Errors when determining 'fair value less costs of disposal'

In this month’s Common Errors article, we continue our series on errors that can be made in applying the requirements of NZ IAS 36 Impairment of Assets, focusing on errors that can be made by not applying the requirements of NZ IAS 36 and NZ IFRS 13 Fair Value Measurement when determining an asset’s recoverable amount using ‘fair value less cost of disposal’ (FVLCD).

Basic requirements of NZ IAS 36

NZ IAS 36 contains 25 paragraphs on how to calculate value in use (VIU), setting out very detailed guidance on the:

Basis for estimating future cash flows
Composition of estimates of future cash flows
Foreign currency future cash flows, and
Discount rate.

At the same time, NZ IAS 36 only contains two paragraphs on the fair value method. These discuss what should be regarded as a ‘cost of disposal’ and the treatment of liabilities to be assumed by the buyer, rather than containing any detailed guidance on how to determine fair value. However, it would be wrong for preparers to conclude that determining fair value less costs of disposal (FVLCD) is not subject to the application of very strict principles, which if not applied correctly, could lead to errors.

Fundamentally, the determination of FVLCD is something far more sophisticated than a discounted cash flow model which contains wildly optimistic forecasts and is back-engineered to show that there is no impairment charge. FVLCD is not a means of circumventing the strict rules around preparing discounted cash flow models for VIU calculations.

Can FVLCD be reliably measured?

We should not underestimate the difficulties in determining fair value where there are no observable inputs into the valuation model. NZ IAS 36 acknowledges that in some circumstances, it may not be possible to determine FVLCD, in which case the VIU model must be used.

Although the preparer effectively has the choice to determine an asset’s recoverable amount by either determining its VIU or FVLCD, preparers and auditors should be aware of the inherent difficulties in determining FVLCD for an asset where there are no recent observable transactions, or is not being actively marketed for sale.

The use of FVLCD is typically applied to assets that are not actually in use, i.e. mothballed mining assets, or assets that are in the start-up phase, or not fully in production.

What is fair value?

NZ IAS 36 defines fair value as ‘… the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.’

IAS 36 (the international equivalent of NZ IAS 36) was originally issued in 1998 by the International Accounting Committee (IASC), the predecessor to the IASB. It was not until the release of NZ IFRS 13 (IFRS 13) in May 2011 that detailed guidance was produced on fair value. Preparers and auditors now need to follow the principles set out in NZ IFRS 13 if they are going to use FVLCD as the basis of determining an asset’s recoverable amount.

The majority of the ‘common errors’ highlighted in this article therefore centre on these NZ IFRS 13 principles not being applied correctly.

Fair value is a market-based measurement, not an entity-specific measurement

A fundamental principle of NZ IFRS 13 is that fair-value is a market-based measurement, not an entity-specific measurement.

There are therefore two key aspects of this basic principle that impact the application of NZ IAS 36, i.e.:

Inputs into any cash flow model must be those of a market participant, and
Any entity-specific savings or costs should be excluded from the model (refer NZ IAS 36, paragraph) 53A.

Therefore, if a discounted cash flow model is being used to determine a FVLCD, it must not include costs and savings that would not be achieved by a market participant.

Maximise observable inputs and minimise the use of unobservable inputs when calculating FVLCD

In many cases, there are no observable market prices when testing an asset for impairment using FVLCD. NZ IFRS 13, paragraph 3 expressly states that any valuation technique used to determine fair value should maximise the use of relevant observable inputs and minimise the use of unobservable inputs.

This principle is also re-iterated in NZ IFRS 13, paragraphs 61 and 67.

Observable market inputs would include:

An entity’s share price
The share price of similar entities
The price achieved for similar assets
The price being asked for similar assets, and
Inputs into a cash flow model e.g. forward prices on commodities and foreign exchange etc.

With the basic principle of maximising observable market inputs, it is difficult to see how preparers can rely solely on internally generated cash flow forecasts, using inputs that are inconsistent with observable market data.

A simple example is the use of commodity prices and foreign exchange rates in FVLCD models. Although the entity may itself have very good reasons to believe that the consensus pricing on a particular commodity is wrong, or they hold a particular view as to future exchange rates, the inputs into the FVLCD model cannot differ from the market participants’ view.

The fair value hierarchy

A fundamental principal of NZ IFRS 13 is the application of the ‘fair value hierarchy’ which classifies inputs as observable (level 1), unobservable (level 3) and mixed (level 2) as follows:

Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.
Level 2 inputs are inputs, other than quoted prices included within level 1, that are observable for the asset or liability, either directly or indirectly.
Level 3 inputs are unobservable inputs.

This means that entities using level 3 discounted cash flow models to determine FVLCD cannot ignore level 2 or level 1 inputs that may be available. For example, an entity calculating FVLCD for an investment in shares listed on the ASX cannot ignore the level 1 listed share price, and instead use a level 3 discounted cash flow model that uses level 3 inputs.

Similarly, for assets where there are level 2 inputs (i.e. observable price for a similar asset or liability), an entity cannot solely use a level 3 discounted cash flow model to determine FVLCD. The requirement to give highest priority to level 1 inputs, and lowest priority to level 3 inputs, coupled with the requirement to use multiple valuation techniques (refer discussion below), means that level 2 inputs, being observable market prices for similar assets, adjusted for the condition and location of the asset, must be taken into account.

Market conditions at the measurement date

NZ IFRS 13 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Using the measurement date is reinforced in NZ IFRS 13, paragraphs 24 and 62 as follows:

In practice, many entities fail to update assumptions used in FVLCD calculations to reflect current circumstances at measurement date. If a preparer finds themselves arguing that ‘this is only a temporary market blip’, or ‘the market was temporarily negatively impacted by xxxx’, or ‘the market overreacted’ to justify why these factors have been excluded from their FVLCD model, they have fundamentally misunderstood that the FVLCD is determined using market conditions at the measurement date.

Using overly optimistic assumptions in the cash flow models

NZ IAS 36 contains detailed guidance on cash flows to be used in VIU models. It requires that they be realistic, in line with past performance and realistic budgets, and generally be restricted to five years because forecasting beyond five years is generally not considered to be reliable.

Prima facie this guidance does not apply to the FVLCD model, however, FVLCD is driven by the principle that using FVLCD simply does not allow for the use of bullish optimism in terms of growth, profitability, etc. The growth rates and the associated risks of not achieving growth should be that of market participants, not that of management.

Use of multiple valuation techniques

Under the fair value hierarchy contained within NZ IFRS 13, the ideal fair value model is an observable market price for an asset. In reality, this is very unlikely to be achieved in impairment testing under NZ IAS 36, and there is therefore a tendency to resort solely to discounted cash flow models to determine FVLCD. NZ IFRS 13, paragraph 63 expressly states that when an observable market is not available, e.g. when valuing a cash-generating unit (CGU), multiple valuation techniques will be appropriate.

Paragraph 63 also states that in such cases, the fair value is then ‘the point within that range that is most representative of fair value in the circumstances’. Many preparers simply use a single valuation method, usually based on a DCF, ignoring the market approach and the cost approach.

Incorrect development of level 3 models

If FVLCD needs to be determined using level 3 inputs (i.e. there are no level 2 or level 1 inputs), then the preparer must still aim to determine a fair value that represents ‘...an exit price at the measurement date from the perspective of a market participant that holds the asset..’.

This exit price must be produced using risk assumptions that a market participant would use.

The NZ IAS 36 guidance on VIU models allows the uncertainty for the amount and timing of cash flows to be dealt with by either probability adjusting the cash flows, or by adjusting the discount rate. The same applies when building level 3 FVLCD models, but it is a requirement of NZ IFRS 13 that these uncertainties are that of market participants, and therefore does not represent overly optimistic internal entity-specific views

Fair value less costs of disposal

NZ IAS 36 requires recoverable amount of an asset to be its FVLCD, rather than just its fair value.

Some entities ‘forget’ to deduct costs of disposal to arrive at the recoverable amount. This means that recoverable amount is overstated, and therefore any impairment charge is understated.

Other entities could incorrectly deduct too many costs of disposal, and therefore potentially understate recoverable amount, and overstate the impairment charge. This may occur, for example, when termination costs associated with reorganisations of a business post disposal are treated as a cost of disposal.

Accounting for liabilities associated with an asset or group of assets

Sometimes, the disposal of an asset would require the buyer to assume a liability and only a single fair value less costs of disposal is available for both the asset and the liability. This could occur, for example, where a purchaser of a mine also takes over the restoration obligation. In such cases, the liability needs to be deducted from the carrying amount of the CGU assets, otherwise the impairment charge will be overstated.

It may be necessary to consider some recognised liabilities to determine the recoverable amount of a cash-generating unit. This may occur if the disposal of a cash-generating unit would require the buyer to assume the liability. In this case, the fair value less costs of disposal (or the estimated cash flow from ultimate disposal) of the cash-generating unit is the price to sell the assets of the cash-generating unit and the liability together, less the costs of disposal. To perform a meaningful comparison between the carrying amount of the cash-generating unit and its recoverable amount, the carrying amount of the liability is deducted in determining both the cash-generating unit’s value in use and its carrying amount. NZ IAS 36, paragraph 78

In the New Year we will continue with this series and will look at common errors made because impairment is not tested at the correct unit of account.