A European example of challenges in determining the appropriate discount rate for purposes of the impairment calculation

Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA) (for more background see here); this is from their 13th edition:

• “The issuer operates in the renewable energy sector and manufactures and sells solar panels. It was in the process of listing on a regulated market. The prospectus under review included IFRS financial information for the years 2009, 2008 and 2007.
• In 2007, the issuer recorded 171 million euro of goodwill as a consequence of the acquisition of the solar panels´ manufacturing business from another entity. This was the only intangible asset with indefinite useful life recognised in the statement of financial position.
• More than 99% of the goodwill was allocated to the manufacturing of solar panels CGU. In its impairment test, the recoverable amount of the CGU was determined by calculating value in use based on pre-tax cash flows over a six year period…
• In determining the discount rate, the issuer calculated the cost of debt as the average of the interest rates on its outstanding borrowings, but excluded a long-term subordinated loan from the calculation.
• The issuer disclosed that no goodwill impairment losses had been recognized. The budgeted gross margins that were disclosed considered the expected market development. The growth rates were consistent with those forecasted in the industry sector and the discount rates were determined before tax and reflected specific risks related to the relevant segments. The issuer disclosed that an increase of 0.5 percentage points in the discount rate would not lead to recognition of goodwill impairment. Nonetheless, the decrease in the disclosed discount rate from 2008 to 2009 was larger than the 0.5 percentage points scenario included in the sensitivity analysis in the 2009 financial statements.”

The enforcer (as ESMA likes to term it), concluded that the issuer didn’t comply with IAS 36, requiring it to review the impairment calculations, to record the resulting goodwill impairment and to provide additional disclosures in its financial statements. There were several aspects to this, one of them being that the cash flow estimates used in these calculations simply didn’t agree with the issuer’s own financial budgets. Perhaps the following aspect is the more interesting one though:

• “IAS 36 paragraphs 55 – 57 require the discount rate to be a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the asset for which the future cash flow estimates have not been adjusted. In particular, the enforcer noted that IAS 36 paragraph A19 requires the discount rate to be independent of the entity’s capital structure and the way the entity financed the purchase of the asset.
• The enforcer did not agree with the cost of debt used by the issuer in the post-tax weighted average cost of capital (WACC) calculation, since the credit risk spread applied did not reflect current market assessments of the time value of money and the risks specific to the asset. The enforcer requested the entity to recalculate its debt rate, considering as a starting point (IAS 36 paragraphs A17 – A19) all new loans entered into by the issuer in 2009 that reflect the current market assessment of credit risk, as well as the long term subordinated loan that was originally excluded from the calculation.”

Just a starting point

Unfortunately, the summary of the issue is too general to allow engaging with it in much depth. Even so, it seems to encapsulate the considerable difficulties of putting the theory of IAS 36 into practice. Although the summary cites the requirement to determine a discount rate that’s independent of the entity’s own capital structure, it then immediately goes on to impose what seems like a highly artificial approach to the issue, heavily driven by the specific components of that very capital structure. That is, the interest rate attaching to the new loans entered into during 2009 might be driven higher by (say) the entity’s strained financial circumstances at that time, reducing their relevance as an asset-specific measure; the long-term subordinated loan might have been negotiated under different circumstances altogether (for example, under the influence of a related party relationship), rendering it even less relevant to making that assessment. Of course, ESMA is careful to say that it only required referring to these matters “as a starting point” rather than as the entirety of the calculation. But as it only describes the starting point and not where the assessment went from there, it’s hard to get much out of the anecdote.

Likewise, the example doesn’t dwell on the use of a WACC approach to determining the discount rate, but this can be problematic. Some of the recurring issues don’t seem to apply here: as the entity seems to have been only in a single line of business, it’s apparently not necessary to consider whether the entity-wide WACC might reflect an averaging of different kinds of operations with different attached risks. But as above, it might certainly reflect entity-specific aspects of risk and structure that don’t apply to the individual assets. Overall, it’s very easy to succinctly describe why a particular impairment calculation was wrong; it’s much harder though to explain the elements of a good one.

The opinions expressed are solely those of the author