Kpmg Ingles Nic 36

CORPORATE FINANCE

Praktische Umsetzung des IFRS Impairment Test nach IAS 36WP/StB Dr. Marc Castedello, Partner KPMG Mnchen

Vortrag LMU Mnchen, 1. Februar 2006

ADVISORY

2006 KPMG Deutsche Treuhand-Gesellschaft AG, the German member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International.

1 2006 KPMG Deutsche Treuhand-Gesellschaft Aktiengesellschaft Wirtschaftsprfungsgesellschaft, the German member firm of KPMG International, a Swiss cooperative. All rights reserved. The KPMG logo and name are trademarks of KPMG International.

Agenda

1. Concept of impairment test

2. Level of impairment test

3. Carrying amount of CGUs

4. Valuation approaches for recoverable amount

5. Fair value less cost to sell

6. Value in use

7. Comparison value in use and fair value

8. Example


1. Concept of impairment testAccounting for business combinations

Impairment preparationPPA IFRS 3

Determination of acquisition

cost

Purchaseprice

allocation

Definition ofcash generating

units

Impairment Test IAS 36

Allocationof assets

and liabilities

1. IDENTIFICATION

Goodwillallocation

Impairmenttest

2. ANALYSIS 3. VALUATION

Identification of all tangible assets with expected deviation between fair value and book valueIdentification of intangible assets and contingent liabilitiesThose intangible assets which do not meet the relevant accounting criteria are part of goodwill

Determination of fair value of identified assets and liabilities/contingent liabilitiesCalculation of deferred taxes Determination of the remaining goodwill

Determination of valuation methods for the assetsDetermination of valuation assumptions (e.g. useful live) for the assetsGathering of data for the valuation


Assets have to be carried at no more than their recoverable amount:

CGU >

1. Concept of impairment testRecoverable amount

asset carrying amount

CGU asset

recoverable amount

Recoverable amount is the greater of . . .Value in use

Present value of the future cash flows expected to be derived from an asset or CGU

Reflecting the internal perspective of accounting company

If either fair value less costs to sell or value in use exceeds the assets carrying amount, it is not necessary to estimate the other amount

Fair value less costs to sellThe amount obtainable from the sale of an asset or CGU in an arms length transaction between knowledgeable, willing parties, less costs of disposal

Reflecting the external perspective of market in which the company is operating


1. Concept of impairment testCash generating unit

A cash-generation unit is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or group of assets.

CGU

CGUs without allocated goodwill CGUs with allocated goodwill

assets goodwill

IAS 36.69:

an entity considers various factors including how management monitors the entity's operations () or how management makes decisions about continuing or disposing of the entity's assets and operations.

IAS 36.81:

the lowest level within the entity at which the goodwill is monitored for internal management purposes


2. Level of impairment test Impairment test of intangible assets (without goodwill)

Most important assets that have to be tested for impairment are intangible assets like brands, customer relationship, technology, patents etc.Fair value of this assets has been assessed on their individual level of each single asset, because independent cash inflows are no prerequisite to determine fair valueCharacteristic of these assets is, that they regularly do not produce any independent cash inflows, but create the latter in combination with other assetsFrom a value in use perspective these assets have to be tested on a CGU level

but

According to IAS 36.22 they can be tested on a individual level for impairment as long as their fair value can be determined individually and the latter is higher as their carrying amountImportant simplification for many intangible assets, because methodology of PPA process can be used as well for impairment test


2. Level of impairment testImpairment test of assets (without goodwill)

Can fair value less costs to

sell be determined for individual asset?

Fair value less costs to sell

>carrying amount

Fair value less costs to sell

>carrying amount

Asset generates largely independent

cash flows?

Value in use>

carrying amount

Value in use>

carrying amount

no impairment

CGU

impairment

impairment

no impairment

no impairment

no impairment

CGU

individual asset

individual asset

No

No

No

Yes

YesYes

Yes Yes

No

NoNo

Yes

Impairment test on individual

asset level

Impairment test on

CGU level

Source: IDW RS HFA 16


2. Level of impairment test Impairment test of assets (without goodwill)

Practical problem:IAS 36 is focussing on cash-inflows. Thus, cash-outflows can be dependent from cash-outflow for other assets

Therefore, a cash-flow statement on CGU-level is no prerequisite

Example: Retail Group

Market a

Customers market a

Cash-inflows

Market b

Customers market b

Logistic centre Procurement

Cash-outflows

Cash-inflows

Each market basically builds a CGU!

but:

1) expansion in new geographical markets

2 key account management


2. Level of impairment test Impairment test of goodwill (I)

Goodwill does not generate cash flows independently from other assets or group of assets

IAS 36.80: For purpose of impairment testing, goodwill is allocated to CGUs or groups of CGUs, that are expected to benefit from the synergies of the combination. IAS 36.82: One has to take into account how management monitors the operations. Therefore, the development of additional reporting system is typically not necessaryIAS 36.80b: The CGU shall not be larger than a segment based on either the entitys primary or the entitys secondary reporting format determined in accordance with IAS 14 Segment Reporting (IAS 36.80)IAS 36.81: In terms of a methodology no certain rule of allocation exists (non-arbitrary, IAS 36.81). Goodwill can even be assigned to units, which have not been acquired in the particular transaction

Goodwill does not necessarily reflect synergies, but value drivers that fail to meet the identification criteria of IAS 38.Management are the people who decide about the acquisition (and not the local management of the units). Decision can only be based on existing reporting system.

In practice, tendency to test on segment level

Possible allocation measures relative cash flows of CGUs relative EBIT/EBITDA of CGUs relative fair values of assigned intangibles to CGUs

A business combination leads to one goodwill, even though a SPA comprises different values for different legal entities. A goodwill cannot lead to a badwill for a single CGU and a higher goodwill for the remaining CGUs


2. Level of impairment test Impairment test of goodwill (II)

Quelle: IFRS-Praxis

Group

Segments (IAS14)

Strategic business units

Operative business units

Profit centre

Legal entities


3. Carrying amount of CGUsPrinciples of allocation

Overall principle(IAS 36.75)

The carrying amount of a CGU shall be determined on a basis consistent with the way the recoverable amount of the CGU is determined.There is just one carrying amount, which is independent how the recoverable amount is determined

Working Capital(IAS 36.88)

For practical reasons allocation is accepted. In practise due to overall principle and cash flow determination very common.

Tax assets Assets and liabilities in connection with taxes like deferred tax assets and liabilities and current tax asset and liability are not considered

Minority interests The goodwill does not comprise the minority interest. Due to the fact that recoverable amount includes minority interest the carrying amount has to be grossed up

Recognised liabilities(IAS 36.76b)

Basically, no financing activities are considered

Pensions The recoverable amount should be determined without any consideration of pension costs at all. Consequently, pensions must be deducted in the carrying amount. Alternatively, recoverable amount can be reduced by pensions liability, which correspondingly has to be considered in the carrying amount


4. Value categories for recoverable amount Value in use and fair value less cots to sell

Recoverable amount

Value in use Fair value less cost to sell

Valuation perspective

Assessment of asset/CGU in its current condition within the company

Income approach only (see also IDW RS HFA 16 Tz. 20)

true synergy effect between CGUs / assetsno improvements or enhancementsno future restructuringno cash flows from financing and taxes on income

WACCmarket participant tax rateexisting capital structure of CGU(s)

Valuation approaches

After the IDW RS HFA 16 Tz. 20 hierarchy: 1. market approach2. income approach

Assessment of asset / CGU from the perspective of a hypothetical buyer less cost of disposal

Composition of estimates of future cash flows

no true synergy effects between CGU / assetscash flow from financing & taxes on income

Cost of capital WACCmarket participant tax ratemarket-based capital structure


4. Valuation approaches for recoverable amountValue in use and fair value less costs to sell

Market approach

2. Market price on active markets (IAS 36.26)

1. Binding sale agreement(IAS 36.25)

Income approach

Discounted cash flow method (IAS 36 BCZ 16)

Value in use

3. Best information available (IAS 36.27)

Fair value less cost to sell

Analogy method: recent transactions for similar

assets (IAS 36.27)

Net selling price reflects the markets expectation of the

present value of future cash flows (IAS 36

BCZ 11(b))

Value in use is the enterprises estimate of the present value of the future cash

flows (IAS 36 BCZ 11 (c))

Level 1active markets

Level 2quoted prices

Level 3observ. market

inputs

Level 4 not directly observ.

market inputs

Level 5entity inputs

Fair Value Hierarchy

FASB

US-GAAP comparison


5. Fair value less costs to sellMarket approach

Market approach is usually not applicable for single assets, but for CGUs

Multiples reflect current market transactions to indicators that drive the profitability of the asset

Indicators might be revenue, market shares, operating profit, cash-flow

However, observable market prices are often difficult to be transferred to fair value in terms of IFRS 3

Market approach

Determination of multiples based on comparable transactions

Market capitalisation of comparable company that equals

CGU

What about analysts

estimations?

Historic Transaction

Price

Sales / EBIT Sales / EBIT Market Capitalisation

Multiple

Premium

Synergies

Do buyer specific synergies increase

fair value?

Has a control premium to be added in order to reflect fair

value?


5. Fair value less costs to sell Income approach

The relevant cash flows are determined on the basis of cash flow forecasts for the CGU

In practise, typically managements estimation of cash flows is used, but IAS 36 requires to focus on market expectations, which means the use of external rather than internal figures

The cash flow projection has to be consistent with the determination of the carrying amount

One has to bear in mind that the valuation object is not an enterprise, but a bundle of assets

Basically, the cash flows can be calculated as follows:

The tax rules of the country in which the cash flows are generated have to be applied

The costs for disposal have to be deducted. Depending on the size of the transaction a range of 0,5 to 3,0 % seems to be reasonable

CGU of Capital Invested of Change ICrate tax Corporate t

CGU of Taxes andInterest before Earnings EBITwhere

IC-t)-(1EBITflowCash

CGU

CGU

CGUCGUCGU

===

=assets of CGU

financial assets

receivables

inventories payables

short term accruals


5. Fair value less costs to sell Income approach cost of capital

For all methods of the income approach: The relevant cash flows have to be discounted to present value

For asset valuation, the entity value has to be determined, because the asset is - unlike legal entities in case of enterprise valuations - not a legal subject with own financing activities

However, financing is a decision on the level of the investor. But how are single assets or CGUs typically financed by a hypothetical buyer? Practical answer: Long lived assets and CGUs are typically financed by equity and debt. For practical reasons the WACC is applied. Working capital is usually debt financed.

WACC = [re * E/(D+E) + rd * D/(D+E) * (1-t) ]

Capital structure of companies typically

operating these assets

Equity rate of return of the asset/CGU

corroborated from peer group companies

Corresponding tax rateto taxation of cash flow


5. Fair value less costs to sell Valuation summary

The standard requires to base fair value on the best information available if neither a binding sales agreement nor an active market for the asset is existing

This does not mean that the standard wants the final judgement to be based on one single valuation approach (market versus income)

This seems to be consistent with the Fair Value Measurement Project under US-GAAP

However, the practical problem arises how to rank a market value e.g. based on comparable transactions and a DCF value after it is unlikely that they result in the same value

One possible solution might be taking an weighted or unweighted average, but finally the conclusion is based on professional judgement!

DCF-value

EBITDA-multiples

Market Capitalisation

0 10 20 30 40

Carrying amount


6. Value in use Basis for cash flows

Cash flow projections shall be based on the following (IAS 36.33):

The most recent financial forecast approved by management

The period covered by the forecast shall be no more than 5 years unless a longer period can be justified

Beyond this period, the projections of the forecast shall be extrapolated

The growth rate shall not exceed the long term average growth rate of relevant products, industries and markets unless a higher rate can be justified

N This seems to make the value in use look like the more attractive approach that can be summarized as follows: An impairment is the penalty for expression of a lack of creativity in terms of forecasting [Schildbach, T., WPG 10/2005, page 558]BUT (IAS 36.34):

Management assesses the reasonableness of the assumptions on which its current cash flow projections are based by examining the causes of differences between past cash flow projections and actual cash flows.

Management shall ensure that the assumptions on which its current cash flow projections are based are consistent with past actual outcomes, provided the effects of subsequent events or circumstances that did not exist when those actual cash flows were generated make this appropriate.


6. Value in use Estimates for future cash flows

Closer look makes the approach looking much less attractive, as cash flowsShall include company specific expectations and factors like synergies between the object to be valued and other assets

Shall not include cash inflows/outflows from

a future restructuring to which the entity is not yet committed

much stricter than IDW S1 / HFA 10 improving or enhancing the assets (CGUs) performance

what is improvement or enhancement of a CGU?

financing activities

income tax receipts or payments (IAS 36.44 and IAS 36.50)

Topical issue in practice, but often neglected

Technical problemfor discount rate


6. Value in use Discount rate

The discount rate shall be a pre-tax rate (IAS 36.55)Problem: The calculation of a pre-tax discount rate on basis of the CAPM requires a market risk premium on a pre-tax basis which is not availablePragmatic solution:

In principle, value in use should be an enterprise-specific measure determined in accordance with the enterprises own view of the best use of that asset. Logically, the discount rate should be based on the enterprises own assessment both of the time value of money and of the risks specific to the future cash flows from the asset. However, IASC believed that such a rate could not be verified objectively.Therefore, IAS 36 requires that the enterprise should make its own estimate of future cash flows but that the discount rate should reflect, as far as possible, the markets assessment of the time value of money. Similarly, the discount rate should reflect the premium that the market would require from uncertain future cash flows based on the distribution estimated by the enterprise.

The value in use is calculated with an after-tax WACCIn order to meet the equivalence criteria the cash flow must also be determined after-tax The resulting value is the value in use The calculation includes the TAB in line with the calculation of the fair value less costs to sell (IAS 36.BCZ85)To determine the pre-tax WACC, the cash flow has to be adjusted by income taxesFollowing the assumption that a pre-tax valuation equals a post-tax valuation, the pre-tax WACC should be determined via goal-seeker


7. Comparison value in use and fair value less cost to sellDiscount rates

Parameter of WACC

Value in use Fair Value less cost to sell

Cost of equity Peer Group (Beta derivation)Base rate of business plan currency (differention)Levered Beta reflects capital structure of CGU/companyMarket risk premium (depending on cash flow origination)individual risk discounts premium in terms of cash flow projection of management

Financing costs of CGU

Long-term growth rate

As enhancement / improvement of assets /CGU must not be taken into consideration, long term growth limited, sometimes even zero or negative (IAS 36.36)

Long-term market growth rate

Consideration of taxes (after tax WACC)Taxes reflect country specific marginal rate of tax (weighted)After tax cash flows (same tax rate)Adjustment of after tax WACC into pre tax

Capital structure from CGU/company

Cost of debt Financing costs of peer group

Peer Group (Beta derivation)Base rate of business plan currency (differention)Levered beta reflects target structure of peer groupMarket risk premium (depending on cash flow origination)

Taxes Consideration of taxes (after tax WACC)Taxes reflects country specific marginal rate of tax (weighted)After tax cash flow applying same tax rate

Capital structure Capital structure from peer group


7. Comparison value in use and fair valuePotential advantages of the fair value less cost to sell

Elimination of synergies

Fair value less cost to sell

Value in use

Reduction of complexity as the business plan does not have to be adjusted by effects from restructuring and extension of capital investments

Harmonisation with fair value according to US GAAP

Elimination of future cash inflows or outflows expected to arise from future restructurings or from improving or enhancing asset's performance

+

+

+

+

-

-

-

-


7. Comparison value in use and fair valueTypical approach for goodwill impairment test

Determination fair value less cost to sell

Fair value less cost to sell > value in use

yes

no

Carrying amount >Fair value less cost to sell

Determination value in use

Impairment based on value in use

impairment based on Fair value less cost to sell

no impairment

yesno

no

yes

Carrying amount > value in use


8. Example: Fair value less cost to sell Financials cash generating unit

No allocation of these assets according to

IAS 36

t=0 t=1 t=2 t=3 t=4 ff.

Plan Results (sustained growth) 2,0%Sales turnover 3.000,00 3.100,00 3.200,00 3.264,00Operating costs 1.740,00 1.798,00 1.856,00 1.893,12EBITDA 1.260,00 1.302,00 1.344,00 1.370,88EBITDA - Margin 42,0% 42,0% 42,0% 42,0%

195,00 213,00 230,00 235,00EBIT 1.065,00 1.089,00 1.114,00 1.135,88EBIT- Margin 35,5% 35,1% 34,8% 34,8%

Interest 0,00 0,00 0,00 0,00EBT 1.065,00 1.089,00 1.114,00 1.135,88Tax 30% 319,50 326,70 334,20 340,76EAT 745,50 762,30 779,80 795,12

Allocated items for CGUGoodwill 100,00 100,00 100,00 100,00 100,00

Fixed assets 3.800,00 4.000,00 4.500,00 4.700,00 4.700,00

Current assets 1.000,00 1.300,00 1.600,00 1.700,00 1.763,00

Tax assets

Net Assets 4.270,00 4.480,00 4.690,00 4.950,00 5.013,00

Pension claims

Interest accrued liabilites

Other 630,00 920,00 1.510,00 1.550,00 1.550,00


8. Example: Fair value less cost to sellImpairment test (1/2)

t=0 t=1 t=2 t=3 t=4 ff.

EBIT 1.065,00 1.089,00 1.114,00 1.135,88Adjusted tax on profits 30% 319,50 326,70 334,20 340,76NOPLAT 745,50 762,30 779,80 795,12+Amortisation 195,00 213,00 230,00 235,00-/+ Capital expenditures -395,00 -713,00 -430,00 -235,00-/+ Investment working capital -10,00 290,00 -60,00 -63,00-/+ Investment other assets 0,00 0,00 0,00 0,00Free cash flow 535,50 552,30 519,80 732,12

WACC 7,3% 7,3% 7,3% 7,3%Terminal growth 2,0%Present value of cash flows 499,07 479,71 420,76 11.181,62

Sum of cash flows 12.581,160,00

Fair Value 12.581,16Disposal costs 2% 251,62Fair Value less cost to sell 12.329,54

Carrying Amount 4.270,00

Impairment indication - No -


8. Example: Fair value less cost to sellImpairment test (2/2)

WACC - Derivation

Cost of Equity 8,5%

Cost of debt 5,0%

Average capital structure of market participants 80,0%

Market value debt capital 80Market value total capital 100

Standard business tax rate 30,0%

Tax Shield 1,2%

WACC 7,30%


Example: Value in use Financials cash generating Unit

Elimination of enhancement and

improvement including operating

consequences

Assumption:No sustainable growth due to limitation of

investment on replacement

t=0 t=1 t=2 t=3 t=4 ff.

Plan Results 0,0%Sales 3.000,00 3.000,00 3.000,00 3.000,00

Operating costs 1.740,00 1.740,00 1.740,00 1.740,00EBITDA 1.260,00 1.260,00 1.260,00 1.260,00EBITDA - Margin 42,0% 42,0% 42,0% 42,0%

Depreciation 195,00 195,00 195,00 195,00EBIT 1.065,00 1.065,00 1.065,00 1.065,00EBIT- Margin 35,5% 35,5% 35,5% 35,5%

Interest 0,00 0,00 0,00 0,00EBT 1.065,00 1.065,00 1.065,00 1.065,00Tax 30% 319,50 319,50 319,50 319,50EAT 745,50 745,50 745,50 745,50

Allocated item for CGUGoodwill 100,00 100,00 100,00 100,00 100,00

Fixed assets 3.800,00 3.800,00 3.800,00 3.800,00 3.800,00

Current assets 1.000,00 1.250,00 1.550,00 1.650,00 1.713,00

Taxed assets

Net Assets 4.270,00 4.270,00 3.980,00 4.040,00 4.103,00

Pension claims

Interest accrued liabilities

Other 630,00 880,00 1.470,00 1.510,00 1.510,00


Example: Value in use Impairment test (1/2)

t=0 t=1 t=2 t=3 t=4 ff.

EBIT 1.065,00 1.065,00 1.065,00 1.065,00Adjusted tax on profits 30% 319,50 319,50 319,50 319,50NOPLAT 745,50 745,50 745,50 745,50+Amortisation 195,00 195,00 195,00 195,00-/+ Capital expenditures -195,00 -195,00 -195,00 -195,00-/+ Investment working capital 0,00 290,00 -60,00 -63,00-/+ Investment other assets 0,00 0,00 0,00 0,00Free Cash flow 745,50 1.035,50 685,50 682,50

WACC 7,6% 7,6% 7,6% 7,6%Terminal growth 0,0%Present value of cash flows 692,84 894,39 550,26 7.208,62


Value in use 9.346,12

Carrying Amount 4.270,00

Impairment indication - No -


Example: Value in use Impairment test (2/2)

WACC - Derivation

Costs of equity 8,5%

Cost of debt 5,0%

Capital structure CGU 60,0%

Market value debt capital 60Market value total capital 100

Standard business tax rate 30,0%

Tax Shield 0,9%

WACC 7,60%


Example: Value in use Determination of the real pre-tax discount rate

Pre-tax rate by iterative

computation acc. IAS 36 BCZ 85

Operating result pre-taxation

t=0 t=1 t=2 t=3 t=4 ff.

EBIT 1.065,00 1.065,00 1.065,00 1.065,00Adjusted tax on profits 0% 0,00 0,00 0,00 0,00NOPLAT 1.065,00 1.065,00 1.065,00 1.065,00+Amortisation 195,00 195,00 195,00 195,00-/+ Capital expenditure -195,00 -195,00 -195,00 -195,00-/+ Invested working capital 0,00 290,00 -60,00 -63,00-/+ Invested assets 0,00 0,00 0,00 0,00Free cash flow from tax 1.065,00 1.355,00 1.005,00 1.002,00

WACC from tax 11,1% 11,1% 11,1% 11,1%Terminal growth 0,0%Present value of cash flows 958,32 1.097,15 732,24 6.558,41


Value in use 9.346,129.346,12
Agenda1. Concept of impairment testAccounting for business combinations1. Concept of impairment testRecoverable amount1. Concept of impairment testCash generating unit2. Level of impairment test Impairment test of intangible assets (without goodwill)2. Level of impairment testImpairment test of assets (without goodwill)2. Level of impairment test Impairment test of assets (without goodwill)2. Level of impairment test Impairment test of goodwill (I)2. Level of impairment test Impairment test of goodwill (II)3. Carrying amount of CGUs Principles of allocation4. Value categories for recoverable amount Value in use and fair value less cots to sell4. Valuation approaches for recoverable amountValue in use and fair value less costs to sell5. Fair value less costs to sellMarket approach5. Fair value less costs to sell Income approach5. Fair value less costs to sell Income approach cost of capital5. Fair value less costs to sell Valuation summary6. Value in use Basis for cash flows6. Value in use Estimates for future cash flows6. Value in use Discount rate7. Comparison value in use and fair value less cost to sell Discount rates7. Comparison value in use and fair valuePotential advantages of the fair value less cost to sell7. Comparison value in use and fair valueTypical approach for goodwill impairment test8. Example: Fair value less cost to sell Financials cash generating unit8. Example: Fair value less cost to sellImpairment test (1/2)8. Example: Fair value less cost to sellImpairment test (2/2)Example: Value in use Financials cash generating UnitExample: Value in use Impairment test (1/2)Example: Value in use Impairment test (2/2)Example: Value in use Determination of the real pre-tax discount rate

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Kpmg Ingles Nic 36