Value in Use as the Recoverable Amount (IAS 36)

Value in use (IAS 36.30-57) can be shortly defined as future cash inflows and outflows from continuing use of the asset and from its ultimate disposal, which are then discounted to reflect time value for money and risk. In practice, a single estimate of cash flows derived from budgets is used most often, but IAS 36 allows also the use of the expected value approach. See Appendix A to IAS 36 (IAS 36.A1-A14) for more discussion on this topic.

Under IAS 36, the carrying amount of assets in the statement of financial position should not be higher than the economic benefits expected to be derived from them. The amount of economic benefits is the recoverable amount as per IAS 36 terminology. Recoverable amount is the higher of an asset’s (IAS 36.6):

  • fair value less costs of disposal and
  • its value in use.

If the carrying amount is higher than the recoverable amount, the asset is impaired, i.e. entities need to decrease the value of the asset through recognition of an impairment loss.

Example: Simple impairment test of a CGU based on value in use

Below is a simple impairment test of a CGU that is based on value in use. It’s best to download and review the accompanying excel file.

Value in use calculation starts with cash flow projections:

Note: you can scroll the table horizontally if it doesn’t fit your screen

 20X120X220X320X420X5terminal
year
ForecastForecastForecastForecastForecast
Revenue3,0003,1003,1503,1503,2003,200
EBITDA1,0001,0331,0501,0501,0671,067
Depreciation (1)570570570570570570
Operating income430463480480497497
Capital expenditures (2)530530530530530570
Tax at nominal rate of 19% (3)828891919494
Reduction in tax (4)272930303131
Tax after tax credit545961616363
Cash flow generated
by the CGU before tax
470503520520537497
Cash flow generated
by the CGU post-tax
416445459459474434


Footnotes:
(1) Depreciation: this is notional tax depreciation needed for value in use purposes only (to calculate income tax charge). Notional, i.e. with the assumption that carrying value of CGU and its tax base are equal on day 1.
(2) Capital expenditures: Strictly speaking, this should include only replacements of existing assets after the end of their useful life (see the section on improvements and restructuring). It may be different from the depreciation charge e.g. due to changes in technology.
(3) Tax at nominal rate of 19%: Tax is calculated as a % of operating income. Temporary differences should be ignored as they are already included in deferred tax. Interest in impairment tests is ignored in cash flow projections, as cost of capital is reflected in the discount rate.
(4) Reduction in tax: it is assumed here that the entity from this example operates in a region with high unemployment rate and gets its tax charge reduced by a third.

Based on the cash flow projections above, the value in use in calculated as follows (see the formulas in the spreadsheet):

1,971Present value of cash flows for years 20X1 to 20X5
10,000Present value of terminal year
11,970Total recoverable amount

The discount rate (WACC) used in this calculation amounts to 5.48% and PGR (perpetuity growth rate – estimated growth rate beyond period covered by cash flow projections) to 2%.

Recoverable amount is then compared to the carrying amount of the CGU calculated as follows:

3,760Goodwill
7,230Property, plant and equipment
1,320Intangible assets
400Other assets
12,710Total carrying amount of CGU

As the carrying amount of CGU is higher than its recoverable amount by $740, the CGU is impaired and an impairment loss of $740 is recognised in P/L.


Discount rate used for the value in use calculation should reflect current market assessments of: (IAS 36.55-57 and IAS 36.Appendix A15-A21):

  • time value of money for the periods until the end of the asset’s useful life;
  • risks specific to the asset for which the future cash flow estimates have not been adjusted.

The discount rate used for testing assets for impairment should not be specific to the capital structure of the entity (IAS 36.A19). Therefore, a benchmark rate for companies in similar industry operating in the same country/region should be used instead of entity-specific one.

As a rule, IAS 36 requires discounting pre-tax cash flows with pre-tax discount rate. In practice, a different approach is commonly adopted. The discussion below and calculations in the excel file lead to a post-tax WACC.

WACC (weighted average cost of capital) is the discount rate most often used for value in use calculations. One could easily write a 500-page book on calculating WACC, but a simple approach is presented below. Note that different WACC will be applicable to cash flows in different countries, currencies or even for different products, even if within the same CGU tested.

Below is a calculation of WACC simplified for illustrative purposes. I highly recommend reviewing it in the accompanying excel file available for download. Each element of the calculation is discussed in the following sections.

Let’s start with the equation:

WACC equation
WACC equation
  • Re = cost of equity
  • Rd = cost of debt
  • g = gearing level
  • t = corporate tax rate

For example, see this calculation of WACC for a retail chain (groceries) in UK (again, check the excel file):

Input data:
1.66%UK government bond yield (30Y)
19%UK corporate tax rate
1.07beta
99%gearing
5.92%ERP (equity risk premium) (includes country risk premium)
1.96%credit spread
This gives Re and Rd at:
8.00%Re (cost of equity)
3.62%Rd (cost of debt)
Which leads to WACC at:
5.48%Calcualted post-tax WACC

There are many different approaches to estimating cost of equity. Below is an example based on the popular Capital Asset Pricing Model (CAPM). IAS 36.A17 sees CAPM as a good starting point. You can also check this excel file mentioned above for an example showing calculation of WACC for retail chain operating in UK.

CAPM equation:

Re = Rf + β x ERP

  • Re = cost of equity
  • Rf = risk free rate
  • β = beta
  • ERP = equity risk premium

Risk free rate is usually based on the yield of government bonds (denominated in the same currency as estimated cash flows) with time horizon close to the timing of cash flows. For testing CGUs with cash flows discounted into perpetuity, very long-term bonds (e.g. 20-year) should be used. If the government bond yield has a significant default risk built in the yield, entities need to adjust the government bond yield for default risk by using credit spreads.

Beta is a measure of volatility (risk) relative to the market. If a stock’s beta = 1 then the stock, statistically speaking, moves in line with the market. The reference market is usually a broad index in a given country (such as S&P 500 in the US). If e.g. beta = 1.2, then the stock in question is more volatile than the market. For example, when market is up by 10%, the stock with beta of 1.2 goes up by 12% (10% x 1.2).

Beta is calculated using regression analysis. Betas for specific entities or industries can be obtained from sources such as Bloomberg or Reuters (paid subscription). Free of charge data is published by Aswath Damodaran (http://pages.stern.nyu.edu/~adamodar/).

When obtaining betas, entities must understand the difference between unlevered and levered betas. Unlevered beta is beta of a company without debt, i.e. without the effects of financial leverage:

Unlevered beta = levered beta / [1 + (1 – tax rate) x gearing]

For the purpose of WACC used in impairment testing, entities need a levered beta, but this should not result from the gearing ratio or beta specific to the reporting entity. Instead, a benchmark gearing should be used, e.g. average gearing for the sector in the entity’s country or region.

ERP is a premium that investors expect to get because they invest in riskier assets. It is expressed as yield on the top of a risk free rate. E.g. if the risk free rate is 2% and ERP is 5%, then, on average, investors expect equities to yield 7%. ERP is usually calculated based on historical premiums, it is done by comparing returns on equities and risk free rates over a specified period.

For markets that are not mature enough, ERP is calculated by adding country risk premium (CRP) to ERP calculated for a mature market. E.g. for countries in Eastern Europe, entities can take ERP calculated for Germany and add CRP for a specific country. CRP is calculated based on sovereign rating and/or credit spreads.

As we can imagine, the whole exercise can get very sophisticated. For now, similarly to obtaining betas, entities can make use of sources like Bloomberg, Reuters (paid subscription) or Mr Damodaran.

As with cost of equity, the aim is to obtain a benchmark cost of debt, not an entity-specific borrowing rate. Estimating a benchmark cost of debt is usually a matter of adding the credit spread to risk free rate. Credit spreads can be estimated based on:

  • bond ratings for entities from relevant sector and country/region and
  • average credit spreads for bonds with the same ratings.

Another approach, adopted by Mr Damodaran, is to estimate global credit spread which is then increased by additional risk premium based on standard deviation of stock prices. Again, Bloomberg, Reuters (paid subscription) or Damodaran are your friends.

Pre-tax vs. post-tax approach

IAS 36 requires calculating value in use using pre-tax cash flows and a pre-tax discount rate. Such a requirement results from the fact that tax cash flows add complexity to value in use calculation. However, rates that can be observed on the market are generally post-tax, so in practice value in use is often calculated with post-tax cash flows and a post-tax discount rate.

Under post-tax approach to value in use calculation, tax cash flows taken for the calculation are not the same cash flows that the entity expects to pay to tax authorities. Entities should not take into account temporary differences and unused tax losses, as they are dealt with by IAS 12 and already recognised as deferred tax where appropriate.

Ideally, entities should calculate tax payments as if the tax base of the assets was equal to their recoverable amount. This would be a complex and self-feeding calculation, so in practice it is often assumed that the tax base of assets is equal to their carrying value in the statement of financial position. In other words, accounting depreciation is used when arriving at income tax charge for value in use calculation.

If there are material timing differences between tax and accounting depreciation, it is also acceptable to use tax depreciation, but then the carrying amount of CGU should also include deferred tax assets/liabilities. Deferred tax is recognised on an undiscounted basis in the statement of financial position, but for impairment testing purposes it is appropriate to use discounted amount.

IAS 36 requires to disclose pre-tax discount rate and entities should follow this requirement even if the value in use was calculated on a post-tax basis. IAS 36.BCZ85 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. The pre-tax discount rate is not always the post-tax discount rate grossed up by a standard rate of tax.’ So instead of grossing up the post-tax rate by nominal income tax rate, entities can calculate pre-tax rate iteratively, e.g. by using a goal seek spreadsheet function so that the value in use based on pre-tax cash flows and pre-tax discount rate is the same as value in use based on post-tax cash flows and post-tax discount rate.

When adopting post-tax approach, it is a good idea to disclose both discount rates: pre-tax and post-tax.

Fortunately, the IASB plans to simplify the requirements a bit by removing the requirement to use pre-tax inputs in the calculation.

It is important to be consistent in determining carrying amount of a CGU and related cash flows. For practical reasons, value in use calculation often includes cash flows related to provisions, items of working capital or hedging instruments. The carrying amount of CGU in such cases should also include those assets and liabilities, e.g. when a trade payable decreases the carrying amount of a CGU, cash flows should also be decreased by the cash outflow required to settle this payable. When including changes in working capital in terminal year (i.e. projecting them into perpetuity), entities need to make sure that this balance is reasonable and supportable based on experience (especially for entities being paid mostly by cash and having negative working capital balances). As we can see in this example, terminal year forms a substantial part of value in use.

On the other hand, some liabilities, e.g. long term post-employment benefits, are recognised and paid on an on-going basis, so it means that future payments partially relate to future events and these payments should be included in projected cash flows. In other words, entities can’t exclude payments of e.g. post-employment benefits from cash flows because they already recognised an actuarial provision. In will be difficult in practice to distinguish payments relating to provision already recognised and payments relating to service in future years, so it’s best to come up with a simplified solution, e.g. based on current service cost included in a financial forecast.

Another important thing to note is that for some provisions, notably for dismantling provisions, entities should be very cautious when including them in the carrying amount of a CGU and its value in use. These provisions are discounted using a risk free rate (as required by IAS 37) in the statement of financial position and it is not appropriate to discount related cash outflows in impairment tests using WACC applied to assets. For some CGUs, the difference may be material.

Additionally, cash flows relating to some provisions are often excluded from business plans, which in turn are used for impairment tests (e.g. timing of cash flow is unknown or expected to take place after the period covered by the plan). In such a case, the present value of cash outflow can be added separately to the value in use if the provision is taken into account in the calculation of carrying amount. Again, remember about using proper discount rate for the cash flows for which provisions are recorded (not WACC).

Example: Deferred tax liabilities and goodwill arising on fair value adjustments following a business combination

Entity A acquires Entity X for $100m. Following this acquisition, entity A recognises well-known brand of Entity X at its fair value of $70m. Brand is determined to have indefinite useful life and it is not tax deductible. Tax rate is 30%. Fair value (equal to tax base) of other identifiable assets of Entity X is $15m.

The following entries are made in consolidated financial statements of Entity A:

$mDRCR
Cash100
Brand X70
Other assets of X15
Deferred tax relating to brand X21
Goodwill (balancing figure)36

Entity A recognised $21m of deferred tax liability relating to brand X ($70m x 30%), as the tax base of brand X is $0. The brand will not be amortised, so deferred tax will be released following a disposal of, or impairment loss on, the brand

Entity X is a separate CGU and the following assets should be tested for impairment according to IAS 36. For the sake of simplicity, let’s assume that impairment test takes place one day after the acquisition and the carrying of assets did not change.

Goodwill36
Brand X70
Other assets of X15
Total121

As we can see, the carrying amount of assets to be tested is $121m, which is counter-intuitive as Entity A paid only $100m for these assets. Let’s assume that the recoverable amount of Entity X is equal to what Entity A paid, i.e. $ 100m. Does it mean that an impairment loss of $21m needs to be recognised immediately after the acquisition?

As we can see, the $21 m of excess of carrying amount over recoverable amount results from deferred tax liability relating to brand X. IAS 36 does not take into account this kind of mismatch, but in practice it is acceptable to include the deferred tax liability in the calculation of carrying amount of CGU:

Goodwill36
Brand X70
Other assets of X15
Deferred tax relating to brand X(21)
Total100

As a result, no impairment loss is recognised.


For the purpose of calculating value in use, entities should adjust the internal pricing between CGUs to arrive at estimated market prices. The requirement to adjust internal transfer pricing relates to all CGUs, not only to those with active market for their output (IAS 36.71).

Q&A – Transfer pricing between subsidiaries and impact on their separate financial statements

Entity A has two subsidiaries X and Y.  X produces goods that are then sold to Y, and Y uses them to produce final goods that are sold to external customers. X sells its goods to Y below cost, therefore X is not profitable. X would be able to sell its products to external customers at price higher than paid by Y. X and Y are separate CGUs in consolidated financial statements prepared by A.

Question 1: For the purpose of impairment tests, should entities adjust the prices paid by Y to X so that they reflect estimated market prices?

Answer 1: Yes. This is a requirement set out in paragraph IAS 36.71

Question 2: What prices should be used by entities X and Y for the purpose of impairment testing in their separate financial statements?

Answer 2: This is less obvious as IAS 36 does not refer explicitly to separate financial statements, but my answer is that in separate financial statements of X and Y prices should be adjusted as well based on IAS 36.71. If this is the case, the disclosure should make it clear what approach was applied. Prices should be adjusted by both entities X and Y.


Corporate expenses should be allocated to CGUs in the cash flow projections as set out in paragraphs IAS 36.100-103. See also illustrative example 8 to IAS 36.

IAS 36 states (IAS 36.44-49) that projected cash flows should exclude any estimated future cash inflows or outflows expected to arise from future restructurings (until the criteria for recognition of provision are met) or from improving or enhancing the asset’s performance. See also illustrative examples 5 and 6 to IAS 36. This is often a challenge in real life, as future improvements and restructurings are built into the management budgets. Preparing cash flow projections that exclude such items would often necessitate major modification of an approved budget. A common solution to this challenge is to:

  1. calculate the value in use derived from an approved budget that includes future improvements/ restructurings,
  2. estimate the present value of cash flows resulting from major future improvements/ restructurings (often based on a business case for a new project)
  3. calculate: 1. minus 2. – to arrive at value in use that excludes future major improvements/ restructurings.

If the impact of future improvements/ restructurings makes a huge difference in value in use calculation, it may be worth considering changing the base for recoverable amount calculation to fair value less costs of disposal. In arriving at the fair value of a CGU, entities may take future improvements/ restructurings into account provided that they would be taken into account by a market participant. On the other hand, in fair value calculation entities can’t take into account any circumstances specific to the reporting entity that would not be available to a third party (see IAS 36.53A).

IASB tentatively decided to allow (in future IAS 36 improvements) inclusion of cash flows resulting from a future restructuring or enhancement in value in use calculation to align it with approved budgets and forecasts.

IAS 36.54 requires future cash flows in foreign currency to be discounted using a discount rate appropriate for that specific currency and translated using the spot exchange rate at the date of the value in use calculation. This condition usually requires adjustments to management forecasts, as these are often prepared using expected exchange rates and not the spot rate.

Cash flows taken to value in use calculation should be consistent with the discount rate applied to them. As discount rate already reflects time value of money and business risks, entities should exclude interest and dividend payments from cash flows used for value in use calculation.

See other pages relating to IAS 36:

Scope of IAS 36 Impairment of Assets
IAS 36 Impairment of Assets: Cash-Generating Units (CGU)
IAS 36 Impairment of Assets: Value in Use as the Recoverable Amount
IAS 36 Impairment of Assets: Allocation and Reversal of Impairment Losses
IAS 36 Impairment of Assets: Disclosure

© 2018-2020 Marek Muc

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