Friday 1 May 2015
In this document, we will review some of the requirements for the cash flow projections prepared for the value in use calculation used in impairment testing.
Remember that an impairment test is performed if an entity detects an indicator that an asset may be impaired. An impairment test may also need to be performed if the entity has recognized goodwill or an intangible asset with an indefinite life on its balance sheet when it acquired the asset in question. Finally, an entity may also need to perform an impairment test, if it is in the process of building or creating an intangible asset that is not ready for use.
When assets do not individually generate cash flows, for the purposes of the impairment test, they are grouped together into cash generating units. For example, the different pieces of equipment and the infrastructure at a mine would normally be grouped into a cash-generating unit (CGU) at the level of the mine, since cash is only generated through the shipment of ore from the mine. In the subsequent paragraphs of this article, the word asset will be used interchangeably with cash generating unit.
The impairment test is performed by comparing the CGU's carrying amount to its recoverable amount which is the greater of its fair value less costs of disposal or its value in use. If either of the fair value less costs of disposal or the value in use is greater than the carrying amount, it is not necessary to calculate the other. If however, they are both inferior to the carrying amount it is necessary to calculate both to see which one is greater.
On the other hand, if the asset is held for disposal, or if there is no reason to believe that an asset's value in use materially exceeds its fair value less costs of disposal, there is no requirement to calculate its value in use.
Fair value versus value in use
According to IFRS 13 Fair Value Measurement, the fair value of an asset may be determined using the most appropriate of three possible approaches - the market approach, the cost approach and the income approach. The income approach uses a discounted cash flow model which may at first glance seem similar to the value in use approach. The principal difference is that the fair value calculation will reflect assumptions that market participants would use when pricing the asset. Conversely, the value in use reflects the effects of factors that may be specific to the entity and not applicable to entities in general.
A review of the notes to the financial statements produced by multiple mining companies in recent years indicates that the recoverable amount is often based on the fair value less costs of disposal. This would seem to indicate that the assumptions used by a market participant sometimes result in a higher value than the value in use calculations. Notwithstanding this apparent tendency, the value in use still generally needs to be calculated to determine which value is greater - the value in use or the fair value less costs of disposal.
The value in use approach
Value in use is defined in IAS 36 Impairment of Assets (paragraph 6) as the present value of the future cash flows expected to be derived from an asset or cash-generating unit.
The value in use is calculated using the following steps:
- The future cash inflows and outflows from continuing use of the asset are estimated
- The cash inflow from the ultimate disposal of the asset is estimated.
- These cash inflows and outflows are then discounted using an appropriate discount rate.
The remainder of this article will focus on the steps involved in estimating future cash inflows and outflows from continuing use of the asset. The particularities of the other two elements will be addressed in a separate document.
Assumptions used and basis for the cash flows
The future cash flows are estimated based on the approved budgets and forecast for a period of up to five years. Subsequent to that, the cash flows are extrapolated using the long-term growth rate for the industry. Here are some of the restrictions and guidelines outlined in IAS 36 Impairment of Assets for the value in use approach.
Basisfor cash flows
- Basic assumptions:
- Use: reasonable and supportable assumptions, giving greater weight to external evidence
- Avoid using: unreasonable or unsupportable assumptions, or assumptions that are contrary to external evidence and cannot be supported
- Basis for cash flow projections up to 5 years:
- Use: the most recent financial budgets or forecasts approved by management for a period up to 5 years
- Avoid using: although the cash flow forecast will generally extend beyond 5 years, the portion beyond the fifth year should be based on an extrapolation of the 5th year, unless the use of management forecasts can be justified
- Growth rate for extrapolations of cash flow projections beyond 5 years:
- Use: asteady or declining growth rate for subsequent years, unless an increasing rate can be justified
- Avoid using: along-term average growth rate that exceeds the rate for the products, industries, or country in which the entity operates, or for the market in which the asset is used, unless a higher rate can be justified
- Estimated costs and savings:
- Avoid using: the impact of future restructurings or improvements or enhancements of the asset's performance
Before using the next year's budget as a basis for the value in use calculation, management should ensure that past budgets were reasonable predictors of actual financial results. This can be done by reviewing the budget variance analysis for the previous two years and understanding the underlying reasons for the variances. Once this understanding is obtained, one can then assess if these variances are likely to repeat themselves in the future. If they are likely to repeat themselves, notably because of the way the budget is prepared, management may need to assess if an adjustment is required to the budget before using it in the value in use calculation.
If the past variances are negligible, one might ask if the assumptions used in the current budget are consistent with past performance and with current conditions.Even if they are consistent with past performance, if current conditions have changed significantly since the budget was prepared, it may need to be adjusted.
One of the key factors that needs to be considered is the expected commodity price for the minerals produced by the mine. If the long-term or consensus price forecasts that are generally available in the marketplace are significantly different from the levels used to prepare the budgets or the forecast, management may need to modify the assumptions related to price in the budget or forecast before they are used for the purposes of the impairment tests. Such a change would certainly need to be considered if there was a significant and enduring decrease in commodity prices.
In the interests of having a well-documented file, it will be worthwhile ensuring that a budget and a forecast have been prepared or updated and approved prior by management prior to the valuation dates for the impairment test.
Preparation of the cash flow projections from continuing use
The estimated cash flow projections from continuing use need to include the following elements:
- Estimated cash inflows
- Estimated cash outflows incurred to generate the cash inflows that can be directly attributed, or allocated on a reasonable and consistent basis, to the asset
IAS 36 Impairment of Assets provides guidelines of what items are to be included or excluded in the cash flow projections used in a value in use calculation. These guidelines are presented in the table below. Generally, they are designed to avoid inconsistencies such as the double-counting or the overlooking of certain types of cash flows. Such inconsistencies might occur for instance if a factor is taken into account or ignored in both the cash flows and the discount rate or in the cash flows and the financial statements.
Items to be included or excluded in the cash flows
- Impact of general inflation on prices:
- Include: if the discount rate includes a premium related to inflation
- Exclude: if the discount rate does not include a premium related to inflation (i.e. if it is limited to the real return)
- Servicing costs:
- Include: day-to-day servicing costs
- Overhead costs:
- Include: overhead costs that can be attributed directly, or allocated on a reasonable and consistent basis
- Preparation costs to make an asset ready for use or sale:
- Include: those not yet recognized in the carrying amount of the asset
- Exclude:those already recognized in the carrying amount of the asset
- To avoid double-counting, exclude cash flows:
- Generated independently by assets other than those under review (i.e. receivables)
- Related to obligations already recognised as liabilities (i.e. payables, or mine rehabilitation provisions)
- Impact of restructuring (cash flows are to be estimated using the current condition of the asset):
- Include: savings from a future restructuring to which an entity is already committed, if the entity has incurred the related costs and/or recognized a restricting provision (using guidelines in IAS 37)
- Exclude: savings from a future restructuring to which an entity is not yet committed
- Impact of improvements to assets (cash flows are to be estimated using the current condition of the asset):
- Exclude:net savings from improvements or enhancements of an asset's performance
- Maintenance costs:
- Include: necessary to maintain the level of economic benefits expected to arise from the asset in its current condition
- Replacement costs:
- Include: of assets with shorter lives when multiple useful lives are involved
- Financing costs (already implicit in the discount rate):
- Exclude: cash flows related to financing
- Income taxes (as a pre-tax rate is used):
- Exclude: cash flows related to income taxes
Foreign currency future cash flows
Since many mining operations are located in countries where more than one currency is involved, the projections need to be prepared taking into consideration the foreign currency aspects. Future cash flows are estimated in the currency in which they will be generated and then discounted using a discount rate appropriate for that currency. An entity translates the present value using the spot exchange rate at the date of the value in use calculation.
When preparing a value in use calculation for an operating mine, it is important to prepare the cash flow projections taking into account the restrictions and guidelines outlined in IAS 36 Impairment of Assets. If possible, the file should be prepared in a manner that shows how the forecast procedures complied with the restrictions. A well-documented file will facilitate the review and audit processes as well as the preparation of the calculation in future years.
About the author
John S. Cochrane is a chartered public accountant who worked as an auditor and consultant at PricewarterhouseCoopers form 1977 to 2003 and at Raymond Chabot Grant Thornton from 2004 until he retired in 2014. From 2010 to 2014, he acted as the IFRS champion for his firm, helping and guiding the firm's partners, staff and clients with the Canadian conversion to IFRS. During this period, he acted as a member on CPA Canada`s IFRS task force for the mining industry and acted as an internal consultant with respect to IFRS matters for mining clients. He has acted as the instructor for IASeminars' IFRS for Mining course since 2012.
Note that IASeminars offers the following course that is relevant to this article: