means that the goodwill that is allocated to a CGU or CGU group may well include an element that relates to the whole of the acquired business or to an inconsistency in the measurement process as well as the synergies that follow from the acquisition itself. This point has been acknowledged by the IASB during the development of the standard:

‘However, the Board was concerned that in the absence of any guidance on the precise meaning of “allocated on a reasonable and consistent basis”, some might conclude that when a business combination enhances the value of all of the acquirer's pre-existing cash-generating units, any goodwill acquired in that business combination should be tested for impairment only at the level of the entity itself. The Board concluded that this should not be the case.’[IAS 36.BC139].

In spite of the guidance in the standard, the meaning of the monitoring of goodwill as well as the allocation process remains somewhat elusive. Nevertheless, all goodwill arising in a business combination must be allocated to CGUs or CGU groups that benefit from the synergies, none may be allocated to CGUs or CGU groups that do not benefit and entities are not permitted to test at the level of the entity as a whole as a default. This means that identifying CGUs and CGU groups that benefit from the synergies is a crucial step in the process of testing goodwill for impairment.

8.1.2 Identifying synergies and identifying CGUs or CGU groups for allocating goodwill

IAS 36 requires goodwill to be allocated to CGUs or CGU groups that are expected to benefit from the synergies of the combination and only to those CGUs and CGU groups. This is irrespective of whether other assets or liabilities of the acquiree are assigned to those CGUs or group of CGUs. [IAS 36.80].

Operating synergies fall into two broad groups, those that improve margin (e.g. through cost savings and economies of scale) and those that give an opportunity for future growth (e.g. through the benefits of the combined talent and technology).

The process is further illustrated in the following example which shows the differences for the purposes of testing impairment between the CGU/CGU groups to which goodwill is allocated and the identification of CGUs.

8.1.3 Measuring the goodwill allocated to CGUs or CGU groups

Although goodwill has to be allocated IAS 36 does not provide any allocation methodologies. One allocation method is a ‘direct’ method, which is based on the difference between the fair value of the net assets and the fair value of the acquired business (or portion thereof) to be assigned to the CGUs, thereby calculating goodwill directly by reference to the allocated net assets. However, this method will not allocate any goodwill to a CGU if no assets or liabilities are assigned to the CGU and, arguably, it will allocate too little goodwill to CGUs that may benefit disproportionately because of synergies with the acquired business. A method that does not have these shortcomings is a ‘with and without’ method that requires the entity to calculate the fair value of the CGU or CGU groups that are expected to benefit before and after the acquisition; the difference represents the amount of goodwill to be allocated to that reporting unit. This will take account of buyer-specific synergies that relate to a CGU or CGU group. These methods are illustrated in the following example.

In this case, the ‘with and without’ method may be more appropriate but this would depend on the availability and reliability of inputs. The ‘direct’ method may in other circumstances give a reasonable allocation of goodwill.

8.1.4 The effect of IFRS 8 – Operating Segments – on impairment tests

Goodwill to be tested for impairment cannot be allocated to a CGU or CGU group larger than an operating segment as defined by IFRS 8. [IAS 36.80, 81, IFRS 8.11‑12]. IFRS 8 is discussed in Chapter 36.

Organisations managed on a matrix basis cannot test goodwill for impairment at the level of internal reporting, if this level crosses more than one operating segment as defined in IFRS 8. [IFRS 8.5]. In addition, the operating segments selected by the entities may not correspond with their CGUs.

These are entities that manage their businesses simultaneously on two different bases; for example, some managers may be responsible for different product and service lines while others are responsible for specific geographical areas. IFRS 8 notes that the characteristics that define an operating segment may apply to two or more overlapping sets of components for which managers are held responsible. Financial information is available for both and the chief operating decision maker may regularly review both sets of operating results of components. In spite of this, IFRS 8 requires the entity to characterise one of these bases as determining its operating segments. [IFRS 8.10]. Similarly, the entity will have to allocate its goodwill to CGUs or groups of CGUs no larger than operating segments even if this means an allocation of goodwill between segments on a basis that does not correspond with the way it is monitored for internal management purposes.

8.1.5 Goodwill initially unallocated to cash-generating units

IFRS 3 allows a ‘measurement period’ after a business combination to provide the acquirer with a reasonable time to obtain the information necessary to identify and measure all of the various components of the business combination as of the acquisition date in accordance with the standard. [IFRS 3.46]. The measurement period ends as soon as the acquirer receives the information it is seeking and cannot exceed one year from the acquisition date. [IFRS 3.45].

IAS 36 recognises that in such circumstances, it might also not be possible to complete the initial allocation of the goodwill to a CGU or group of CGUs for impairment purposes before the end of the annual period in which the combination is effected. [IAS 36.85]. Where this is the case the goodwill (or part of it) is left unallocated for that period. Goodwill must then be allocated before the end of the first annual period beginning after the acquisition date. [IAS 36.84]. The standard requires disclosure of the amount of the unallocated goodwill together with an explanation as to why that is the case (see 13.3 below).

The question arises as to whether the entity ought to test, in such circumstances, the goodwill acquired during the current annual period before the end of the current annual period or in the following year if the annual impairment testing date is before the allocation of goodwill is completed.

In our view, it will depend on whether an entity is able during the ‘measurement period’ and until the initial allocation of goodwill is completed to quantify goodwill with sufficient accuracy and allocate goodwill on a provisional basis to CGUs or group of CGUs.

If the entity is able to quantify goodwill with sufficient accuracy, a provisional allocation of goodwill could be made in the following circumstances:

1. the entity might know that all goodwill relates to a single CGU or to a group of CGUs no larger than a single operating segment; or
2. the entity may know that the initial accounting for the combination is complete in all material respects, although some details remain to be finalised.

In circumstances where a provisional allocation of goodwill could be made, an entity should, in our view, tests this provisional goodwill for impairment in accordance with IAS 36 during the annual period in which the acquisition occurred and in the following years annual impairment test, even if this is before the allocation of goodwill is completed.

In addition, we believe an entity should carry out an impairment test where there are indicators of impairment. This is the case even if the fair values have not been finalised and the goodwill amount is only provisional or goodwill has not necessarily been allocated to the relevant CGUs or CGU groups and the test therefore has to be carried out at a higher, potentially even at the reporting entity level.

In our view, an entity would not need to test the goodwill for impairment until the allocation of goodwill has been finalised, if a provisional allocation of goodwill could not be made and there are no indications of impairment.

When the allocation of goodwill is finalised, in the first annual period after the acquisition date, the entity must consider appropriate actions.

In our view, the acquirer should test in some circumstances the final allocated goodwill for impairment retrospectively, on the basis that the test on provisional goodwill was in fact the first impairment test applying IAS 36. In the following cases an entity should update the prior year's impairment test retrospectively:

• if the entity allocated provisional goodwill to CGUs, although it had not completed its fair value exercise, and tested provisional goodwill of impairment in accordance with IAS 36 (see above); or
• if the entity did not allocate provisional goodwill to the related CGUs but there were indicators of impairment and the entity tested the provisional goodwill potentially at a different level to the ultimate allocation and the impairment test resulted in an impairment (see above).

If the entity did not allocate provisional goodwill to CGUs, there were indicators that the provisional goodwill may have been impaired and the impairment test at a higher, potentially entity level, did not result in an impairment, the entity can choose whether to update the prior year's impairment test retrospectively, but is not required to do so.

In all other scenarios, the acquirer performs only a current year impairment test (i.e. after the allocation has been completed) on a prospective basis.

If the acquirer updates the prior year's impairment test as outlined above, this update could decrease the original goodwill impairment recognised. Such a decrease is an adjustment to the original goodwill impairment. This will not qualify as a reversal and does not violate the prohibition on reversing any goodwill impairments in paragraph 124 of IAS 36. See 11.3 below.

If an entity were to change its annual reporting date, it could mean that it has a shorter period in which to allocate goodwill as IAS 36 requires that allocation of goodwill for impairment purposes is completed by the end of the first annual period after the acquisition and not within 12 months as required by IFRS 3. [IAS 36.84].

8.2.1 Timing of impairment tests

IAS 36 requires an annual impairment test of CGUs or groups of CGUs to which goodwill has been allocated. The impairment test does not have to be carried out at the end of the reporting period. The standard permits the annual impairment test to be performed at any time during an annual period, provided the test is performed at the same time every year. Different CGUs may be tested for impairment at different times.

However, if some or all of the goodwill allocated to a CGU or group of CGUs was acquired in a business combination during the current annual period, that unit must be tested for impairment before the end of the current annual period. [IAS 36.96].

The IASB observed that acquirers can sometimes ‘overpay’ for an acquiree, so that the amount initially recognised for the business combination and the resulting goodwill exceeds the recoverable amount of the investment. The Board was concerned that without this requirement it might be possible for entities to delay recognising such an impairment loss until the annual period after the business combination. [IAS 36.BC173].

It has to be said that the wording of the requirement may not achieve that result, as the goodwill may not have been allocated to a CGU in the period in which the business combination occurs. The time allowed for entities to allocate goodwill may mean that this is not completed until the period following the business combination. [IAS 36.84]. The potential consequences of this are discussed at 8.1.5 above.

Consider also the following example.

IAS 36 requires the annual impairment test for a CGU to which goodwill has been allocated to be performed at the same time every year but is silent on whether an entity can change the timing of the impairment test. We believe a change in timing of the annual impairment test is acceptable if there are valid reasons for the change, the period between impairment tests does not exceed 12 months and the change is not made to avoid an impairment charge. The requirement that the period between impairment tests should not exceed 12 months could mean that an entity would need to test a CGU twice in a year if, for example, it wanted to change the date of the test from October to December. In our view it would in general not be appropriate to change the date of the impairment test again in consecutive years.

8.2.2 Sequence of impairment tests for goodwill and other assets

When a CGU to which goodwill has been allocated is tested for impairment, there may also be an indication of impairment of an asset within the unit. IAS 36 requires the entity to test the asset for impairment first and recognise any impairment loss on it before carrying out the impairment test for the goodwill, although this is unlikely to have any practical impact as the assets within the CGU by definition will not generate separate cash flows. An entity will have to go through the same process if there is an indication of an impairment of a CGU within a group of CGUs containing the goodwill. The entity must test the CGU for impairment first, and recognise any impairment loss for that CGU, before testing the group of CGUs to which the goodwill is allocated. [IAS 36.97‑98].

8.2.3 Carry forward of a previous impairment test calculation

IAS 36 permits the most recent detailed calculation of the recoverable amount of a CGU or group of CGUs to which goodwill has been allocated to be carried forward from a preceding period provided all of the following criteria are met:

1. the assets and liabilities making up the CGU or group of CGUs have not changed significantly since the most recent recoverable amount calculation;
2. the most recent recoverable amount calculation resulted in an amount that exceeded the carrying amount of the CGU or group of CGUs by a substantial margin; and
3. based on an analysis of events that have occurred and circumstances that have changed since the most recent recoverable amount calculation, the likelihood that a current recoverable amount determination would be less than the current carrying amount of the CGU or group of CGUs is remote. [IAS 36.99].

The Basis for Conclusions indicates that the reason for this dispensation is to reduce the costs of applying the impairment test, without compromising its integrity. [IAS 36.BC177]. However, clearly it is a matter of judgement as to whether each of the criteria is actually met.

8.2.4 Reversal of impairment loss for goodwill prohibited

Once an impairment loss has been recognised for goodwill, IAS 36 prohibits its reversal in a subsequent period. [IAS 36.124]. The standard justifies this on the grounds that any reversal ‘is likely to be an increase in internally generated goodwill, rather than a reversal of the impairment loss recognised for the acquired goodwill’, and IAS 38 prohibits the recognition of internally generated goodwill. [IAS 36.125]. The impairment test itself though does not distinguish between purchased and internally generated goodwill.

8.3.1 Testing goodwill ‘created’ by deferred tax for impairment

As described in Chapter 33 at 12, the requirement of IAS 12 to recognise deferred tax on all temporary differences arising on net assets acquired in a business combination may have an impact on the amount of goodwill recognised. In a business combination, there is no initial recognition exemption for deferred tax and the corresponding accounting entry for a deferred tax asset or liability forms part of the goodwill arising or the bargain purchase gain recognised. [IAS 12.22(a)]. Where an intangible asset, which was not recognised in the acquiree's financial statements, is acquired in a business combination and the intangible's tax base is zero, a deferred tax liability based on the fair value of the intangible and the prevailing tax rate will be recognised. The corresponding debit entry will increase goodwill. This then begs the question of how to consider this in the VIU when performing an impairment test on that goodwill and whether there is indeed an immediate impairment that would need to be recognised. We explore the issues in the following examples.

We think that an immediate write down of goodwill created by deferred tax is unlikely to have been the intention of IAS 36 because certain assumptions about taxation have been incorporated into the carrying amount of goodwill that are represented by the deferred tax liability recorded in relation of the intangible asset recognised on consolidation. In order to remove all tax effects from the CGU, the carrying amount of goodwill that relates to taxation and the deferred tax liability should be removed for impairment testing purposes; otherwise it might not be possible to determine the appropriate pre-tax discount rate. This means, in effect, that as at the point of acquisition, the goodwill can be reduced by the deferred tax liability recorded on consolidation in order to test that goodwill for impairment. As a result, the entity does not have to recognise an immediate impairment loss.

Not recognising an immediate impairment loss is consistent with the fact that the goodwill due to deferred tax that is being recognised as part of this acquisition is not part of ‘core goodwill’ (see 8.1.1 above), but is a consequence of the exceptions in IFRS 3 to the basic principle that assets and liabilities be measured at fair value, deferred tax being one of these exceptions (see 8.1.1 above and Chapter 9 at 5.6.2).

Another way of describing this is the lack of tax basis inherent in the asset has already been reflected in the fair value assigned to the asset. As a result, the incremental fair value of the deferred tax liability is nil. Goodwill is reduced by the nominal versus fair value difference of the deferred tax liability which in this case is the full amount of the deferred tax liability related to the intangible.

Continuing with this simplified example, if it is assumed that the intangible asset is amortised over a finite useful life then the deferred tax relating to that asset (€24m in this example) will be released over that life with the effect that the net amount charged to the income statement of €36m (total amortisation less deferred tax, €60m – €24m) will be the same as if the amortisation charge were tax deductible.

At future impairment testing dates, one would adjust for any remaining deferred tax liability at the impairment testing date that resulted in an increase in goodwill at the acquisition date.

In many jurisdictions the amortisation of intangible assets is deductible for tax purposes. This generates additional benefits, called tax amortisation benefit (TAB), impacting the fair value of the intangible. Therefore, the fair value as part of a business acquisition for many intangible assets includes assumptions about the tax amortisation benefit that would be available if the asset were acquired separately. For example, the value of a trademark using the ‘relief from royalty’ method would be assumed to be the net present value of post-tax future royalty savings, under consideration of TAB, in the consolidated financial statements, based on the hypothetical case of not owning the trademark. In order to reach the fair value of the asset, its value before amortisation would be adjusted by a tax amortisation factor reflecting the corporate tax rate, a discount rate and a tax amortisation period (this is the period allowed for tax purposes, which is not necessarily the useful life for amortisation purposes of the asset). In a market approach, fair value is estimated from market prices paid for comparable assets and the prices will contain all benefits of owning the assets, including any tax amortisation benefit.

This means that the difference between the tax amortisation benefit and the gross amount of the deferred tax liability remains part of goodwill.

This is demonstrated in the following example:

Unlike goodwill, the intangible asset will only have to be tested for impairment if there are indicators of impairment, if it has an indefinite useful life or if it has not yet been brought into use. [IAS 36.10]. If the intangible asset is being tested by itself for impairment, i.e. not as part of a CGU, its FVLCD would need to be determined on the same basis as for the purposes of the business combination, making the same assumptions about taxation. If FVLCD exceeds the carrying amount, there is no impairment.

However, as mentioned at 3.1 above, many intangible assets do not generate independent cash inflows as individual assets and so they are tested as part of a CGU. Assuming there is no goodwill in the CGU being tested, then the VIU of the CGU might be calculated on an after-tax basis using notional tax cash flows assuming the asset's tax basis is equal to its VIU as discussed at 7.2.3 above.

When goodwill is included in the CGU, the carrying amount of goodwill that results from the recognition of deferred tax (e.g. the €6m in Example 20.24 above) should be removed for impairment testing purposes. At future impairment testing dates, one should adjust for any remaining difference between the nominal deferred tax liability at the impairment testing date and the original fair value of the assumed tax basis embedded in the intangible asset carrying value that remains at the impairment testing date. This is consistent with the assumption that it could not have been the IASB's intention to have an immediate impairment at the time of acquisition and the same logic and approach is being carried forward from day 1 to future impairment tests.

Another way of describing this is that the fair value of the deferred tax liability in the above example is equal to 30, being the tax amortisation benefit embedded in the fair value of the intangible asset. This tax amortisation benefit does not actually exist given the intangible asset's tax basis is in fact nil. Goodwill is reduced by the nominal versus fair value difference of the deferred tax liability which in this case is 6. If one tests the CGU (including both the intangible asset and goodwill) for impairment, when calculating the VIU following the approach at 7.2.3 above on an after-tax basis (using notional tax cash flows assuming a tax basis equal to VIU) this should not lead to day 1 impairment, given the VIU calculation assumes a full tax basis similar to that assumed in the intangible carrying value, as goodwill has been reduced by the nominal versus fair value difference of the deferred tax liability of 6.

An entity might not continue to make this adjustment if it becomes impracticable to identify reliably the amount of the adjustment, in which case the entity would use VIU without this adjustment or use FVLCD of the CGU as the recoverable amount.

This is illustrated in the following example:

The standard's disclosure requirements including the pre-tax discount rate, principally described at 13.3 below, will apply.

8.3.2 Deferred tax assets and losses of acquired businesses

Deferred tax assets arising from tax losses carried forward at the reporting date must be excluded from the assets of the CGU for the purpose of calculating its VIU. However, tax losses may not meet the criteria for recognition as deferred tax assets in a business combination, which means that their value is initially subsumed within goodwill. Under IFRS 3 and IAS 12, only acquired deferred tax assets that are recognised within the measurement period (through new information about circumstances at the acquisition date) are to reduce goodwill, with any excess once goodwill has been reduced to zero being taken to profit or loss. After the end of the measurement period, all other acquired deferred tax assets are taken to profit or loss. [IFRS 3.67, IAS 12.68].

Unless and until the deferred tax asset is recognised, this raises the same problems as at 8.3.1 above. Certain assumptions regarding future taxation are built into the carrying value of goodwill and one should consider excluding these amounts from the carrying amount of the CGU when testing for impairment. However, if at a later date it transpires that any tax losses carry forwards subsumed in goodwill cannot be utilised, then excluding these amounts from the carrying amount of the CGU for impairment testing is not appropriate and might lead to an impairment.

8.5.1 Changes in composition of cash-generating units

If an entity reorganises the structure of its operations in a way that changes the composition of one or more CGUs to which goodwill has been allocated, IAS 36 requires that the goodwill be reallocated to the units affected. For this purpose, the standard requires the reallocation to be performed using a relative value approach similar to that discussed above when an entity disposes of an operation within a CGU, unless the entity can demonstrate that some other method better reflects the goodwill associated with the reorganised units. [IAS 36.87]. Generally an impairment review would need to be performed prior to the reallocation of goodwill. As a result, if the reorganisation is triggered by underperformance in any of the affected operations, it cannot mask any impairment.

When goodwill is reallocated based on relative values, it may be necessary to assess impairment immediately following the reallocation, as the recoverable amount of the CGUs will be based on the principles of IAS 36 and the reallocation could lead to an immediate impairment.

Again, the standard gives no indication as to what other methods might better reflect the goodwill associated with the reorganised units.

As illustrated in Example 20.28 below, the reallocation based on relative values could lead to an immediate impairment after the reallocation. This is not intuitive given that an impairment review would have been performed immediately before the goodwill reallocation and the restructuring of a business would not be expected to result in an impairment of goodwill.

In our view an allocation based on the relative current value of notional goodwill could, depending on facts and circumstances, be seen as an acceptable alternative to the IAS 36 suggested approach of relative values. This method calculates the current value of notional goodwill in each of the components to be allocated to new CGUs by performing a notional purchase price allocation for each affected CGU. To do this the components fair value is compared with the fair value of the net identifiable assets to obtain the current value of notional goodwill. The carrying amount of the goodwill to be reallocated is then allocated to the new CGUs based on the relative current values of notional goodwill. This approach together with an example of circumstances under which the approach may be acceptable is illustrated in Example 20.28:

The above example is based on a fact pattern where an existing CGU is split into three new CGUs. However, the method could be applied as well in circumstances where components of an existing CGU are allocated to other existing CGUs. The current values of notional goodwill used for reallocation purposes in such a case would need to be based only on the goodwill in the components being reallocated ignoring any goodwill in the existing CGUs to which the components are being allocated.

While the method illustrated above might be seen as an alternative method for goodwill reallocation it requires an entity to perform notional purchase price allocations for the components of each affected CGU and therefore potentially involves a significant time, effort and cost commitment. It is important to note that IAS 36 is not entirely clear whether an entity would need to use an alternative method that might better reflect the goodwill associated with the reorganised units, if the entity is aware of it, or whether an entity could always just default to the IAS 36.87 stated relative value method.

In practice, situations may be considerably more complex than Examples 20.26, 20.27 and 20.28 above. For example, after an acquisition, a combination of disposal of acquired businesses together with a reorganisation and integration may arise. The entity may sell some parts of its acquired business immediately but may also use the acquisition in order to replace part of its existing capacity, disposing of existing elements. In addition, groups frequently undertake reorganisations of their statutory entities. It is often the case that CGUs do not correspond to these individual entities and the reorganisations may be undertaken for taxation reasons so the ownership structure within a group may not correspond to its CGUs. This makes it clear how important it is that entities identify their CGUs and the allocation of goodwill to them, so that they already have a basis for making any necessary allocations when an impairment issue arises or there is a disposal.

9.1.1 Acquisitions or sale of non-controlling interests measured at the proportionate share of net identifiable assets

As described above, in order to enable a like-for-like comparison, IAS 36 requires the carrying amount of a non-wholly-owned CGU to be notionally adjusted by grossing up the carrying amount of goodwill allocated to the CGU to include the amount attributable to the non-controlling interest.

What happens if the non-controlling interest is acquired by the entity so that it is now wholly owned? IFRS 10 requires these purchases to be reflected as equity transactions, which means that there is no change to goodwill. [IFRS 10.23]. Other methods may have been used in the past that may still be reflected in the carrying amounts of goodwill. These methods could have partially or wholly reflected the fair value of the additional interest acquired.

No notional adjustment to goodwill is required when the remaining non-controlling interest is acquired. The carrying amount of the unit, including the recognised goodwill, i.e. the goodwill arising in the acquisition when control was obtained, should be tested against 100% of the recoverable amount of the unit.

In situations where only a portion but not the full outstanding non-controlling interest is acquired or where a portion of an existing holding is sold without loss of control, the question is whether goodwill should be grossed up based on the new non-controlling interest percentage after the transaction or the original percentage. In our view, the answer to this question depends on whether a purchase of an additional non-controlling interest or a sale of a portion of an existing holding occurred.

Assume a situation where entity A owns 80% of entity B, goodwill was recorded at 80 and the non-controlling interest was measured at the proportionate interest in the net identifiable assets. In previous impairment tests goodwill would have been grossed up to 100 (80 × 100% ÷ 80%). When entity A later acquires 10% of the remaining ownership interest in Entity B, leaving a non-controlling interest of 10%, should goodwill for future impairment assessments be grossed up using the current 10% or the previous 20% non-controlling interest? Using the current non-controlling interest holding of 10% would lead to grossed up goodwill of 88.9 (80 × 100% ÷ 90%). This would make an impairment less likely. The alternative is to gross up goodwill with the original non-controlling interest percentage of 20% meaning goodwill could continue to be grossed up to 100. We believe both approaches are acceptable in practice in situations where an additional non-controlling interest is acquired.

However, in our view, if instead entity A sold 20% of the ownership in entity B, resulting in a non-controlling interest of 40% the answer is different. The original non-controlling interest percentage of 20% should be used leading to grossed up goodwill of 100. Using an approach where goodwill is grossed up with the new non-controlling interest percentage, would lead to a goodwill of 133.3 (80 × 100% ÷ 60%). We do not believe it would be appropriate to use this grossed up amount, as no additional goodwill was created through the transaction.

Grossing up of goodwill may be complex in situations where subsequent transactions occur which might entail a combination of non-controlling interests measured initially at fair value and at proportionate interest of net identifiable assets or where there are multiple subsequent transactions involving non-controlling interests. Careful consideration of all facts and circumstances are required to come to an appropriate solution in such cases.

11.4.1 Reversals of impairments – cash-generating units

Where an entity recognises a reversal of an impairment loss on a CGU, the increase in the carrying amount of the assets of the unit should be allocated by increasing the carrying amount of the assets, other than goodwill, in the unit on a pro-rata basis. However, the carrying amount of an individual asset should not be increased above the lower of its recoverable amount (if determinable) and the carrying amount that would have resulted had no impairment loss been recognised in prior years. Any ‘surplus’ reversal is to be allocated to the remaining assets pro-rata, always remembering that goodwill, if allocated to an individual CGU, may not be increased under any circumstances. [IAS 36.122, 123].

11.4.2 Reversals of impairments – revalued assets

If an asset is recognised at a revalued amount under another standard any reversal of an impairment loss should be treated as a revaluation increase under that other standard. Thus a reversal of an impairment loss on a revalued asset is credited to other comprehensive income. However, to the extent that an impairment loss on the same revalued asset was previously recognised as an expense in the income statement, a reversal of that impairment loss is recognised as income in the income statement. [IAS 36.119, 120].

As with assets carried at cost, after a reversal of an impairment loss is recognised on a revalued asset, the depreciation charge should be adjusted in future periods to allocate the asset's revised carrying amount, less any residual value, on a systematic basis over its remaining useful life. [IAS 36.121].

12.2.1 Goodwill synergies arising outside of the reporting entity/subgroup

If goodwill is being tested in the consolidated subgroup or individual financial statements, it may be that the synergies that gave rise to the goodwill are in another part of the larger group because the subgroup is part of a CGU containing other subsidiary companies. It may not be possible to translate some synergies such as economies of scale into cash flows to the entity or subgroup in question. Although there is no impairment at the level of the CGU in the group consolidated financial statements, the entity may not be able to avoid writing down the goodwill in the individual or subgroup statements at the time the first impairment test is performed in the year of the acquisition. In our view, it would not be appropriate to consider synergies arising outside the individual or subgroup financial statements when testing impairment in the individual or subgroup financial statements unless these synergies would be available to market participants and therefore could be built into the FVLCD. Whether this write down needs to be recorded in the statement of profit or loss or whether it is appropriate to treat it as an equity transaction in the form of a distribution to the parent is a matter of judgement.

12.2.2 The effect of IFRS 8 – Operating segments – when allocating goodwill to CGU's in individual (or subgroup) financial statements

As discussed at 8.1 above, goodwill is not necessarily tested at the lowest level of CGUs (however defined in the context of these group entities or subgroups), but at the level of a CGU group at which goodwill is monitored. However, that CGU group cannot be larger than an operating segment before aggregation (see 8.1.4 above). [IAS 36.80].

We believe that for the purposes of testing goodwill in the individual or subgroup's financial statements, companies must apply the guidance in IFRS 8 to determine its operating segments even if IFRS 8 is not applicable because the subsidiary (subgroup) is not public. Therefore, if the application of IFRS 8 would result in the identification of separate operating segments in the individual or subgroup's financial statements, goodwill cannot be tested for impairment at a level above the operating segments in those financial statements (i.e. the operating segments would serve as a ceiling). It would not be appropriate to apply paragraph 80 of IAS 36 in these circumstances based on the operating segments as determined by the ultimate parent entity for its consolidated financial statements.

However, the CGU/CGU group for the purposes of goodwill impairment testing could be at a level lower than the subgroup's operating segments.

12.2.3 Acquisitions by subsidiaries and determining the level at which the group tests goodwill for impairment

IAS 36 requires goodwill to be allocated to the lowest level within the entity at which the goodwill is monitored for internal management purposes. If a subsidiary undertakes acquisitions and recognises goodwill in its own financial statements, the level at which the subsidiary's management monitors the goodwill may differ from the level at which the parent's or group's management monitors goodwill from the group's perspective.

If a subsidiary's management monitors its goodwill at a lower level than the level at which the parent's or group's management monitors its goodwill, a key issue is whether that lower level should, from the group's perspective, be regarded as the ‘lowest level within the entity at which the goodwill is monitored for internal management purposes’? The answer is not necessarily, as is demonstrated in the following example.

12.4.1 Fair value less costs of disposal (FVLCD) for investments in subsidiaries, associates and joint ventures

In order to establish FVLCD an entity must apply IFRS 13's requirements as outlined at 6 above and described in detail in Chapter 14.

If an entity holds a position in a single asset or liability that is traded in an active market, IFRS 13 requires an entity to measure fair value using that price, without adjustment. This requirement is accepted when the asset or liability being measured is a financial instrument in the scope of IFRS 9. However, when an entity holds an investment in a subsidiary, joint venture or associate the question is what the unit of account is, the individual shares or the investment as a whole, and whether it would be appropriate to include a control premium when determining fair value provided that market participants take this into consideration when pricing the asset. See 6.1.1 above and Chapter 14 at 5.1.1 for considerations and recent developments in respect of this.

Unlike investments with quoted prices, discussed above, there are less issues if FVLCD is used to determine the recoverable amount of an asset that does not have a quoted price in an active market and is either:

• an investment in a subsidiary, joint venture or associate; or
• a CGU comprising the investment's underlying assets.

Using FVLCD may avoid some of the complexities of determining appropriate cash flows because of transfer pricing and other intra-group transaction issues, described in 12.1 above and 12.4.2 below.

12.4.2 VIU for investments in subsidiaries, associates and joint ventures

Unlike most other assets, an investment in a subsidiary, joint venture or associate can be viewed as either:

• an individual asset that can generate income, e.g. in the form of dividends; or
• as an asset that represents the underlying assets and liabilities that are under the control of the subsidiary, joint venture or the associate.

IAS 28 acknowledges this by stating:

‘In determining the value in use of the investment, an entity estimates:

1. its share of the present value of the estimated future cash flows expected to be generated by the associate or joint venture, including the cash flows from the operations of the associate or joint venture and the proceeds on the ultimate disposal of the investment; or
2. the present value of the estimated future cash flows expected to arise from dividends to be received from the investment and from its ultimate disposal.

Under appropriate assumptions, both methods give the same result.’ [IAS 28.42].

This means that there are broadly two approaches in testing for impairment: one focuses on the investment and the cash flows the parent receives (dividends and ultimate disposal proceeds) and the other considers the recoverable amount of the underlying assets of the investment and the cash flows generated by these assets. These two approaches are considered at 12.4.2.A and 12.4.2.B respectively. Whichever view is taken, the entity needs to ensure that the cash flows are appropriate (see 12.1 above in respect of considerations around intra-group transfer pricing).

It is important to note that, whether an entity calculates VIU using its share of the present value of estimated cash flows of the underlying assets or the dividends expected to be received, it is necessary to adjust them to reflect IAS 36 restrictions, e.g. those in respect of improvements and enhancements (see 7.1.2 above), restructuring (see 7.1.3 above), growth (see 7.1 and 7.1.1 above) and discount rates (see 7.2 above). A practical challenge may be to obtain sufficiently detailed information to make such adjustments for investments in entities that are not controlled by the parent, in which case the entity may have to use FVLCD to establish the recoverable amount.

12.4.3 Equity accounted investment and indicators of impairment

In connection with issuing IFRS 9, the IASB amended IAS 28 to include the impairment indicators an entity needs to use to determine whether it is necessary to recognise any additional impairment loss once it has accounted for losses, if any, under IAS 28. [IAS 28.40‑41A]. These impairment indicators are the same indicators as previously stated in IAS 39 – Financial Instruments: Recognition and Measurement – for financial assets.

The indicators of impairment require ‘objective evidence of impairment as a result of one or more events that have occurred after the initial recognition’. [IAS 28.41A]. However, one would not expect any significant difference in the impairment indicators under IAS 36 and IAS 28 because both look for objective evidence, sometimes in virtually identical terms and neither claims that its list of indicators is exclusive. [IAS 36.13, IAS 28.41A]. This means that an impairment test should not be avoided because an impairment indicator is not mentioned specifically in IAS 28.

If an entity has reason to believe that the carrying amount of an investment in an associate or joint venture is higher than the recoverable amount, this is most likely a sufficient indicator on its own to require an impairment test.

12.4.4 Equity accounted investments and long term loans

Investors frequently make long-term loans to associates or joint ventures that, from their perspective, form part of the net investment in the associate or joint venture. Under previous IFRS guidance, it was not clear whether these should be accounted for, and in particular tested for impairment, as part of the net investment under IAS 28 and IAS 36, or as stand-alone investments by applying the requirements of IFRS 9.

After receiving a request related to the interaction between IFRS 9 and IAS 28 and whether the measurement of long-term interests that form part of the net investment in associates and joint ventures should be governed by IFRS 9, IAS 28 or a combination of both, the IASB, in its October 2016 meeting, tentatively decided to propose amendments to IAS 28 to clarify that an entity applies IFRS 9, in addition to IAS 28, to long-term interests that form part of the net investment and to include the proposed amendments in the next cycle of annual improvements (2015–2017). However, in May 2017 the Board decided to finalise the amendments as a narrow scope amendment in its own right.

The amendments clarify that an entity applies IFRS 9 to long-term interests in an associate or joint venture to which the equity method is not applied but that, in substance, form part of the net investment in the associate or joint venture. This clarification is relevant because it implies that the expected credit loss model in IFRS 9 applies to such long-term interests.

The Board also clarified that, in applying IFRS 9, an entity does not take account of any losses of the associate or joint venture, or any impairment losses on the net investment, recognised as adjustments to the net investment in the associate or joint venture that arise from applying IAS 28.

To illustrate how entities apply the requirements in IAS 28 and IFRS 9 with respect to long-term interests, the Board also published an illustrative example when it issued the amendments.

The amendments were effective for periods beginning on or after 1 January 2019. Earlier application was permitted.

The amendments are to be applied retrospectively but they provide transition requirements similar to those in IFRS 9 for entities that apply the amendments after they first apply IFRS 9.

12.4.5 Equity accounted investments and CGUs

IAS 28 states that the recoverable amount of an investment in an associate or a joint venture should be assessed for each associate or joint venture, unless it does not generate cash inflows from continuing use that are largely independent of those from other assets of the entity. [IAS 28.43]. This means that each associate or joint venture is a separate CGU unless it is part of a larger CGU including other assets, which could include other associates or joint ventures.

If there is goodwill in the carrying amount of an associate or joint venture, this is not tested separately. [IAS 28.42]. However, there may be additional goodwill in the group that will be allocated to a CGU that includes an associate or joint venture, that will be tested for impairment by reference to the combined cash flows of assets and associates and joint ventures.

12.4.6 Equity accounted investments and testing goodwill for impairment

When calculating its share of an equity accounted investee's results, an investor makes adjustments to the investee's profit or loss to reflect depreciation and impairments of the investee's identifiable assets based on their fair values at the date the investor acquired its investment. This is covered in IAS 28 which states that:

‘Appropriate adjustments to the investor's share of the associate's or joint venture's profits or losses after acquisition are also made to account, for example, for depreciation of the depreciable assets, based on their fair values at the acquisition date. Similarly, appropriate adjustments to the investor's share of the associate's or joint venture's profits or losses after acquisition are made for impairment losses recognised by the associate, such as for goodwill or property, plant and equipment.’ [IAS 28.32].

Although this refers to ‘appropriate adjustments’ for goodwill impairment losses, this should not be interpreted as requiring the investor to recalculate the goodwill impairment on a similar basis to depreciation and impairment of tangible and intangible assets. The ‘appropriate adjustment’ is to reverse that goodwill impairment that relates to pre-acquisition goodwill in the investee before calculating the investor's share of the investee's profit. After application of the equity method the entire equity-accounted carrying amount of the investor's investment, including the goodwill included in that carrying amount, is tested for impairment in accordance with IAS 28. [IAS 28.40‑43]. Note that there is no requirement to test investments in associates or joint ventures for impairment annually but only when there are indicators that the amount may not be recoverable. These requirements are described in detail in Chapter 11 at 9.

Impairment write-offs made against investments accounted for under the equity method may be reversed if an impairment loss no longer exists or has decreased (see 11.4 above). Although IAS 36 does not allow impairments of goodwill to be reversed, [IAS 36.124], this impairment is not a write-off against goodwill, but a write-off against the equity investment, so this prohibition does not apply. IAS 28 states that ‘an impairment loss recognised in those circumstances is not allocated to any asset, including goodwill, that forms part of the carrying amount of the investment in the associate or joint venture. Accordingly, any reversal of that impairment loss is recognised in accordance with IAS 36 to the extent that the recoverable amount of the investment subsequently increases’. [IAS 28.42].

13.2.1 Disclosures required for impairment losses or reversals

For each class of assets the entity must disclose:

1. ‘the amount of impairment losses recognised in profit or loss during the period and the line item(s) of the statement of comprehensive income in which those impairment losses are included.
2. the amount of reversals of impairment losses recognised in profit or loss during the period and the line item(s) of the statement of comprehensive income in which those impairment losses are reversed.
3. the amount of impairment losses on revalued assets recognised directly in other comprehensive income during the period.
4. the amount of reversals of impairment losses on revalued assets recognised directly in other comprehensive income during the period.’ [IAS 36.126].

A class of assets is a grouping of assets of similar nature and use in an entity's operations. [IAS 36.127].

These disclosures can be made as an integral part of the other disclosures, for example the property, plant and equipment note reconciling the opening and closing values (as set out in Chapter 18 at 8) may contain the required information. [IAS 36.128].

Additionally, IAS 36 links disclosure of impairments with segment disclosures. Thus, if an entity reports segment information in accordance with IFRS 8 then any impairments or reversals must be disclosed by reportable segment as follows:

1. the amount of impairment losses recognised in profit or loss and directly in other comprehensive income during the period; and
2. the amount of reversals of impairment losses recognised in profit or loss and directly in other comprehensive income during the period. [IAS 36.129].

13.2.2 Material impairments

If an impairment loss for an individual asset or a cash-generating unit is recognised or reversed during the period and is material to the financial statements of the reporting entity as a whole, the following disclosures are required:

1. the events and circumstances that led to the recognition or reversal of the impairment loss;
2. the amount of the impairment loss recognised or reversed;
3. for an individual asset:
   1. the nature of the asset; and
   2. if the entity reports segmental information in accordance with IFRS 8, the reportable segment to which the asset belongs.
4. for a cash-generating unit:
   1. a description of the cash-generating unit (such as whether it is a product line, a plant, a business operation, a geographical area, or a reportable segment as defined in IFRS 8);
   2. the amount of the impairment loss recognised or reversed by class of assets and if the entity reports segment information in accordance with IFRS 8, by reportable segment; and
   3. if the aggregation of assets for identifying the cash-generating unit has changed since the previous estimate of the cash-generating unit's recoverable amount (if any), a description of the current and former way of aggregating assets and the reasons for changing the way the cash-generating unit is identified.
5. the recoverable amount of the asset or CGU and whether the recoverable amount of the asset or cash-generating unit is its fair value less costs of disposal (FVLCD) or its value in use (VIU);
6. if the recoverable amount is FVLCD:
   1. the level of the fair value hierarchy (as defined by IFRS 13, see 6.1 above) within which the fair value measurement of the asset or CGU is classified, without taking into account whether the costs of disposal are observable;
   2. if the fair value measurement is classified as Level 2 or Level 3 of the fair value hierarchy, a description of the valuation technique(s) used to measure FVLCD. The entity must disclose any change in valuation technique and the reason(s) for making such a change; and
   3. if the fair value measurement is classified as Level 2 or Level 3 of the fair value hierarchy, each key assumption on which management has based its determination of fair value less costs of disposal. Key assumptions are those to which the asset's or CGU's recoverable amount is most sensitive.

      The entity must also disclose the discount rate(s) used in the current measurement and previous measurement if FVLCD is measured using a present value technique; and

7. if the recoverable amount is VIU, the discount rate used in the current estimate and previous estimate (if any) of VIU. [IAS 36.130].

It is logically possible for impairment adjustments in aggregate to be material, yet no single one material in itself, in which case the previous requirement that relates to individual assets or CGUs could theoretically be circumvented. Therefore the following ‘catch all’ requirement is added:

‘An entity shall disclose the following information for the aggregate impairment losses and the aggregate reversals of impairment losses recognised during the period for which no information is disclosed in accordance with paragraph 130:

• 1. the main classes of assets affected by impairment losses and the main classes of assets affected by reversals of impairment losses.
  2. the main events and circumstances that led to the recognition of these impairment losses and reversals of impairment losses.’ [IAS 36.131].

In addition, in these circumstances, if there are any cases of impairment adjustments where intangible assets with indefinite useful life and goodwill are not involved, IAS 36 encourages the disclosure of key assumptions made in the recoverable amount calculations used to determine any impairments recognised in the period. [IAS 36.132]. However, as set out below, an entity is required to give this type of disclosure when goodwill or intangible assets with an indefinite useful life are tested for impairment.