In my last article, I tried to outline the main things to consider and to avoid when preparing the c

ash flow projections for the impairment tests under IAS 36 .

Here let's illustrate the theory and show the numerical example of making cash flow projections
for impairment tests.

Please be warned that there are many variations of the cash flow projections and value in use
calculations, and you should always apply your judgment (while following the rules).

And now the small recap:

The impairment testing aims at proving that the carrying amount of an asset or cash-generating
unit is LOWER than its recoverable amount .

Recoverable amount is the higher of fair value less costs of disposal and value in use.

We always know the carrying amount – please look to your financial statements or accounting
records.

However, in order to determine the recoverable amount, we need to find out either fair value less
costs of disposal or value in use.

Single asset or cash generating unit?

The first decision you should make in your impairment test is:

Should you test a single asset or a cash-generating unit?

It depends.

You should test a single asset for impairment when:

 It is possible to determine the asset's fair value less cost of disposal AND it is greater than
the asset's carrying amount. In this case, you don't have to calculate value in use, because
the asset is not impaired; or
 The asset generates anonymously identifiable and independent cash inflows.

Based on my own experience, the vast majority of companies perform impairment tests on cash-
generating units, because it is hard to determine fair value of used assets and the assets generate
independent cash inflows rarely on its own.

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For this reason, this example will show you how to draft the cash flow projections for value in
use calculation on cash-generating unit (CGU), not on an individual asset.

Example: Cash flow projections for cash-

generating unit
A parent performs an impairment test of its cash-generating unit, which is a whole subsidiary.

The carrying amount of a subsidiary, including allocated goodwill and working capital (current
assets and current liabilities), is CU 150 000.

It is not possible to determine its fair value less costs of disposal and therefore the parent
determines the subsidiary's recoverable amount based on its value in use.

At the end of 20X1, the subordinate reported the following results:

 Revenue from principal activities: CU 50 000

 Fixed costs: CU 25 000
 Variable costs: CU 15 000
 Net profit for the year before taxation: CU 10 000
 Closing working capital (net current asset): CU 1 000

For the purpose of value in use calculation, the parent makes the following assumptions:
  Based on information about the subsidiary's industry, the market expects the growth of
5% per year in average for the next 5 years, and then 2% in the long term. These rates are
nominal and include the effect of inflation.
 Pre-tax discount rate determined based on company's cost of capital is 8% pa
 Based on past experience, the company assumes the annual replacement capital
expenditure of CU 500 per year net of the inflation effect.
 Fixed are the same in real terms (hint: careful about the inflation costs!). They exclude
depreciation and amortization.
 Variable are about 30% of the revenue.
 The assumed inflation rate is 1.5% pa for the next 10 years.

Step 1 – Starting point: 5-year forecast

When you are testing a whole company or even its part as CGU, it is necessary to draft net pre-
tax cash flows generated by that CGU for a maximum of 5 years .

Our starting point is to prepare the forecast of CGU's profits – not yet cash flows.

Based on the numbers and assumptions above, we can calculate the net profits as follows:

Notes:

 Revenue in the year 20X2 was calculated as revenue in 20X1 of CU 50 000 increased by
the growth rate of 5%: 50 000*(1+5%) = 52 500. Revenues in the next years were
calculated accordingly.
 Fixed costs were increased by the inflation rate of 1.5% each year. For the year 20X2:
CU 25 000*(1+1.5%) = 25 375
 Variable are simply 30% of revenue costs
 EBIDTA = earnings before interest, depreciation, tax and amortization

Now, you might ask: Why did we stop at profit before tax, depreciation, interest and
amortization?

The reasons are as follows:

  Depreciation and amortization are not included , because they are NOT the cash items.
Our aim is to arrive at pre-tax cash flows.
 Interest is a financing item which is excluded as required by IAS 36;
 Value in use is calculated on a pre-tax basis to avoid complications related to tax losses
carried forward, deferred taxation, etc.

Step 2: Adjust EBIDTA to arrive at cash flows

Once you have your EBIDTA forecasts, you need to realize that they do not represent the cash
flow projections for value in use calculation.

Not yet.

We have to take a few more items into account:

 Changes in working capital: payments of liabilities and collections of receivables

generally do not enter into EBIDTA, but they affect the net cash flows.
Therefore, don't forget to adjust EBIDTA by the net change in working capital.
 There might be some expenditures for replacement of non-current assets in order to
maintain the production capacity of CGU. Neither those are included in EBIDTA,
because they enter in profit or loss as depreciation or amortization.

With regard to changes in working capital, you need to forecast the net balance of your working
capital at the end of each period and then adjust EBIDTA.

For example, if opening net balance of your working capital in 20X2 is CU 1 000 (net assets)
and closing balance of your working capital in 20X2 is CU 1 100, then the cash flow change in
net working capital is CU -100.

The logic is simple: you have more money tied up in a working capital at the end of 20X2 than in
the beginning of 20X2, thus the net cash flow change is negative as you have less cash available
(CU 1 000-CU 1 100).

Our adjusted cash-flow table is as follows:

Notes:

 Opening and closing net working capital numbers are forecasted, in other words – I made
them up in this example.
 Capex is assumed annual 500 increased by the inflation rate.

Step 3: Discount net cash flows with pre-tax discount rate

Now it's time to choose the most appropriate discount rate.

In many cases, companies use their own cost of capital derived by WACC model , which is often
OK for auditors, too.

However, be careful, because WACC will give you post-tax rate and you are required to use pre-
tax rate here.

You can make an attempt to calculate value in use based on post-tax rate, but in such a case your
cash flows need to incorporate tax effects – and that is not a very nice, neat and reliable exercise.

I strongly recommend calculating pre-tax rate from your post-tax rate (eg WACC) – here's an
article that can help .

However, let me add here, that this formula does not always work well. In other words, pre-tax
rate is not always the post-tax rate grossed up by the appropriate tax rate.

But let's not get into many details here, because that's the topic for another article.

One more consideration when discounting:

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You need to make a good assumption when most of your cash flows happen .
In the beginning of the year? At the end of the year? Or are they spread evenly throughout the
year?

If they are spread evenly, then you should apply so-called “mid-year convention” in calculating
your discount factors.

For example, let's say that you want to discount cash flows in the year 2 and you assume they are
spread evenly throughout the year 2.

Thus you will use the number 1.5 as number of years in the discount factor formula. It indicates,
that the cash flows happen in the middle of the year 2.

In the following table, I use the year-end convention . For example, in the year 2, I use number 2
as number of years in the discount factor formula:

Notes:

 Discount factor for the year 20X3 (year 2) = 1/((1+8%) to the power of 2)
 Present value of cash flows in the year 1 = net cash flows in the year 1 of 10 768
multiplied with the discount factor for the year 1
 Net present value = sum of all present values of cash flows in individual years

Step 4: Calculate terminal value

As I explained in the previous article , terminal value is a very important number because it
estimates the net cash flows beyond forecasted period of maximum 5 years.
In some cases the terminal value represents the net cash flows to receive from the sale of an asset
at the end of its useful life.

However, in this particular case we can reasonably assume that a subsidiary – our CGU in testing
– will operate its business for an indefinite number of years.

Therefore the terminal value estimates the net cash flows beyond forecasted period .

Two most common methods to calculate it are:

1. Exit multiple – this is the multiple of shareholders' cash flows in the last year of
projections.
In our example, we assume to make net cash inflow of 17 032 CU at the end of year 5 in
your projections.Market data says that similar companies sell for multiple of 10 meaning
that to sell your company you can ask ten times your net shareholders ' cash flow.

In this case, you can estimate your terminal value to be 10 x 17 032 = 170 320.

Then you need to discount it with the pre-tax discount rate: 170 320 * 0.681 = 115 988
and include in the cash flow projections.

2. Perpetuity – you will take the last year's projection and apply perpetuity formula to it.
In this example, we project the net cash inflow of 17 032 CU at the end of year 5.We
assume the long-term growth rate to be 2% and your pre-tax discount rate is 8%.Then we
can apply the growing perpetuity formula which is the cash flow after the first period
divided by the difference between the discount rate and the growth rate.
In fact you are calculating growing perpetuity as a series of periodic payments that grow
at a proportionate rate for an infinite amount of time.So, your terminal value would be:
o CU 17 032, being the net cash flow in the last year (year 5) – just note that here it
is unadjusted, but you should adjust it for terminal value calculation if needed;
o Increased by the annual rate of 2%: CU 17 032*(1+2%)= 17 373;
o Divided by the difference between the discount rate of 8% and growth rate of 2%
= 17 373/(8%-2%) = 289 550;
o Discounted to present value, because you calculate this at the end of year 5 = 289
550 * 0.681= 197 184

As you can see, the two amounts are different when we use different methods:

 Exit multiple method: CU 115 988; and

 Perpetuity method: CU 197 184.

This is quite normal, because perpetuity method assumes to carry on with business and accept
business risks beyond 5 years, and exit multiple method assumes selling the business and getting
rid of all associated business risks.

Which method to apply?

When the plan is to sell a subsidiary after 5 years, then exit multiple is probably more suitable
method.

However, when the plan is to continue the business indefinitely, then perpetuity method is more
acceptable.

Step 5: Sum up and calculate value in use

To arrive at value in use, we must sum up the net present value of cash flows in the next 5 years
and the present value of terminal value:

 Net present value of cash flows: CU 54 139

 Present value of terminal value (using perpetuity method): CU 197 184
 Value in use: CU 251 323

You can now see why you should get the terminal value right: it represents 78% of value in use.

The carrying amount of CGU was CU 150 000. Value in use is CU 251 391, which is much
greater than the carrying amount and thus there's no impairment.

Final words
Please – if you calculate your value in use very close to the carrying amount, then expect that
your auditor will ask a lot of questions and examine your calculations thoroughly.

The reason is that in such a sensitive case , even a slight shift in your assumptions can bring you
from “no impairment” to “impairment loss like a hell”.

Did you like this article or do you have any questions? Please leave me a comment below.
Thanks!