Valuation requirements in impairment testing: A strategic perspective

When it comes to impairment testing, getting the methodology right matters. It’s more than a compliance exercise. It can provide a clear view of asset performance and future viability when done right. However, it can misstate asset values and obscure risks if done poorly.

In the second instalment of our ‘Valuation requirements in impairment testing: A strategic perspective’ series, our experts discuss the practical components of impairment testing, including how to identify cash-generating units (CGUs), choose the right valuation method, and handle tax and lease considerations. Throughout our series, we discuss how engaging a valuation specialist can help management avoid common pitfalls and confidently withstand scrutiny from auditors and the regulator.

Identification of cash-generating units

A CGU is defined as the smallest identifiable group of assets that generates cash inflows largely independently of other assets. In plain terms, it’s the lowest level at which you can isolate cash flows for an asset or group of assets.

Getting CGU identification wrong can lead to inaccurate impairment conclusions.

If a CGU is drawn too broadly, strong assets can mask the underperformance of weaker ones (delaying necessary write-downs). If drawn too narrowly, a supportive asset might be unfairly tested on its own and get written down when it actually contributes value as part of a larger group.

When determining CGUs, management and directors should consider:

• Independence of cash flows: Do specific assets or operations generate cash on their own, or only as part of a larger unit? For example, a factory that produces intermediate goods solely for use in another division likely isn’t an independent CGU - it’s part of a larger CGU
• Geographical or operational separation: If different locations or product lines have largely separate markets and cash flows, they might be separate CGUs. Conversely, interconnected operations (e.g. a mining asset and its dedicated port and rail infrastructure) typically form one CGU
• Asset interactions: If one asset’s output is used by another internally, they likely belong to the same CGU. For instance, you wouldn’t usually test a corporate brand name for impairment separately from the business that uses the brand, since the brand alone doesn’t generate cash independently of that business.

Finally, document the rationale for CGU definitions and goodwill allocations. Consistency from year to year is expected; if you change CGU structure, be prepared to explain why (e.g. due to a business reorganisation or divestment) and ensure goodwill is reallocated on a reasonable basis. A systematic approach to defining CGUs and allocating goodwill will make impairment tests far more reliable and easier to audit or defend under scrutiny.

Valuation methodologies for recoverable amount

There are two primary routes for estimating recoverable amount: value in use (VIU) and fair value less costs of disposal (FVLCD).

Deciding which to use and applying them correctly is crucial.

VIU: This is an income approach valuation - essentially a discounted cash flow (DCF) valuation of the asset or CGU, using its remaining useful life or an appropriate projection period. The standard requires that VIU be based on reasonable and supportable assumptions, with a few key considerations set out below:

• No ‘extra’ future restructurings or asset enhancements can be included in VIU beyond those the company is already committed to. For example, you can’t assume a major expansion or a radical efficiency improvement in the VIU unless you have started or committed to that plan, because that would be valuing a different asset than the one in its current condition
• Cash flow forecasts should come from budgets/business plans that management has approved. Beyond the detailed forecast period, you may use steady or declining growth projections (no significant extrapolations)
• Terminal value assumptions must be supportable - the growth rate in perpetuity is typically assumed to mirror inflation unless there is strong evidence that the CGU will grow faster indefinitely
• The discount rate should reflect the risks specific to the CGU. It’s typically derived from the company’s weighted average cost of capital (WACC) or cost of capital, adjusted (if necessary) for risks for which the cash flows aren’t already adjusted. Since VIU is an entity-specific value, using the company’s own WACC (adjusted to the CGU’s risk profile) is common practice.

FVLCD: This is essentially an exit price for the asset/CGU, i.e. what it would fetch in a sale (minus any costs to sell). Fair value can be estimated using a market approach (e.g. using valuation multiples from comparable transactions) or an income approach (DCF) or even replacement cost approach if applicable, but framed from a market participant perspective.

• Key points:
  • If available, FVLCD should consider factors like market sentiment, synergy value to typical buyers, and actual precedent transaction metrics. For example, if similar businesses have been selling for 8x earnings before interest, taxes, depreciation and amortisation (EBITDA) in recent transactions, that might inform your fair value estimate for a CGU, however you need to adjust for size, growth, or other differences, which is a matter of judgement and open to scrutiny by regulators
  • Any disposal costs (transaction costs) should be deducted to get to the ‘less costs to dispose’ part. This is typically based on the valuers’ experience or evidence of costs incurred on similar transactions
  • Independent valuations or appraisals may be sought, especially for unique assets - this is where engaging a specialist is often critical. If you choose FVLCD for something like a specialised property or mining asset, a professional valuer can provide a market valuation supported by industry data and transaction evidence. Auditors and regulators take comfort in fair values that are backed by independent and qualified valuers who undertake a robust process
  • Fair value should be from a market participant’s viewpoint, not a fire sale (orderly transaction is assumed).

Using the right method:

The choice of method often depends on the nature of the asset and the availability of data:

• If an asset is highly specialised or for internal-use only, VIU might be the only viable method (because no active market or comparable sales exist)
• If an asset is readily marketable or there have been comparable transactions (e.g. investment properties, or a business unit similar to others being bought and sold in mergers and acquisitions (M&A) deals), FVLCD may be the more evidence-based route
• From a mining perspective, a VIU assessment is likely to be undertaken if a company's project is producing. Whereas if the asset is placed on care and maintenance because the project is not currently economically viable, a FVLCD using a comparable transactions approach is likely to be more appropriate
• VIU via DCF is commonly used for goodwill and intangibles attached to a larger business, but it should be cross-checked with market evidence (perhaps by deriving implied valuation multiples from the DCF and seeing if those are in line with comparable transactions).

Tax considerations in impairment models

Valuation models for impairment need to handle tax carefully to avoid distortion. Accounting standards require the recoverable amount to be assessed on a pre-tax basis, meaning the final impairment decision (write-down or not) is based on comparing a pre-tax carrying value to a pre-tax recoverable amount. However, since pre-tax discount rates are not directly observable in the market, in practice most valuers (and accountants) perform the valuation on a post-tax basis and then convert it to a pre-tax equivalent for disclosure.

• Post-tax approach with iterative solve for pre-tax rate: It’s common (and acceptable) to calculate value in use (VIU) using post-tax cash flows and a post-tax discount rate (WACC). To comply with AASB 136, an implied pre-tax discount rate is then back-solved such that, if you applied that rate to pre-tax cash flows, you’d get the same present value. This works because the value of a CGU should theoretically be the same whether calculated on a pre-tax or post-tax basis.
• Excluding tax losses: A frequent error in VIU calculations is the misapplication of carry-forward tax losses. The error occurs when companies mistakenly include the benefit of unused tax losses in the cash flow projections (on the logic that those losses shelter future taxable income, effectively increasing future cash flows). However, if those tax losses are expected to be utilised, their benefit should already be reflected as a deferred tax asset (DTA) on the balance sheet. Including them in the VIU effectively double counts the benefit: once as a DTA, and again as higher post-tax cash flows. This will overstate the recoverable amount and potentially mask an impairment. The correct approach excludes carry-forward tax losses from the impairment test calculations. The CGU’s recoverable amount should be based on operating cash flows from the assets, ignoring any benefit of prior tax losses; any DTA from tax losses is assessed separately under accounting standards for deferred taxes.

Right-of-use assets under IFRS 16

Management and directors should remember that leased assets are subject to impairment just like owned assets.

It’s not uncommon for right-of-use (ROU) assets to be overlooked in impairment reviews because they are relatively ‘invisible’ (no physical owned asset, just a right-to-use accounting entry), but doing so can be significant. For instance, the ROU asset could be impaired if a company has an onerous lease (say, above-market rent for a location that underperforms). The impairment loss might effectively represent the economic penalty of being locked into a lease where the costs exceed the benefits.

An ROU asset (for example, a lease for office space, retail stores, or equipment) should be tested for impairment either individually or as part of a CGU, depending on how it generates cash:

• Typically, an ROU asset works with other assets to generate cash. For example, a leased storefront is integral to the retail CGU operating in that location. The lease asset doesn’t generate cash independently of the products sold in the store and the workforce running it. In such cases, the ROU asset’s carrying value is tested as part of the relevant CGU (e.g. included in the store’s CGU carrying amount and recoverable amount calculation).
• If a leased asset generates independent cash inflows, you would test it on its own. In practice, this is uncommon – one scenario might be a property lease for a sub-let building where the rental income from subtenants is the cash inflow associated with that ROU asset. However, management should be aware that where a (head) lessee subleases an asset and transfers substantially all of the risks and rewards incidental to ownership of the underlying asset to the sublessee, the head lessee no longer recognises a ROU asset but rather a receivable, which would be subject to impairment requirements in AASB 9 Financial Instruments.

Conclusion

In summary, companies should consider not just the assets they own but also those they lease when thinking about impairment. A comprehensive impairment review will cover all non-financial assets, irrespective of ownership. Valuation specialists can assist in ensuring that ROU assets are properly included in CGUs and that their impact on cash flows is correctly captured.

BDO’s valuation team brings technical expertise, market data, and independent judgement that can enhance the quality of an impairment review. Engaging a valuation specialist is an investment in getting it right.

The next instalment of our three-part series, 'Valuation requirements in impairment testing: A strategic perspective’ advises on how to avoid pitfalls and add strategic value to the impairment testing process.