The discount rate in the IFRS impairment test (IAS 36)

Goodwill is usually the focus of the impairment test under IFRS

IAS 36 applies to property, plant and equipment, intangible assets and goodwill, as well as certain financial assets, e.g. associates, companies accounted for using the equity method and joint ventures. The balance sheet approach for all other assets is governed by separate standards.  

Not all of the aforementioned types of assets that fall under IAS 36 require an annual impairment test to be carried out:  

• Tangible assets: Not required
• Intangible assets: required if the intangible asset has an indefinite useful life or is not yet in use
• Goodwill: Required
• Financial assets: Not required

In addition, an impairment test must be carried out for all assets whenever there are indications of a reduction in value.

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When is there an impairment?

An asset must be written down if its recoverable amount falls below its carrying amount. The recoverable amount is defined as the higher of the fair value and the value in use.

• Fair value: The value of the asset that could be realized by selling it after deducting notional selling costs.
• Value in use: reflects the company's internal view and answers the question of what value the asset contributes within the company through its own use.

An impairment loss must therefore be recognized if the carrying amount is lower than either the fair value or the value in use.

When is a discount rate used in an impairment test?

To answer this question, we should take a closer look at the determination of the fair value and the value in use. The determination of the fair value follows the fair value hierarchy of IFRS 13:

• Level 1: Observed market price
• Level 2: Derived value based on observed market prices
• Level 3: Value determination using standard valuation methods, including the comparative value method, cost-oriented methods and capital value-oriented methods

This hierarchy must be adhered to. No discount rate is required at levels 1 and 2, but at level 3 it is only required for the capital value-oriented method. However, when determining the value in use, the capital value-oriented method must be used, so a discount rate is always required here.

Since goodwill must be subjected to an impairment test once a year and this corresponds to a value in use, the determination of a discount rate is almost always necessary when preparing IFRS consolidated financial statements.

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Which discount rate should be used for which asset?

The standard IAS 36 recommends (not conclusively) the following discount rates:

• Weighted average cost of capital (WACC)
• Marginal borrowing rate
• Other interest rates on borrowed capital

A discount rate must always be appropriate to the risk of the cash flows/reflows of funds from an asset or a cash-generating unit (CGU). For assets that generate cash flows that correspond to the company's overall business, the weighted average cost of capital (WACC) is generally suitable:

• Property, plant and equipment: weighted average cost of capital (WACC)
• Intangible assets: Weighted average cost of capital (WACC)
• Goodwill: Weighted average cost of capital (WACC)
• Financial assets: cost of equity of the respective financial asset

The possibility that the cost of debt capital for one of these categories, which is also mentioned in the standard, may be relevant cannot be ruled out, but it should be a rare exception.

A pre-tax discount rate – what does that mean and how should it be used?

There are two ways to deal with this problem:

• So-called "upward adjustment" of the interest rate by dividing it by [ 1 – tax rate ]: for example, a 7% post-tax interest rate would be calculated as a 10% pre-tax interest rate and applied to a pre-tax cash flow. However, this method is only mathematically equivalent to a post-tax valuation if constant cash flows are present and is therefore not recommended.
• Iterative calculation of the pre-tax interest rate: The impairment calculation is carried out on a post-tax basis, and then a pre-tax rate is determined in the pre-tax calculation by iteration, which leads to the same value. This approach has its weaknesses and is dominant in practice.

Databases for determining the discount rate

To determine the WACC and the cost of equity, a number of parameters are required, including the beta factor, the riskfree base rate and the credit spread, which are determined by searching a database. When selecting a database, the following points should be considered:

• Search functionality and scope: Important parameters such as beta factors require a suitable group of listed companies for comparison.
• Documentation: The data and results used should be well documented, ideally directly in the database's report format.
• Efficiency and updates: Simultaneous determination of all parameters increases efficiency. A replicable determination of the WACC is enormously time-saving.

A comparison of different data providers can be found here.

Conclusion

The discount rate plays a central role in the IFRS impairment test in accordance with IAS 36, especially when measuring goodwill. Choosing the appropriate discount rate is crucial to achieving realistic and reliable results. It is essential to make well-founded assumptions and to carefully analyze and document the underlying data. The iterative calculation of the pre-tax interest rate has established itself as a practical approach, although it has its weaknesses. Careful selection of data sources and thorough documentation are also essential components of a successful impairment test. A comparison can be found here.

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