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    Chapter 9

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    of 16
    CHAPTER Impairment Testing for Goodwill 9.1 How to Perform Impairment Testing for Goodwill Subsequent to the recognition of goodwill arising from business combinations in the acquirer's book, IAS 36 requires the acquirer to carry out the impairment rest for the acquired goodwill on an annual basis. Goodwill is conceptually made of two components: fair value of the going concern clement of the acquiree’s existing business and fair value of the expected synergies and other benefits from combining the acquirer's and acquirce’s net assets and businesses. The going concern element reflects the higher return that can be generated from the acquiree’s existing business (which is a combination of assets and liabilities or net assets that can create synergics) as compared to that of the net assets if they are acquired individually. The going concern clement also includes other benefits such as the ability for the acquirce to earn monop- oly profits or to get large subsidies for its operation costs. On the other hand, the remaining component of goodwill represents the synergies resulting from the combination of net assets and businesses of both the acquirer and the acquire Such a combination will create its own synergies and benefits and hence will have different values as compared to other combinations. Goodwill reflects synergies and docs not itself generate cash flows indepen dently of other assets or groups of assets, but instead supports the cash flow generation of the cash-generating unit (CGU}. The CGU is defined as the smallest identifiable group of assets that generates cash inflows that are largely indepen- dent of the cash inflows from other assets or groups of assets. Hence, impair- ment testing for goodwill is performed at the CGU level to which the goodwill 195 196 CHAPTER9 * Impairment Testing for Goodwi is connected and at which the goodwill is monitored for internal management purposes. Goodwill can be allocated to the acquirer’s CGU or group of CGUs that is expected to benefit the synergies from the business combinations. In some sircumstances, the synergies can only be obtained and realised if more than two ‘CGUs are combined together (or group of CGUs). Therefore, it is important to note that cach CGU or group of CGUs (also known as the CGU(s)) to which the goodwill is allocated represents the lowest level within the entity at which the goodwill is monitored for internal management purposes. In addition, the allo- cated CGU{s) cannot be larger than an operating segment (before aggregation) which is defined in IFRS 8 Operating Segments as follows: “An operating segment is a component of an entity A. that engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same entity), B._ whose operating results are regularly reviewed by the entity’s chief operat- ing decision maker to make decisions about resources to be allocated to the segment and assess its performance, and information is available, ‘. for which discrete finan An operating segment may engage in business activities for which it has yet to carn revenues, for example, start-up operations may be operating segments before earning revenues’. 9.2 Steps to Carry Out Impairment Testing for Goodwill The impairment testing for goodwill can be carried out in the steps shown in ure 9.1. Step 1: Allocating Goodwill to the CGU(s) In accordance with IAS 36, acquited goodwill in a business combination is required to be allocated to each of the acquirer’s CGU, or group of CGUs that generally benefits from the synergies of the business combination regardless of whether the acquirce’s other assets or liabilities are assigned to the CGU(s), FIGURE 9.1 Goodwill Impairment Testing 9.2 Steps to Carry Out Impairment Testing for Goodwill 197 However, IAS 36 does not give detailed guidance on the methodologies to allocate goodwill to the CGU(s). Theoretically and practically, management is in the best position to allocate the goodwill to the CGU(s) based on their under standing and management of the business and its operations, The allocation of goodwill must be built on a reasonable and consistent basis and should reflect how the CGU(s) can benefit the synergies arising from the transaction, The allo- cation of goodwill based on the fair value of each CGU or group of CGUs as of the acquisition date is arguably the most logical method, especially when goodwill or synergies is a key driver for the values of the CGU(s) and therefore the values of the CGU{s) reflect or incorporate synergies. In some cases, valuers further analyse the incremental values of the CGU(s) before and after the trans- action and the allocation of goodwill will be based on the upward changes in values of the CGUts). However, such a method of allocation is not a preferred option given thar such an exercise is time-consuming in nature and is often costly. Instead, the goodwill allocation on its initial recognition is commonly based on one of the following: © Fair value of the net assets and liabi identified and values in the purchase pri * Free cash flows of each CGU or group of Ci * Earnings before interest, taxes, depreciation and amortisation (EBITDA) of each CGU or group of CGUs: or * Sales of each CGU or group of CGUs. ies of cach CGU or group of CGUs as allocation (PPA); Us; It is important for valuers to learn carefully about the nature of synergies and how such synergies can benefit the CGU(s) based on relevant facts and then apply their judgment to select the best method for the allocation of goodwill. Example 9.1 Goodwill allocation In early 2016, A Ltd acquires a subsidiary company that has three product and services di ns X, Y and Z. The 2016 budget EBITDA for divisions x, Y and Z are $20 million, $30 jon and $50 million, respectively. The activities in each division represent the lowest level at which the gaodwill is monitored for internal manage- ment purposes. Goodwill of $40 million arising from this acquisition is allocated based on the proportion of EBITDA of each division as shawn in Table 9.1. ee en SY es SECIS TERESA TABLE 9.1 Goodwill Allocation Based on EBITDA ($M ) Eprtpa PROPORTION © GOODWILL ALLOCATION, B x Goodwill A As100 ‘of $40 million Division x 20 20% 8 Division Y 30 30% 12 Division Z 50 50% 20 Total 100 100% 40 CHAPTER 9 + Impairment Testing for Goodwill Higher of Value in ener ‘Use FIGURE 9.2 Recoverable Amount Step 2: Determining the Recoverable Amount of the CGU(s) IAS 36 defines the recoverable amount of a CGU as the higher of its fair casts of disposal (FVLCOD) and its value in use (VIU). How to calculate FVLCOD Under FVLCOD, a valuer has to determine the following two components: jue less. + Fair value of the CGU(s); and © Costs of disposal (excluding finance costs and income tax expense). The determination of fair value of the CGU(s) shall follow fair value measure- ment principles and guidelines under IFRS 13. The key requirement under IFRS 13 for valuers is to select the valuation methodology that maximises the use of relevant observable inputs and minimises the use of unobservable inputs. In prac- tice, the market approach" (especially the earnings capitalisation method), which involves the analysis of comparable assets and comparable market transactions, is commonly adopted for the determination of the fair value of the CGU(s). In accordance with IAS 36, costs of disposal are incremental costs directly associated with the disposal of the CGU(s), excluding finance costs and income tax expense. IAS 36 also sets out some examples of disposal costs such as legal cost, stamp duty and transaction taxes. In practice, a valuer normally uses a sin- gle percentage (say, 3% or 5%, which is similar to a success fee rate on merg- ers and acquisitions (M&A) transaction size expected by a financial adviser) on the fair value of the CGU(s) to determine the costs of disposal. The appropriate percentage to apply is often detcrmined on a case-by-case basis and is reflective of size, nature of the assumed transaction, industry practice and market partici pants” views, in particular. Example 9.2 Calculation of FVLCOD As at 31 December 2016, A Ltd (‘Co A’) performed impairment testing on the goodwill of $8 million that is allocated to one of its CGUs, Division x. Co A 1. Details of the market approach and its application are discussed in Chapter 3. 9.2 Steps to Carry Out Impairment Testing for Goodwill = 199. TABLE 9.2 Calculation of FVLCOD ($ Muuion) EBITDA EV/EBITDA multiple 7 —= Enterprise value 140 160 Cost of disposal (5% of enterprise value) fa} (8) Recoverable amount (FVLCOD) sion X. applies the FVLCOD approach in estimating the recoverable amount of Di The actual 2016 EBITDA of Division X is aporoximately $20 million. The EV/EBITOA multiple of recent transactions in relation to the companies that are comparable to division X is in the range of six to eight times. Assuming the cost of disposal accounts for 5% of the enterprise value, the recoverable amount of Division x is calculated at $114 million to $152 million a5 shown in Table 9.2. How to calculate the VIU The VIU is the present value of the future cash flows expected to be derived from an asset or a CGU. One important thing to note is that the VIU is different from fair value as defined in IFRS 13 and is different from fair value used as a premise for the determination of FVLCOD. As explained by IAS 36, fair value reflects the assumptions that the market participants would consider when pricing the CGU(s) whereas the VIU reflects certain factors that are only specific to the CGU(s) and are not available for other market participants. The steps in determining the VIU of a CGU is similar to the discounted cash flow (DCF) method under the income approach as discussed in Chapter 4. Basi- cally, there are two components: forecasted cash flows and discount rate. IAS 36 has set out additional guidelines on these two components, and some of the key requirements and considerations are summarised in Table 9.3. One of the key points noted from the requirement of IAS 36 for the puration of the VIU is that the forecast cash flows and discount rate should be on a pre-tax basis. IAS 36 highlights the potential significant impact that future income tax cash flows may have on the recoverable amount and further elabo- rates the following reasons why the calculation of the VIU should use pre-tax cash flows and pre-tax discount rate: © Future tax cash flows may result in temporary differences between the tax base of an asset and its carrying amount (after net off any impairment loss) Tax consequences of temporary differences for most assets are recognised as deferred tax assets of liabilities under the equirements of IAS 12 Income Taxes. Hence, future tax consequences of such temporary differences shall not bbe considered for the determination of the recoverable amount to avoid “dou- ble counting’; © Tax base and cost of an asset are generally the same amount upon its ini- tial recognition. Market participants would consider the benefits of future 200 © CHAPTER * Impairment Testing for Goodwill 2 aeRO RSE NR TABLE 9.3 Key Considerations on the Calculation of the VIU a Requinements AND Consiperations Requine By IAS 36 For THe CaLcuLaTion ‘VIU Components: OF THE VIU_ Forecast cash flows — * Forecast cash flows should be free from both bias and factors not related to the CGU(s); = Forecast cash flows include the cash inflows from the continuing use ‘of the CGUG), cash outflows that are necessarily incurred to generate ‘the cash inflows from the continuing use of the CGU(s) and net cash flows (if any) to be received or paid for the disposal of the CGU(s) at the end of its useful life; * Forecast assumptions are reasonable and supportable based on the management's best estimate and reflective of economic cond that will exist over the remaining useful life of the CGUIs); * External evidence to support the forecast assumptions is preferred; * Forecast cash flows are based on the most recent financial budgets! forecasts approved by management; * Forecast cash inflows affected by internal transfer pricing shall be based on the best estimate of future price(s) that could be achieved in arm's length transactions; * Forecast cash outflows include future overheads that can be attrib- | uted directly, or allocated on a reasonable and consistent basis, to | +the use of the CGU(s); | * Forecast cash flows cover a maximum period of five years, unless a | longer period can be justified; | «Forecast cash flows beyond the periad covered by the most recent budgets/foreeasts by extrapolating (e.9., for the purpose of calcu- lating terminal value) should use a steady or declining growth rate for subsequent years, unless an increasing rate can be justified. This growth rate shall not exceed the long-term average growth rate for the products, industries or countries in which the CGU(s) operate, un- less a higher rate can be justified; * Forecast cash flows (e.9., cost savings arising from reductions in staff costs) expected to arise from future restructurings which are not yet committed or from improving ar enhancing the performance of the CGU(s) are to be excluded; Forecast cash flows do not include cash flows from income tax receipts or payments (i.e., pre-tax cash flows) and financing activi- ties (in practice, post-tax cash flows are normally used together with post-tax discount rates); * Forecast cash flows do not include cash inflows from assets that gen- ‘erate cash inflows that are largely independent of the cash inflows from the CGU(s) under review and cash outflows that relate to some ‘obligations (unless such obligation is required for the calculation of the recoverable amount) that have been recognised liabilities; © When cash flows are forecasted in foreign currency, an appropriate discount for that currency is adopted in discounting the cash flows to the present value which is then translated into local or reporting ‘currency using the spot exchange rate as at the valuation date; VIU Components 9.2 Steps to Carry Out Impairment Testing for Goodwill 201 ee Ech SSE TABLE 9.3. Key Considerations on the Calculation of the VIU REQUIREMENTS AND CONSIDERATIONS REQUIRED BY IAS 36 FOR THE CALCULATION oF THE VIU Forecast cash flows Discount rate © Other factors (such as illiquidity) that market participants would reflect in pricing the forecast cash flows expected generating from the CGU(); and * Forecast cash flows should reflect the range of possible outcomes rather than a single amount. © The discount rate should be free from both bias and factors not related to the CGU(s); * The discount rate should reflect the current market assessment of the time value of money and the risks specific to the CGU(s) for which the forecast cash flows have not been adjusted; * The discount rate should not reflect the risks for which the forecast cash flows have been adjusted to avoid ‘double counting’ impact; * The discount rate should reflect the risk that is consistent with that of the forecast cash flows. For example, if cash flows are forecasted in nominal terms, then the discount rate should reflect the effect of inflation and vice versa; * WACC of the CGU(S), incremental borrowing rate or other market borrowing rates could be considered as a starting point; * Country risk, currency risk, price risk and specific risks associated with the CGU(s) should be considered; * Discount rate is independent of the capital structure of the CGU() (in practice, the capital structure of comparable companies is used for the computation of WACC and additional adjustments to the calculated WACC are considered to reflect the risks specific to the CGUGS); * Discount rate is pre-tax (in practice, post-tax discount rate is normally used together with post-tax cash flows); * Different discount rates could be considered for different future periods where the VIU of the CGU(s) is sensitive to a variance in risks for different future periods; and * Discount rate should reflect the range of possible outcomes rather than a single amount. tax cash flows associated with the asset for pricing purposes. Hence, it is not necessary to make additional adjustments to the net selling price or FVLCOD to account for the future tax benet ind * In principle, the VIU should include the present value of future tax cash flows that would result in the VIU of an asset being equal to its tax base. However, it is not easy to estimate the effect of suca a component, as the effect of tempo- rary differences has to be eliminated and the process to ensure the VIU being equal to its tax base may invelve complex computations, 202 © CHAPTERS + Impairment Testing for Goodwill Theoretically and practically, valuers find it very challenging to estimate the pre~ tax discount rate as required by IAS 36. In addition, LAS 36 does not give much detailed guidance on the calculation of the pre-tax discount rate, except that it states that theoretically discounting after-tax cash flows at an after-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 after-tax discount rate adjusted to reflect the specific amount and timing of the furure tax cash flows. Valuers are more familiar with the ealculation of the after-tax discount rate as the normal valuation approach for businesses usually involves the application of the after-tax discount rate and after-tax cash flows. Hence, in practice, valuers com- monly adopt an after-tax discount rate to discount after-tax cash flows of which the tax cash flows are calculared based on the assumption that tax depreei and accounting depreciation are the same. Specifically, the taxation is calculated based on the earnings before interest tax (EBIT) of the CGU(s) and the appli- cable income tax rate. However, such an approach should be carried out care: fully as the calculation does nor depend on the actual tax cash flows, Instead, it is assumed that there are no timing differences on the taxation and no tax losses carried forward, and therefore, only forecast cash flows that result in the VIU being equal to its tax base are included, In general, such an assumption is quite challenging considering that a CGU normally consists of various assets which have differences in tax base, tax useful life, accounting useful life and existing temporary differences as at a measurement date for impairment testing purposes. Example 9.3 Calculation of the VIU As at 31 December 2016, A Ltd (‘Co A’) performed the impairment testing on the goodwill of $8 million that was allocated to one of its CGUs, Division X. Co A applied the VIU approach in estimating the recoverable amount of Di has considered the key valuation assumptions: Forecast cash flows for an explicit period of five years; Company income tax rate of 17%; Terminal growth rate of 1%; and After-tax discount rate of 11% (mid-period discounting convention to be adapted). Based on the above key valuation assumptions, the recoverable amount of D X is estimated at $166 million, as shown in Table 9.4. TABLE 9.4 Calculation of the VIU (S Miuion) 2017° 2018 = 2019-2020 2021 —-Normatiseo —— =| Revenue 100 110 127 152 182 184 Gross profit 40 4a 1 61 73 74 Operation expense (20) (22) (25) (32) (G8) G9) Depreciation expense 6 @) @) (11) a) a) eBIT 14 15 18 18 24 24 9.2 Steps to Carry Out Impairment Testing for Goodwill 203 | mon Hr RC SS A TABLE 9.4 Calculation of the VIU Eee (S$ Mnuion) 2017-2018 = 20192020) 2021 =~ Normauiseo EBITDA 20 22 26 29 35 35 Income tax expense 17% (2) 8) @) @ @) @) Net change in the - (ay a @ @ - working capital Capex 5) (10) @ 1) ay After-tax cash flows 3 8 4 B uv Terminal growth rate | 1% | 200 and value Time factor Os 15 25 35 AS Discount rate [ 1 1%) 0.949 0.855 0.770 0.694 0.625 Present value of the 3 7 W 9 VW 125 after-tax cash flows Enterprise valuey ‘166 | Recoverable amount Total may not add up due to round offs, In this example, the discount rate of 11% is an after-tax discount rate, and therefore, the cash flows used are also after-tax. For the purpose of disclosing the pre-tax discount rate in financial statements as required by IAS 36, it is a general practice that the pre-tax discount rate is calculated by an iterative com- putation, whereby the VIU of the after-tax cash flows and after-tax discount rate is equal to the VIU of the pre-tax cash flows and pre-tax discount rate. This can be done by using the “Goal Seek’ function in an Excel spreadsheet. As shown in Table 9.5, by changing the discount rate to 13% (i.e., pre-tax discount rate) and the tax rate to 0% (i.e., to derive the pre-tax cash flows), the VIU of pre-tax cash flows remains at $166 million. Some valuers might also simply gross up the after-tax discount rate by a standard income tax rate to derive a proxy for the after-tax discount rate. In this example, should the after-tax dis- count rate of 11% be grossed up by the income tax rate of 17%, the resultant pre-tax discount rate is calculated at about 13%, which is similar to the result of the pre-tax discount rate under the iterative calculation method. However, such a calculation should be performed carefully as the pre-tax discount rate is not always the after-tax discount rate grossed up by a standard tax rate, and this is due to the dependency of the pre-tax discount rate on the timing of future tax cash flows and the useful life of the asset/CGU(s). The grossed-up discount rate by a standard tax rate can be used as a good praxy for the pre-tax discount rate in circumstances when there is no growth in the forecast cash flow over ive forecast period and tax cash flows are accounted for as a constant percentage of total forecast cash flows. 204 © CHAPTERS + Impairment Testing for Goodwill rc nn NERO SA |TABLE 9.5 Calculation of the Pre-tax Discount Rate for Disclosure Purpose (S Mituion) 2017 2018 2019 2020 2021 NORMALISED Revenue 100 110 127 152 182 184 Gross profit 40 44 51 61 B 74. Operation (20) (22) (25) G2) (38) (39) expense Depreciation expense © ® @ a) EBIT 14 1S 18 18 24 24 EBITDA 20 22 26 29 35 35 Income taxexpense 0% - - - - - - Net change in - a) a) @) @ 7 working capital Capex as) (10) @ (1) 2) a After-tax cash flows. 5 an 7 16 2 24 Terminal growth (1% | rate and value 202 ‘Time factor Os 15 25 3.5 4s Discount rate 113%] 0.941 0.834 «0.738 0.654 (0.579 Present value of 5 9 13 10 12 117 after-tax cash flows Enterprise value/Re- | 166 | coverable amount ——eaesss. Total may not add up due to round offs, What are the differences between the VIU and fair value? IFRS 13 excludes the ‘VIU from its requirements of measurement and disclosure as measurement under the VIU is similar to fair value but it is not fair value. IAS 36 further explai that the VIU reflects the effects of factors that may be specific to the the CGU{s}) and not applicable to entities (or comparable compani participants) in general, On the other hand, fair value reflects the assumptions market participants would use when pricing the asset (or the CGU(s)}- IAS 36 further gives some examples of factors that are excluded in fair value measurement to the extent thar such factors are generally nat available for market participants: s/market © Additional value derived from the grouping of assets (or the CGU(s)) (e.g, the creation of a portfolio of investment properties in different locations); = Synergies between the asset (or the CGU) being measured and other assets (or ather CGU(s))s 9.2 Steps to Carry Out Impairment Testing for Goodwill 205 © Legal rights or legal restrictions that are spe the asset (or the CGU(s}}s and + Tax benefits or tax burdens that are specific to the current owner of the asset (or the CGU(s)) However, for the computation of the FVLCOD of the CGU(s) using the DCF method, a valuer may also consider certain factors (that are specifically exeluded in the VIU computation) in the forecast cash flows but to the extent that mar. ket participants would consider such factors in pricing the CGU(s). For exam- ple, net cash flows from improving or enhancing the CGU(s)'s performance (not allowed in the calculation of the VIU) should be included in the calculation of the FVLCOD of the CGU(s) if such net cash flows are considered by market partici pants in pricing the CGUIs). ic only fo the current owner of Step 3: Comparing the Carrying Amount of the CGU{s) to Its Recoverable Amount What is included in the carrying amount of the CGU(s)?. In accordance with [AS 36, the carrying amount of a CGU shall be determined on a basis consistent with the way the recoverable amount of the Ct GU is determined, As the determination of the recoverable amount of a CGU exeludes cash flows associated with assets, that are not part of the CGU and the liabilities that have been recognised, the carrying amount of a CGU will generally * include the carrying amount of only assets that can be attributed directly, or allo- cated on a reasonable and consistent basis, These assets contribute to the genera- tion of future cash inflows used in the determination of the VIU of the CGUs and * exclude the carrying amount of any recognised liability, unless such lia bility is a key input in the determination of the recoverable amount of the CGU. What is the result of comparing the carrying amount with the recoverable amount? If the recoverable amount of the CGU(s) exceeds its cart ‘ing amount, the CGU(s) and the goodwill allocated ro the CGU(s) shall be regarded as not impaired, as shown in Figure 9.4, er “new Value in _ Use FIGURE 9.3 Carrying Amount vs Recoverable Amount 206 © CHAPTER9 + Impairment Testing for Goodwill FIGURE 9.4 Carrying Amount < Recoverable Amount On the contrary, if the carrying amount of the CGU(s} exceeds its recover- able amount, the acquirer shall recognise the impairment loss (i.e., the differ- ‘ence between the carrying amount and the recoverable amount), as shown in Figure 9.5. Step 4: Allocating the Impairment Loss to Goodwill and Other Assets of the CGU(s) ‘The impairment loss is allocated first to reduce the carrying amount of good- will and then to other assets of the CGU(s} pro rata on the basis of the earryi © Impairment aa Value in Use FIGURE 9.5 Camying Amount > Recoverable Amount 9.2 Steps to Carry Out Impairment Testing for Goodwill 207 TABLE 9.6 Goodwill Impairment ($ Mution) 31 Dec 16 FVLCOD 133 viv 166 Recoverable amount (higher of FVLCOD and VIU) 166 | Carrying value of Division X (including goodwill) 169 Impairment loss (3) amount of each asset in the CGU(s). IAS 36 further states that an entity shall not reduce the carrying amount of an asset below the highest of © its fair value less costs of disposal (if measureable}; © its value in use (if determinable); and * zero, Example 9.4 Goodwill impairment testing of Co A As at 31 December 2016, A Ltd (‘Co A’) performs the impairment testing on the goodwill of $8 million that is allocated to one af its CGUs, Division X. The FVLCOD and IU of Division X is estimated at $133 million and $166 million, respectively, and the carrying value {including goodwill) is $169 million as per financial accounts of CoA. The results of impairment testing for goodwill of Division X are shown in Table 9.6. As shown in Table 9.6, the impairment loss of $3 million will be adjusted against the carrying amount of goodwill. After the adjustment, the carrying value of goodwill will be reduced by $3 million as of 31 December 2016, as shown in Figure 9.6. F| t rer | Meroe

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