The adoption of IFRS 16 brings with it changes to other standards. In this article we explore the effect IFRS 16 has on impairment testing, in particular the changes that will need to be made to impairment testing models.
Under IAS 17 operating leases were ‘off-balance sheet.’ This meant that for the purposes of impairment testing, operating lease payments were incorporated into the cashflow forecasts used for determining value in use of an asset or cash generating unit (CGU). With the exception of short-term leases and leases of low value assets, IFRS 16 results in the recognition of right of use (ROU) assets and corresponding lease liabilities.
What impact will this have on my value in use (VIU) cashflows?
Cashflows arising from lease liabilities will need to be excluded from cashflow forecasts as these are financing activities for which there is a specific exclusion under IAS 36. This may seem straightforward; however, caution is required as there are a number of payments which will not be included in the lease liability which will need to be included in cashflow projections. For example:
- Contingent or variable rents such as turnover rents
- Estimates of changes arising from rent reviews which have not been resolved at the balance sheet date
- The impact of future changes in indices and rates which will be included in the lease liability based only upon current rates
- Low value or short term leases where the recognition exemption has been taken
- Where an asset is required for the CGU to continue but the lease is due to expire during the forecasting period, the impact of renewing the lease should be shown. In this scenario, possible approaches would be to either factor in capital outflow to replace the existing asset on expiry or the inclusion of periodic cash flows to lease a similar asset over the forecast period.
In comparison, the treatment of the ROU asset is simpler, as this will be added to the carrying value of assets in the CGU (or tested on its own if it generates independent cashflows).
What if my asset and liability can’t be separated?
There may be some situations where the asset and liability cannot be separated - for example, if the asset were to be sold, the buyer would have to assume the relevant liability. In these situations the liability is deducted from both the value in use (VIU) recoverable amount as well as the carrying amount in order to ensure the two remain comparable. The resulting impact should overall net to nil (a common error here is only deducting it from one side) – see paragraph 78 of the standard.
Will my discount rate change as a result of the adoption of IFRS 16?
The discount rate that is used should be estimated from:
- The rate implicit in current market transactions for similar assets, or
- The weighted average cost of capital (WACC) of a listed entity that has a single asset (or portfolio of assets) similar in terms of service potential and risks to the asset (or CGU) under review.
So the answer is yes, you would expect the discount rate to change as a result of IFRS 16. This is because lease liabilities will now form part of the capital structure for the entities used to derive the WACC from which the discount rate is estimated.
On transition, the difficulty arises from the fact that historic capital structures will not have included liabilities in respect of operating leases; therefore, there may not be any data on capital structures to allow a WACC to be calculated. In such cases, the WACC may need to be derived using an estimation technique. A starting point might be to estimate what the lease liabilities would be using the minimum lease payments which would have previously been included in lease disclosures. In future years, this WACC can then be refined as comparable market data is reported.
What if we are assessing for impairment based on fair value less costs of disposal (FVLCD)?
As a reminder, IAS 36 requires the recoverable amount to be based on the ‘higher of’ the VIU and fair value less costs of disposal (FVLCD). An asset or CGU is impaired only if its carrying amount is in excess of both its VIU and FVLCD. Where the VIU indicates an impairment, you will need to assess the FVLCD before determining if an impairment exists.
The requirements of paragraph 78 of the standard will apply to FVLCD calculations, so if the lease liability would have to be assumed by a buyer, then the liability must be deducted from the recoverable amount as well as the carrying amount.
For help and advice on leasing related matters please get in touch with your usual BDO contact or Mark Edwards.
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