to external evidence.
(b) Base cash flow projections on the most recent financial budgets/forecasts
approved by management, excluding any estimated future cash inflows or outflows
expected to arise from future restructurings or from improving or enhancing the
asset’s performance. These projections can only cover a maximum period of five
years, unless a longer period can be justified.
(c) Estimate cash flow projections beyond the period covered by the most recent
budgets/forecasts by extrapolating them using 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].
7.1.1
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,
Impairment of fixed assets and goodwill 1461
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
1462 Chapter 20
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
&n
bsp; 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
Impairment of fixed assets and goodwill 1463
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.
Example 20.11: Distinguishing enhancement and maintenance expenditure
A telecommunications company provides fixed line, telephone, television and internet services. It must
develop its basic transmission infrastructure (by overhead wires or cables along streets or railway lines, etc.)
and in order to service a new customer it will have to connect the customer’s home via cable and other
equipment. It will extend its network to adjoining areas and perhaps acquire an entity with its own network.
It will also reflect changes in technology, e.g. fibre optic cables replacing copper ones.
Obviously, when preparing the budgets which form the basis for testing the network for impairment, it will
make assumptions regarding future revenue growth and will include the costs of connecting those customers.
However, its infrastructure maintenance spend will inevitably include replacing equipment with the current
technology. There is no option of continuing to replace equipment with something that has been
technologically superseded. Once this technology exists, it will be reflected in the entity’s budgets and taken
into account in its cash flows when carrying out impairment tests, even though this new equipment will
enhance the performance of the transmission infrastructure.
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.
1464 Chapter 20
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 27), 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.
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 288