Blind Freddy – Common errors in accounting for impairment – Part 2c – Errors in determining discount rate

The ‘Blind Freddy’ proposition is a term used by Justice Middleton in the case of ASIC v Healey & Ors [2011] (Centro case) to describe glaringly obvious mistakes.

The essence of our ‘Blind Freddy’ series is to highlight instances where, despite the accounting standards being very clear on a particular accounting treatment, preparers regularly ignore the clear requirements, resulting in financial statements being potentially materially misstated.

In previous articles we have looked at the following ‘Blind Freddy’ errors relating to impairment testing:

Not testing for impairment when AASB 136 Impairment of Assets clearly requires it – Part 1
Basic errors in determining value in use – cash flows - Part 2a and Part 2b.

In this article we look at ‘Blind Freddy’ errors when determining the discount rate to be used in a value in use (VIU) model.

Basic requirements

AASB 136, paragraphs 55 and 56 summarise the requirements for the discount rate to be used when calculating value in use of an asset or cash-generating unit (CGU).

Some typical Blind Freddy errors relating to the discount rate include:

Using a group weighted average cost of capital (WACC) to test a single asset or CGU
Double counting adjustments for variability in future cash flows
Applying bias (optimism) to discount rates
Using an unadjusted incremental borrowing rate as the discount rate
Not adjusting WACC for security over assets that are not being evaluated for impairment, or the impact of other revenue streams of the entity
Not using a pre-tax discount rate
Incorrectly calculating a pre-tax discount rate.

Discount rate

The discount rate (rates) shall be a pre-tax rate (rates) that reflect(s) current market assessments of:

(a) the time value of money; and

(b) the risks specific to the asset for which the future cash flow estimates have not been adjusted.

AASB 136, paragraph 55

A rate that reflects current market assessments of the time value of money and the risks specific to the asset is the return that investors would require if they were to choose an investment that would generate cash flows of amounts, timing and risk profile equivalent to those that the entity expects to derive from the asset.

This rate is estimated from the rate implicit in current market transactions for similar assets or from the weighted average cost of capital of a listed entity that has a single asset (or a portfolio of assets) similar in terms of service potential and risks to the asset under review. However, the discount rate(s) used to measure an asset’s value in use shall not reflect risks for which the future cash flow estimates have been adjusted. Otherwise, the effect of some assumptions will be double-counted.

AASB 136, paragraph 56

Using a group WACC to test a single asset or CGU

The first type of common error you could make when determining the discount rate of a specific asset or CGU is using your unadjusted weighted average cost of capital (WACC) when your group has multiple assets and projects.

Although AASB 136 does refer to WACC, this can only be used for a single asset company because AASB 136 requires that the discount rate must reflect the risks specific to the asset.

Example

Entity A has three business lines:

Business line X is a steady annuity business that Entity A is a market leader in this area
Business line Y is a profitable business line three years into its estimated product lifecycle of ten years
Business line Z is in the start-up phase and represents the use of innovative and unproven technology to enter a new market sector.

It would be inappropriate to use Entity A’s WACC as the discount rate to test Business Z for impairment.

Blind Freddy Error 1

Using the unadjusted WACC as the discount rate in a value in use calculation for a specific asset or CGU that does not have the same risk profile as the rest of the entity.

Double counting adjustments for variability in future cash flows

In Part 2a we discussed the two available methods used to address the risk of variations with cash flows, i.e. either:

Adjust the cash flows to reflect the uncertainty and ranges of cash flows, or
Use a discount rate that incorporates the risk of uncertainty.

A ‘Blind Freddy’ error is to incorporate uncertainty into both the cash flow forecasts and adjust the discount rate for this uncertainty.

When an asset-specific rate is not directly available from the market, an entity uses surrogates to estimate the discount rate. Appendix A provides additional guidance on estimating the discount rate in such circumstances.

AASB 136, paragraph 57

The techniques used to estimate future cash flows and interest rates will vary from one situation to another depending on the circumstances surrounding the asset in question. However, the following general principles govern any application of present value techniques in measuring assets:

….For example, a discount rate of 12 per cent might be applied to contractual cash flows of a loan receivable. That rate reflects expectations about future defaults from loans with particular characteristics. That same 12 per cent rate should not be used to discount expected cash flows because those cash flows already reflect assumptions about future defaults.

Extract of AASB 136, paragraph A3(a) of Appendix A

Appendix A is an integral part of AASB 136

Blind Freddy Error 2

Double counting adjustments for variability in cash flows (and not reading Appendix A of AASB 136 - This appendix is an integral part of the Standard).

Applying bias (optimism) to discount rates

Appendix A expressly states that discount rates are to be free from bias.

Estimated cash flows and discount rates should be free from both bias and factors unrelated to the asset in question..

Extract of AASB 136, paragraph A3(b) of Appendix A

Example

Entity B has a pre-tax WACC of 10%.

It has three business units, two profitable and in well-established sectors (X&Y), and a third business sector (Z) that is only marginally profitable, in a highly competitive market and in a sector that is experiencing declining demand.

It would be wrong to apply a 10% discount rate to business line Z.

As a starting point in making such an estimate, the entity might take into account the following rates:

the entity’s weighted average cost of capital determined using techniques such as the Capital Asset Pricing Model;
the entity’s incremental borrowing rate; and
other market borrowing rates.

AASB 136, paragraph A17 of Appendix A

However, these rates must be adjusted:

to reflect the way that the market would assess the specific risks associated with the asset’s estimated cash flows; and
to exclude risks that are not relevant to the asset’s estimated cash flows or for which the estimated cash flows have been adjusted.

Consideration should be given to risks such as country risk, currency risk and price risk.

AASB 136, paragraph A18 of Appendix A

Blind Freddy Error 3

Applying bias to discount rates by not making appropriate adjustments for specific risks associated with an asset.

Using an unadjusted incremental borrowing rate as the discount rate

In many cases, an entity’s borrowing rate will be reduced, either because the lender has security over assets that are not being evaluated for impairment, or because of the impact of other revenue streams of the entity. Unless an entity is a single asset entity, it is unlikely the incremental borrowing rate reflects an asset specific discount rate.

Blind Freddy Error 4

Using an unadjusted borrowing rate as the discount rate for entities that are not single asset entities.

Not adjusting WACC for security over assets that are not being evaluated for impairment, or the impact of other revenue streams of the entity

Entity C has two operating business - one is to operate as an investment property business, renting out commercial buildings, and the other is a retail operation in the garden centre sector.

Entity C’s borrowings are fully secured against all of its properties and it therefore has a reduced cost of borrowings because of the security given to the lender.

It would be wrong to apply an unadjusted WACC to the garden centre business because of the impact on the borrowing rate of the security given on the investment properties.

Blind Freddy Error 5

Using an unadjusted WACC where the input for the cost of borrowings has been inappropriately reduced by the impact of securities given against borrowings.

Not using a pre-tax discount rate

Paragraph 55 requires the discount rate used to be a pre-tax rate. Therefore, when the basis used to estimate the discount rate is post-tax, that basis is adjusted to reflect a pre-tax rate.

AASB 136, paragraph A20 of Appendix A

Example

Entity D is a single asset business and has a WACC of 10%. Entity D uses 10% as the discount rate in the VIU model.

This is not in line with the requirements of AASB 136 to use a pre-tax discount rate because WACC is a post-tax discount rate.

Blind Freddy Error 6

Using WACC, which is a post-tax rate as the discount rate for the VIU model.

Incorrectly calculating a pre-tax discount rate

Example

Entity E is a single asset business and has a WACC of 10%.

Entity E calculates the pre-tax discount rate (assuming a corporate tax rate of 30%) to be 14.28% (10%/0.7) as the discount rate in the VIU model.

Unfortunately, calculating a pre-tax discount rate is not as simple as grossing up the post-tax discount rate. If a post-tax borrowing rate or WACC is used as a starting point for determining a pre-tax discount rate, a two step process needs to be adopted, i.e.:

Determine the post-tax cash flows by modelling out the quantum and timing of tax payments to arrive at post-tax cash flows, which can then be discounted using the WACC (post-tax discount rate) to arrive at ‘recoverable amount’, and then
Use the ‘recoverable amount’ and pre-tax cash flows to determine the internal rate of return/pre-tax discount rate.

Blind Freddy Error 7

Doing a simple gross up of the WACC/post-tax discount rate to arrive at a pre-tax discount rate.

Next month

In next month’s article we look at common errors made when determining ‘fair value less costs of disposal’.