Dealing with impairment of assets, or cash generating units (CGU), involves one quite difficult task – to determine asset’s / CGU’s recoverable amount. Sometimes it might be an easy job, especially when fair value can be established and it is probably higher than value in use. But when there is no fair value available (or for any other reason), then we have to cope with calculation of asset’s / CGU’s value in use.

What is value in use? You could find definition in several standards, including IAS 36, but let’s try it quickly: Value in use is present value of future cash flows expected to be derived from asset / CGU under review. And, in order to arrive at present value, we must ensure that both future cash flows and discount rate are pre-tax.

Now here is the difficulty. As you know, you always look at the market for some appropriate market rate that you can use in your value in use calculation. But! The rates in the market, especially for equity, are stated post-tax. So what to do?

Solution 1 – Simple, but not precise way

One solution to this problem could be simple grossing up your post-tax market rate and tax rate, like in the following formula:

pre-tax rate = post-tax rate / (1 – tax rate)

Now let me say although this method is very simple, in my opinion it should be used just rarely, if in any case. For example, when asset or CGU is not that material to your company, or variance in a discount rate does not cause any material errors in value in use.

Special For You! Have you already checked out the  IFRS Kit ? It’s a full IFRS learning package with more than 40 hours of private video tutorials, more than 140 IFRS case studies solved in Excel, more than 180 pages of handouts and many bonuses included. If you take action today and subscribe to the IFRS Kit, you’ll get it at discount! Click here to check it out!
Why not to use this simple method as the basic one? The main reason is that in most cases, the timing of your tax payments is never the same as timing of your tax base (income and expenses). Many entities pay taxes one year after obtaining taxable revenues and expenses. And that might cause significant difference in your real pre-tax rate and pre-tax rate calculated this way. You should bear in mind that pre-tax rate must take not only asset’s / CGU’s post-tax rate and relevant tax rate into account, but also asset’s / CGU’s useful life and timing of future cash flows.

So how to calculate pre-tax rate more precisely?

Solution 2 – “Top-down” calculation

If you have obtained market rate that is post-tax and you have pre-tax cash flow projections for your asset / CGU under review, you can try to use this method. It’s kind of other way round and I’ll try to draft it in 3 steps:

Step 1 – Estimate post-tax cash flows

First of all, we shall calculate asset’s / CGU’s value in use with application of post-tax rate. But hang on a minute – we have post-tax rate and pre-tax cash flows and this inconsistency would not give us the answer even close to correct. Therefore, I would do the following:

  • Estimate future tax payments from our pre-tax cash flow projection. Do it on a year-by-year basis. But be careful here. If you want to be really precise, you should take various tax issues into account – for example, future tax allowances related to asset / CGU, utilization of future tax losses, temporary differences, etc. Simply – try to estimate tax payments as realistic as possible, not by multiplying tax base and tax rate.
  • Deduct estimated future tax payments from pre-tax cash flows. And also do it on a year-by-year basis.

Fine, thus we arrive at post-tax cash flows.

Step 2 – Calculate value in use on post-tax basis

That is clear. You have post-tax cash flows in your table and you also have post-tax discount rate. So using discounting technique, get present value of your post-tax cash flows.

Before I get to the last step, let me remind simple consistency rule: when calculating value in use, you should be consistent to avoid double counting. And, you should arrive to the same result. So, when you calculate value in use using post-tax cash flows and post-tax discount rate, that rate shall be the same as calculated from pre-tax values. In other words:

post-tax cash flows discounted by post-tax rate
= pre-tax cash flows discounted by pre-tax rate
= value in use

The step 3 is derived from this logic.

Step 3 – Calculate pre-tax rate from value in use and pre-tax cash flows

That’s why I call it “top down” calculation. You just work out the rate at which the present value of pre-tax cash flows equals the value in use. Sure, this is not as easy as it seems, because it requires using certain iteration technique. But all is doable!

Now you might ask: Why to bother with pre-tax rate when we already have value in use from post-tax values? The answer is that you might be required to disclose your pre-tax discount rate in the notes to the financial statements or elsewhere when necessary.

Please watch the video with the explanation here:

If you’d like to review numerical calculation of pre-tax rate together with demonstration of simple iteration technique in MS Excel, please check out the video on this topic that is part of our IFRS Kit.