How will higher interest rates and inflation affect impairment testing of non-financial assets?

16 January 2023 (updated 31 October 2023)

 

Global IFRS Institute | Uncertain times

In many countries, inflation is at levels not seen in decades. In response, central banks have raised interest rates and economic activity overall is slowing down. At the same time, long-term government bond yields increased significantly and many companies have been experiencing the effects of soaring commodity prices and labour costs (and in some cases, a significantly lower share price). All of these factors are indicators of possible impairment if they are expected to have (or have already had) a significant adverse effect.

For some companies it is highly likely that indicators of impairment exist. If so, those companies using a discounted cash flow (DCF) model to estimate the recoverable amount of their assets or cash-generating units (CGUs) would need to consider how to reflect the impact of higher inflation and interest rates. The impacts may be significant – e.g. affecting key inputs to the model such as the forecasted revenues, profitability and the discount rate. These impacts may be a key area of focus for investors so we highlight some of the key points to consider below. 

Valuation – In real or nominal terms?

Under low inflation conditions, valuations are often performed in nominal terms – i.e. the cash flows and discount rate include the effect of inflation. In times of high and unstable inflation (e.g. in hyperinflationary economies), valuations may be performed in real terms – i.e. the cash flows and discount rate exclude the effect of inflation. The value conclusion should be the same irrespective of whether the valuation is performed in real or in nominal terms. [Insights 3.10.310.10]

Whichever method is used, the cash flows and the discount rate applied to them need to be determined on a consistent basis. If the cash flows include the effects of general inflation, then the discount rate also includes the effects of inflation and vice versa. [IAS 36.40]

This article addresses valuations that are performed in nominal terms. 

Impact on future revenues, costs and profit margins

When the DCF is prepared on a nominal basis, a good starting point is to consider the impact of inflation on the estimated future costs of materials, services and labour during the forecast period (typically the next five years). In the case of the Ukraine-Russia war, costs of materials and commodities (including energy prices) increased significantly due to supply chain issues and the sanctions imposed on Russia. Many of the impacts of these factors are expected to persist, at least in the near term.

The expected level of changes in the costs of materials and services in the forecast period may differ significantly from the general level of inflation in the economy overall. Using inflationary measures such as CPI¹ and PPI² to estimate the change in future costs may not be appropriate.

In an inflationary environment, companies often seek to increase prices to compensate for increases in the costs of production. However, a company’s ability to pass on cost increases and maintain its profit margins typically depends on the nature of its products (or services) and its competitive position. Companies that are not price makers may find it challenging to maintain their profit margins over time when inflation is high. Further, consumers may change their spending habits as their disposable income falls due to high inflation – e.g. they may either opt for cheaper products or decrease their spending.

Forecasting capital expenditure

In an inflationary environment, a company’s capital expenditure on maintaining property, plant and equipment (PP&E) cannot be assumed to be equal to its depreciation expense. Rather, it will exceed it, if a company is to maintain its assets in real terms. This is because capital expenditure is based on the current and future prices of PP&E; depreciation expense is based on historical price.

Impact on the long-term growth rate

The long-term growth rate is a key input in a DCF calculation. It is used to calculate the terminal value – i.e. the value of an asset or a CGU beyond the forecast period. The long-term growth rate comprises the following.

• Inflationary growth: In an inflationary economic environment, companies with no real growth should still exhibit growth in cash flows at the rate of the long-term price changes in their products/services and costs.
• Real growth: The real long-term growth rate can be positive or negative, depending on the relative strengths or weaknesses and risks associated with the subject asset or CGU.

Distinguishing between real growth and inflationary growth is important when forecasting future cash flows. This is because real growth requires expansionary investment in the business, whereas inflationary growth requires no further cash investment beyond the amount necessary to maintain the company’s assets in real terms.

When calculating value in use, IAS 36 Impairment of Assets requires a company to use a steady or declining long-term growth rate that is consistent with that of the product, industry or country, unless there is clear evidence to suggest another basis. When calculating fair value less costs of disposal, the long-term growth rate should reflect a rate that market participants would use in performing the valuation. [IAS 36.33(c), 36]

Impact on the discount rate

DCF calculations are typically very sensitive to even small changes in the discount rate. The recent increase in long-term interest rates may have significantly reduced the recoverable amount of assets (e.g. real estate) or CGUs, unless cash flow projections have been adjusted upwards.

Companies often use the WACC³ formula as a starting point to estimate the appropriate discount rate when determining enterprise value. This formula is a weighted average of the cost of debt and equity, both of which are affected by changes in the risk-free rate. [Insights 3.10.300.30]

The risk-free rate is generally derived from the yield on government bonds that are in the same currency and have the same or a similar duration as the cash flows of the asset or CGU. This means that companies often need to consider 10-, 20- or 30-year government bonds; the yields on these bonds have increased significantly recently. [Insights 3.10.300.120]

Disclosure of key assumptions and judgements

IAS 36 requires disclosure of the key assumptions used to determine the recoverable amount when testing goodwill and indefinite-lived intangible assets for impairment. It also requires sensitivity disclosures if a reasonably possible change in a key assumption would cause the CGU’s carrying amount to exceed its recoverable amount. Typically, a DCF calculation is sensitive to small changes in the long-term growth rate and the discount rate. [IAS 36.134(d)–(f)]

Under IAS 1 Presentation of Financial Statements, a company needs to disclose its key assumptions about the future and other major sources of estimation uncertainty at the reporting date that have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities in the next financial year. [IAS 1.122–123, 125, 129]

In times of increased economic uncertainty, companies may need to expand their disclosures in the financial statements. In such times, disclosures relating to impairment testing of non-current assets are likely to be a focus area for investors. They may also need to include sensitivity disclosures and disclose the key assumptions and judgements made by management. For example, companies exposed to high commodity price volatility may need to provide granular disclosures on how they incorporate this into their key assumptions (e.g. their cash flow projections, terminal values and growth rates) – both for their costs of production and their ability to pass on higher costs to customers. Companies may need to explain the impact of the increasing interest rates on their impairment testing and consider adjustments to the range of reasonably possible changes in assumptions in their sensitivity analysis.

Companies that prepare interim financial statements also need to consider whether to update the IAS 36 disclosures included in their most recent annual financial statements. 

• any indicators of impairment exist for the company’s non-financial assets or CGUs. If so, perform the impairment test even if recent impairment tests have shown significant headroom;
• cash flow projections used to calculate recoverable amounts have been updated for the effects of rising inflation and interest rates;
• discount rates and long-term growth rates used in valuations have been updated;
• the assumptions used in projecting cash flows and the discount rate are consistent;
• changes are required to the useful lives and/or residual values of assets tested for impairment (or for which indicators of impairment exist); and
• disclosure of key assumptions and judgements is provided as required under IAS 1 and IAS 36.