Traditional and expected cash flow approaches to
present value
Traditional approach
Accounting applications of present value have traditionally used a single set of estimated cash flows and a single discount rate, often described as 'the rate commensurate with the risk'. In effect, the traditional approach assumes that a single discount rate convention can incorporate all the expectations about the future cash flows and the appropriate risk premium. Therefore, the traditional approach places most of the emphasis on selection of the discount rate.
In some circumstances, such as those in which comparable assets can be observed in the marketplace, a traditional approach is relatively easy to apply. For assets with contractual cash flows, it is consistent with the manner in which marketplace participants describe assets, as in 'a 12 per cent bond'.
However, the traditional approach may not appropriately address some complex measurement problems, such as the measurement of non-financial assets for which no market for the item or a comparable item exists. A proper search for 'the rate commensurate with the risk' requires analysis of at least two items—an asset that exists in the marketplace and has an observed interest rate and the asset being measured. The appropriate discount rate for the cash flows being measured must be inferred from the observable rate of interest in that other asset. To draw that inference, the characteristics of the other asset's cash flows must be similar to those of the asset being measured. Therefore, the measurer
must do the following:
identify the set of cash flows that will be discounted;
identify another asset in the marketplace that appears to have similar
cash flow characteristics;
compare the cash flow sets from the two items to ensure that they are similar (for example, are both sets contractual cash flows, or is one
contractual and the other an estimated cash flow?);
evaluate whether there is an element in one item that is not present in
the other (for example, is one less liquid than the other?); and
evaluate whether both sets of cash flows are likely to behave (ie vary) in a
similar fashion in changing economic conditions.
Expected cash flow approach
The expected cash flow approach is, in some situations, a more effective measurement tool than the traditional approach. In developing a measurement, the expected cash flow approach uses all expectations about possible cash flows instead of the single most likely cash flow. For example, a cash flow might be CU100, CU200 or CU300 with probabilities of 10 per cent, 60 per cent and 30 per cent, respectively. The expected cash flow is CU220. The expected cash flow approach thus differs from the traditional approach by focusing on direct analysis of the cash flows in question and on more explicit statements of the assumptions used in the measurement.
The expected cash flow approach also allows use of present value techniques when the timing of cash flows is uncertain. For example, a cash flow of CU1,000 may be received in one year, two years or three years with probabilities of 10 per cent, 60 per cent and 30 per cent, respectively. The example below shows the computation of expected present value in that situation.
Present value of CU1,000 in 1 year at 5%
Probability
Present value of CU1,000 in 2 years at 5.25%
Probability
Present value of CU1,000 in 3 years at 5.50%
Probability
Expected present value
CU952.38
10.00%
CU902.73
60.00%
CU851.61
30.00%
CU95.24
CU541.64
CU255.48
CU892.36
The expected present value of CU892.36 differs from the traditional notion of a best estimate of CU902.73 (the 60 per cent probability). A traditional present value computation applied to this example requires a decision about which of the possible timings of cash flows to use and, accordingly, would not reflect the probabilities of other timings. This is because the discount rate in a traditional present value computation cannot reflect uncertainties in timing.
The use of probabilities is an essential element of the expected cash flow approach. Some question whether assigning probabilities to highly subjective estimates suggests greater precision than, in fact, exists. However, the proper application of the traditional approach (as described in paragraph A6) requires the same estimates and subjectivity without providing the computational transparency of the expected cash flow approach.
Many estimates developed in current practice already incorporate the elements of expected cash flows informally. In addition, accountants often face the need to measure an asset using limited information about the probabilities of possible cash flows. For example, an accountant might be confronted with the following
situations:
the estimated amount falls somewhere between CU50 and CU250, but no
amount in the range is more likely than any other amount. Based on that limited information, the estimated expected cash flow is CU150 [(50 + 250)/2].
the estimated amount falls somewhere between CU50 and CU250, and the most likely amount is CU100. However, the probabilities attached to each amount are unknown. Based on that limited information, the estimated expected cash flow is CU133.33 [(50 + 100 + 250)/3].
the estimated amount will be CU50 (10 per cent probability), CU250 (30 per cent probability), or CU100 (60 per cent probability). Based on that limited information, the estimated expected cash flow is CU140 [(50 × 0.10) + (250 × 0.30) + (100 × 0.60)].
In each case, the estimated expected cash flow is likely to provide a better estimate of value in use than the minimum, most likely or maximum amount taken alone.
The application of an expected cash flow approach is subject to a cost-benefit constraint. In some cases, an entity may have access to extensive data and may be able to develop many cash flow scenarios. In other cases, an entity may not be able to develop more than general statements about the variability of cash flows without incurring substantial cost. The entity needs to balance the cost of obtaining additional information against the additional reliability that information will bring to the measurement.
Some maintain that expected cash flow techniques are inappropriate for measuring a single item or an item with a limited number of possible outcomes. They offer an example of an asset with two possible outcomes: a 90 per cent probability that the cash flow will be CU10 and a 10 per cent probability that the cash flow will be CU1,000. They observe that the expected cash flow in that example is CU109 and criticise that result as not representing either of the amounts that may ultimately be paid.
Assertions like the one just outlined reflect underlying disagreement with the measurement objective. If the objective is accumulation of costs to be incurred, expected cash flows may not produce a representationally faithful estimate of the expected cost. However, this Standard is concerned with measuring the recoverable amount of an asset. The recoverable amount of the asset in this example is not likely to be CU10, even though that is the most likely cash flow. This is because a measurement of CU10 does not incorporate the uncertainty of the cash flow in the measurement of the asset. Instead, the uncertain cash flow is presented as if it were a certain cash flow. No rational entity would sell an asset with these characteristics for CU10.
Discount rate
Whichever approach an entity adopts for measuring the value in use of an asset,
interest rates used to discount cash flows should not reflect risks for which the estimated cash flows have been adjusted. Otherwise, the effect of some assumptions will be double-counted.
When an asset-specific rate is not directly available from the market, an entity uses surrogates to estimate the discount rate. The purpose is to estimate, as far
as possible, a market assessment of:
the time value of money for the periods until the end of the asset's useful
life; and
factors (b), (d) and (e) described in paragraph A1, to the extent those
factors have not caused adjustments in arriving at estimated cash flows.
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.
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.
The discount rate is independent of the entity's capital structure and the way the entity financed the purchase of the asset, because the future cash flows expected to arise from an asset do not depend on the way in which the entity financed the purchase of the asset.
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.
An entity normally uses a single discount rate for the estimate of an asset's value in use. However, an entity uses separate discount rates for different future periods where value in use is sensitive to a difference in risks for different periods or to the term structure of interest rates.
Appendix B
Amendment to IAS 16
The amendment in this appendix shall be applied when an entity applies IAS 16 Property, Plant and Equipment (as revised in 2003). It is superseded when IAS 36 Impairment of Assets (as revised in 2004) becomes effective. This appendix replaces the consequential amendments made by IAS 16 (as revised in 2003) to IAS 36 Impairment of Assets (issued in 1998). IAS 36 (as revised in 2004) incorporates the requirements of the paragraphs in this appendix. Consequently, the amendments from IAS 16 (as revised in 2003) are not necessary once an entity is subject to IAS 36 (as revised in 2004). Accordingly, this appendix is applicable only to entities that elect to apply IAS 16 (as revised in 2003) before its effective date.
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The text of this appendix has been omitted from this volume.
Appendix C
Impairment testing cash-generating units with goodwill and
non-controlling interests
This appendix is an integral part of the Standard.
In accordance with IFRS 3 (as revised in 2008), the acquirer measures and
recognises goodwill as of the acquisition date as the excess of (a) over (b) below:
the aggregate of:
the consideration transferred measured in accordance with
IFRS 3, which generally requires acquisition-date fair value;
the amount of any non-controlling interest in the acquiree
measured in accordance with IFRS 3; and
in a business combination achieved in stages, the acquisition-date
fair value of the acquirer's previously held equity interest in the acquiree.
the net of the acquisition-date amounts of the identifiable assets
acquired and liabilities assumed measured in accordance with IFRS 3.
Allocation of goodwill
Paragraph 80 of this Standard requires goodwill acquired in a business
combination to be allocated to each of the acquirer's cash-generating units, or groups of cash-generating units, expected to benefit from the synergies of the combination, irrespective of whether other assets or liabilities of the acquiree are assigned to those units, or groups of units. It is possible that some of the synergies resulting from a business combination will be allocated to a cash-generating unit in which the non-controlling interest does not have an interest.
Testing for impairment
Testing for impairment involves comparing the recoverable amount of a
cash-generating unit with the carrying amount of the cash-generating unit.
If an entity measures non-controlling interests as its proportionate interest in the net identifiable assets of a subsidiary at the acquisition date, rather than at fair value, goodwill attributable to non-controlling interests is included in the recoverable amount of the related cash-generating unit but is not recognised in the parent's consolidated financial statements. As a consequence, an entity shall gross up the carrying amount of goodwill allocated to the unit to include the goodwill attributable to the non-controlling interest. This adjusted carrying amount is then compared with the recoverable amount of the unit to determine whether the cash-generating unit is impaired.
Allocating an impairment loss
Paragraph 104 requires any identified impairment loss to be allocated first to
reduce the carrying amount of goodwill allocated to the unit and then to the other assets of the unit pro rata on the basis of the carrying amount of each asset in the unit.
If a subsidiary, or part of a subsidiary, with a non-controlling interest is itself a cash-generating unit, the impairment loss is allocated between the parent and the non-controlling interest on the same basis as that on which profit or loss is allocated.
If a subsidiary, or part of a subsidiary, with a non-controlling interest is part of a larger cash-generating unit, goodwill impairment losses are allocated to the parts of the cash-generating unit that have a non-controlling interest and the parts that do not. The impairment losses should be allocated to the parts of the
cash-generating unit on the basis of:
to the extent that the impairment relates to goodwill in the
cash-generating unit, the relative carrying values of the goodwill of the
parts before the impairment; and
to the extent that the impairment relates to identifiable assets in the cash-generating unit, the relative carrying values of the net identifiable assets of the parts before the impairment. Any such impairment is allocated to the assets of the parts of each unit pro rata on the basis of the carrying amount of each asset in the part.
In those parts that have a non-controlling interest, the impairment loss is
allocated between the parent and the non-controlling interest on the same basis as that on which profit or loss is allocated.
If an impairment loss attributable to a non-controlling interest relates to goodwill that is not recognised in the parent's consolidated financial statements (see paragraph C4), that impairment is not recognised as a goodwill impairment loss. In such cases, only the impairment loss relating to the goodwill that is allocated to the parent is recognised as a goodwill impairment loss.
Illustrative Example 7 illustrates the impairment testing of a non-wholly-owned cash-generating unit with goodwill.
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