Cost of Capital and Impairment Testing Study: 2011

Transcription

1 Corporate Finance Cost of Capital and Impairment Testing Study: 2011 Empirical survey of South African companies kpmg.co.za

2 b Cost Section of Capital or Brochure and Impairment name Testing Study 2010

3 Table of Contents Foreword 2 Summary of Findings 1. About this study Basic principles and aims of the study Data collection 6 2. Significance of the Impairment Test Time, frequency and triggering events 7 3. Organisation and Implementation of the Impairment Test Criteria, level and number of CGU s defined How recoverable amount is determined and which valuation method is used Balance sheet items included when determining the carrying amount Measurement of Cash Flows Group budget preparation and modifications made to the budget for the impairment test Principles applied in the currency translation Basis for computing the tax expense for measuring cash flow Determination of the Cost of Capital Detail applied in the cost of capital determination Performing a pre-tax calculation Cost of Capital Parameters Risk-free rate of return Market risk premium Beta Cost of equity Cost of debt Capital structure Weighted cost of capital Growth rates 34

4 1 Cost of Capital and Impairment Testing Study 2011 List of Abbreviations APT AltX CAPM CGU DCF EBIT EBITDA FVLCS IAS IASB IFRS JSE KPMG MRP VIU WACC Arbitrage Pricing Theory Johannesburg Alternative Exchange Capital Asset Pricing Model Cash Generating Unit Discounted Cash Flow Earnings Before Interest and Taxes Earnings Before Interest, Taxes, Depreciation and Amortisation Fair Value less Costs to Sell International Accounting Standards International Accounting Standards Board International Financial Reporting Standards Johannesburg Stock Exchange KPMG South Africa Market Risk Premium Value In Use Weighted Average Cost of Capital

5 Cost of Capital and Impairment Testing Study Foreword The international economy continues to be plagued with a number of unexpected and devastating events such as the crisis in the Middle East and the natural disasters that have hit Japan. Surprisingly, despite this, the global recovery seems to be continuing at a slow and steady pace. In South Africa, the economy continues its recovery from the recession period with some solid improvements in GDP growth during 2010 and this progress appears to be continuing positively into Interest in South African assets from foreign investors remains high, contributing to a stronger rand as well as more merger and acquisition activity. This coupled with a stable interest rate environment bodes well for further economic progress in South Africa. Notwithstanding these uncertain economic times, companies continue to make acquisitions, albeit at a much slower rate than in the period leading up to the recession of 2008/9. These acquisitions frequently reflect significant premiums being paid over net asset value which then need to be analysed into components in terms of International Financial Reporting Standards. These components result in assets, namely goodwill or other assets, which later have to be tested for impairment. These impairments, how they are performed and their resultant impact are of interest to the financial reporting community. This survey attempts to provide some insight as to the manner in which these tests are being conducted in South Africa and some of the outcomes of these tests. This survey has been run for several years in Europe. This is the first time that this survey is being run in South Africa and although the response rate was fairly low, we are confident that this maiden version will spur interest for future years as was the case in Europe, where response rates increase from year to year. Trends and developments are analysed against the European survey responses in this version. The format follows that of our European survey, and covers the following four main areas: Organisation and implementation of impairment tests Measurement of cash flows Determination of cost of capital The level of the cost of capital parameters. Our survey was conducted from November 2010 to February 2011 and therefore financial statements from 31 December 2009 to 31 October 2010 were included in our analysis. This survey is an empirical investigation with the aim of setting out company practice in South Africa in relation to the areas outlined above. Information and remarks in the survey are not intended to provide complete information as to the correct treatment or interpretation of the regulations for impairment testing. I would like to thank the companies who participated in the survey for their time and interest. I would also like to extend my sincere thanks and gratitude to the staff who were involved in putting the survey together. Elizabeth Sherratt Director Transactions & Restructuring

6 3 Cost of Capital and Impairment Testing Study 2011 Summary of findings Data collected Questionnaires were sent to a total of 350 companies listed on the Johannesburg Stock Exchange, of which 38 responded. This resulted in a response rate of 11% The highest respondents per industry were the mining sector (15%) and the financial services sector (11%) Significance of the impairment test During the 2010 financial year, 36% of companies surveyed recognised some form of impairment during the year In addition to the annual test for impairment, approximately 50% of respondents also identified impairment indicators. A total of 3 monitored the events stipulated in IAS 36, while 39% monitored company specific material events. Organisation and implementation of the impairment test Approximately 46% of respondents identified Cash Generating Units at one level below the segment level, with 42% of respondents identifying at a segment level 81% of companies surveyed identified a maximum of ten CGUs for the goodwill impairment test. For the asset impairment test, 96% of respondents identified 10 CGUs or less In total 65%, of companies surveyed calculated the recoverable amount using the value in use approach with 19% using the fair value less costs to sell approach. All companies that calculated both approaches stated that the value in use amount was higher than the fair value less costs to sell amount. Measurement of cash flows Approximately 5 of respondents utilised their unmodified group budget for impairment testing purposes 80% of companies surveyed prepared their group budget a maximum of three months before the impairment test A majority of respondents made no adjustments to their group budget in light of the financial crisis, however 23% completely revised their budgets as a result.

7 Cost of Capital and Impairment Testing Study Determination of the cost of capital Overall, 54% of respondents determine a CGU specific cost of capital A vast majority of companies surveyed (value in use 92%, fair value less cost to sell 54%) perform an after tax calculation first. Only (value in use and fair value less cost to sell) of respondents use goal seeking for the iteration calculation to pre tax values, while 12% (value in use) and (fair value less cost to sell) use a grossing up approach. Cost of capital parameters A total of 75% of companies surveyed determine the risk free rate based on a national or foreign government bond with an average life of 8 years and 16 years respectively. The average risk free rate determined was 7.44% The average cost of equity based on the responses was 13.5 with the average after tax cost of debt being 8.12% In determining the debt to equity ratio to use in the weighted average cost of capital calculation (WACC), 65% of respondents based this calculation on book values while only 35% based this on market values. The average debt to equity ratio provided by respondents was 40% The average WACC provided by the companies who participated in this survey was 12.3% The average terminal growth rate applied by the respondent companies was 5.3% for the value in use approach and 5. for the fair value less cost to sell approach. The average market risk premium applied by South African companies was 5.7% in 2010 Over 96% of companies surveyed utilised historic betas in determining the cost of equity. Overall, 37% (42% value in use and 35% fair value less cost to sell.) of respondents derived these betas from a peer group of companies

8 5 Cost of Capital and Impairment Testing Study About this study 1.1 Basic principles and aims of the study The impairment test in terms of IAS 36 is a complex process described in detail in the standard with little practical guidance, which therefore raises many questions as to its implementation. The central issue which our survey has sought to address, therefore, is to determine how the IFRS rules are actually being implemented by companies in their impairment testing processes given the fact that often applications of certain areas of IAS 36 are both unclear and detailed interpretation is frequently required. Both the impairment test and the rules of IAS 36 have gained even more significance than in the past due to the volatility of capital markets. In addition to the different alternatives which result from the room for interpretation in IAS 36, this study also provides an understanding of the difficulties in the practical implementation of impairment testing. We have summarised our analysis in separate sections related to four main areas: The purpose of each section is described separately in the relevant section. Where necessary, we have outlined the essence of the applicable IFRS rules to provide a better understanding to the reader. The vast majority of respondents (89%) to this survey report in accordance with IFRS and the survey results were therefore based on the financial statements prepared in accordance with IFRS. This is the first survey conducted by KPMG South Africa regarding the cost of capital and impairment testing. This survey is primarily based on an equivalent study undertaken by KPMG Europe LLP conducted across Germany, Switzerland, the Netherlands, Austria and Spain for the 3 prior years (referred to forthwith as the European survey ). We have not been able to assess trends in our data as a result of this being the maiden South African survey, but where necessary, we have drawn comparisons of our findings to the data in the equivalent European study. Organisation and implementation Measurement of forecast cash flows for the impairment test Determination of the cost of capital for the impairment test Cost of capital used and the parameters applied.

9 Cost of Capital and Impairment Testing Study Data collection We attempted to contact all companies listed on the JSE main board and the Alternative Exchange (AltX). We contacted over 350 companies and had 38 formal responses (approximate 11% response rate). The European survey had a response rate of 20.5% in 2010, 18. in 2009 and 14.9% in Of these respondents, 96% had head offices in South Africa with 4% having their head offices located abroad. The overwhelming majority of respondents (8) were listed only on the JSE main board with only 4% of respondent s being listed on the AltX. The remaining of respondents were dual listed on other international exchanges. We contacted these companies between November 2010 and March Our respondents were from a wide variety of industries. Due to the relatively small response rate, it was not possible to perform an analysis per industry. The majority of respondents were from the mining (15%) and financial services (11%) sectors, which is expected given the JSE s heavy influence by these sectors. Overall, the range of industries covered by the respondents generally represents the composition of the JSE at any given time. Fig 1: Composition of the sample by industry 4% 4% 4% 4% 4% 15% 11% Forestry and paper Industrial engineering General industrials Financial services Industrial transportation Other Health care Insurance 4% 4% 7% 7% Chemicals Real estate Telecommunications Mining Technology Retail Support Services

10 7 Cost of Capital and Impairment Testing Study Significance of the impairment test 2.1 Time, frequency and triggering events The significance of impairment testing has increased against the background of recent volatile capital markets. Most companies have become more cautious about impairment since the financial crisis began in 2008/9. These circumstances also influence the cost of capital and the multiples used by companies, which in turn are frequently used to determine the values of CGUs for impairment testing purposes. Although the financial crisis peaked in 2008/9, its effects are still prevalent. Approximately 35% of respondents reported goodwill impairment in 2010, with 50% of respondents reporting asset impairment. In total, 36% of respondents incurred some form of impairment in 2010, being either goodwill or asset impairment. In light of the above, a question arises as to the extent to which the surveyed companies performed their impairment tests by virtue of triggering events. On both the asset and goodwill impairment, 50% of respondents stated that the impairment test was performed due to a trigger event. These results are in line with the international benchmark, as the European survey for 2009/10 revealed that 53% of their respondents performed an impairment test due to a triggering event. A triggering event may arise in different ways, which are specifically mentioned in IAS36. When considering the trigger events, the majority of respondents stated that the criteria set out in IAS 36 (3) and company specific material events (39%) were considered. Fig 2: Criteria to determine a triggering event 19% 4% 39% 3 Company-specific material events are checked Events mentioned in IAS 36 are checked Specific events were defined and monitored Other

11 Cost of Capital and Impairment Testing Study Background IFRS When must an impairment test be performed? Goodwill and intangible assets with an indefinite useful life are not subjected to scheduled amortisation but only to be amortised in the event of impairment (impairment only approach). Goodwill, intangible assets with indefinite useful lives and intangible assets not yet available for use are to be subjected to an annual impairment test and at further intervals if evidence suggests impairment (trigger events) The impairment test is intended to ensure that assets are not valued at more than their recoverable amount. To the extent that book value exceeds the recoverable amount it is necessary to recognise impairment. At every reporting date, all assets are to be tested for impairment in order to ascertain if there are indications that the value of these assets has declined beyond their recoverable amounts IAS contains a preliminary list of indicators which, if identified, require the performance of an impairment test. Generally a distinction is made between internal indicators (the origin of which lies in the CGU and/or the enterprise itself), and external indicators (for example: increase in market interest rates, a significant and unexpected decline in market value, significant adverse effects in the technological, market, economic, or legal environment). Ultimately, an enterprise should identify the respective relevant indicators and test for impairment at regular intervals.

12 9 Cost of Capital and Impairment Testing Study Organisation and implementation of the impairment test In general, IAS 36 provides companies with limited guidance in the determination of the cash generating units ( CGUs ) for an impairment test. In addition to the definition of CGUs, two subjects are frequently discussed and debated within the framework of the organisation and implementation of impairment tests. These are: the consistent determination of: a) the recoverable amount and of b) the carrying amounts in line with the standard. In order to determine the most widely used approach, we asked the following questions: According to which criteria and at which level are CGUs defined? How many different CGUs have been defined? How have the recoverable amounts been determined and which valuation methods are used? Which Statement of Financial Position items are included when determining the carrying amount? 3.1 Criteria, level and number of CGU s defined IAS 36 sets out the criteria for the determination of a CGU in a business, for goodwill and impairment tests. The identification of CGUs requires judgement and can be one of the most difficult areas of impairment accounting. While the key test is the identification of independent cash inflows, IAS 36 also refers to other tests such as the manner in which management monitors operations and makes decisions about continuing or disposing of assets and/or operations. The greater the number of CGUs in a company, the more work is required to perform the impairment tests. The lower the number, the larger the size of the respective CGUs. The larger the size of the CGU resulting from a business combination of several units, the easier it is for a better earnings outlook in one area to compensate for a worse earnings outlook in another area. In total, 46% of the respondents surveyed, identify their CGUs at one level below the segment level. This is in contrast to the results of the European survey at which a much larger proportion, 84% of respondents, established their CGUs at segment level or below. Fig 3: Level of CGUs for goodwill impairment 42% 4% 46% One level below the segmant level Two levels below the segmant level Segmant level Other The majority of respondents (5) determined their CGUs according to their legal entities/sub groups or according to their product groups (15%). These findings are broadly in line with the results in the European survey (41% legal entities and 39% product groups). Another noticeable observation is that almost no respondents (4%) determined their CGUs by geographic location.

13 Cost of Capital and Impairment Testing Study Fig 4: Criteria for the determination of CGU s for goodwill impairment Not applicable Other Functions Geographic 4% Legal entities/sub groups 5 Product groups 15% Background IFRS What are the criteria to use when determining CGUs? As a rule, the impairment test for goodwill is to be performed at the CGU level According to IAS 36.6, a CGU is defined as the smallest identifiable group of assets that generates cash inflows from continuous use that are largely independent of the cash inflows from other assets or groups of assets When testing a CGU for impairment, the purchased and identifiable assets and liabilities, as well as the goodwill, must be allocated to the buyers CGUs at the time of purchase. Goodwill is therefore allocated to those CGUs that are likely to profit from the expected synergistic benefits of the business combination regardless of whether other assets or liabilities have been allocated to these CGUs (IAS 36.80) The CGUs or groups of CGUs to which goodwill is allocated must represent the lowest management level at which goodwill is monitored for internal management purposes. However, they may not be larger than an operating segment in terms of IFRS 8. With regard to the number of CGUs selected for the goodwill impairment test the majority of respondents (81%) identified 10 CGUs or less. This is in line with results from the European survey, with 75% of their respondents identifying a maximum of 10 CGUs or less.

14 11 Cost of Capital and Impairment Testing Study 2011 Fig 5: Number of CGUs % % <5 6<10 15% 11.5% 7.7% 4% 0% 0.0% 0% 0% 0.0% 11<15 16<20 21< The differences in CGU numbers are more distinct for the asset impairment test, with approximately 95% of respondents identifying asset CGUs of 10 or less when performing asset impairments. A minority of respondents identified as many as 60 CGUs for their asset impairment test. 3.2 How recoverable amount is determined and which valuation method is used According to IAS 36.18, the recoverable amount is the higher of either the fair value less cost to sell or the value in use. If the first value measured already exceeds the carrying amount, it is not necessary for companies to measure both value in use and fair value less costs to sell (IAS 36.19). This gives companies the latitude to select which valuation concept they wish to adopt and which valuation concept they wish to use in the first step. This raises a question of what criteria should be used in selecting between these valuation approaches. Both concepts are based on different valuation assumptions which must be considered in performing the valuation, together with separate advantages and disadvantages in terms of feasibility and the amount of work required. The value in use reflects value from the the perspective of the company using the asset or CGU. As a result, the income approach is applied. In determining the cash flows, a company using this approach must consider the real synergistic benefits between CGUs and assets in the entity. Furthermore, cash flows from future capital expenditure that will improve or enhance the asset s performance, or restructurings to which the entity is not yet committed are excluded when using this approach. Finally, cash flows from financing activities and tax cash flows must be excluded from this approach. In comparison, the fair value less cost to sell approach is more closely associated with the market price or value derived from a market for an asset or CGU. Therefore, in utilising this approach it must first be determined if a market based method can be used. A market based method is usually difficult to apply because such information is not normally available for valuing specific CGUs. In these cases the income approach may also be used to determine the fair value less costs to sell. To this end, as opposed to the value in use approach, when determining the relevant cash flows, real synergies not available to the typical market participant, must be excluded.

15 Cost of Capital and Impairment Testing Study Essentially, each company must understand the requirements and implications of the different valuation methods in arriving at their decision as to which approach to take in each individual case. Important questions that every company should consider when performing an impairment test include: do we have sufficient, reliable market data to perform a market based valuation? Which adjustments must be made to the budgets if the income approach is selected (i.e. to determine the value in use or fair value less costs to sell)? Is it possible to perform these adjustments reliably with sufficient justification? In line with the results of the European survey for 2009/10 (85%), over 80% of South African respondents have derived the recoverable amount using either the value in use or the fair value less cost to sell approach. A small number of respondents () calculated both approaches. Of the total responses, the value in use was the most consistent method adopted with 65% of respondents applying this method exclusively. Only 19% of respondents exclusively applied the fair value less costs to sell approach. Fig 6: Applied measure of value Possibly one of the reasons for the higher percentage of companies only applying the value in use approach is attributed to the fact that, in light of the recent economic crisis, companies assume that a market based approach would lead to lower values than a value-in-use approach, which would potentially lead to impairment. According to IAS 36.25, the fair value less costs to sell is primarily determined by the market based method. As a result of the declining prices in the stock market, the fair value less costs to sell approach would be assumed to be lower than the carrying amount of an asset. However, in practise the fair value less costs to sell approach is regularly determined using the income approach due to the lack of comparable market data in respect of individual CGUs. As a result, it is important to compare the total fair value less cost to sell of all the individual CGUs to the market capitalisation of an entity to determine if these values are consistent with each other. In addition, when the recoverable amount of a CGU is determined on the basis of value in use and material parts of the entity are tested for impairment, a high level comparison between the market capitalisation, with adjustment for the market value of debt and any surplus assets, and the total value in use for all CGU s may provide some support that the assumptions and discount rate used are appropriate for the cash flows applied in the value in use calculation. There may be certain circumstances in which these amounts may differ with valid justification, such as market exaggerations in times of economic downturn, in which case market based values may well be below values in use. However, the entity s market capitalisation represents the equity market s view of the entity s operations and differences should therefore be carefully considered as to whether they are supportable. Our findings confirmed this assessment with 100% of our respondents who calculated values on both approaches confirming that the value in use was higher (European survey stated 71% of respondents stated value in use was higher). Against this background, an impairment test based on fair value less costs to sell will frequently result in a company recognising impairment. This further confirms why most respondents preferred the recoverable amount on a value in use approach. 65% 19% Approximately 65% of respondent utilise the fair value less cost to sell approach in determining the recoverable amount. Fair value less costs to sell Value in use Both Not applicable

16 13 Cost of Capital and Impairment Testing Study 2011 Background IFRS Which valuation methods are used to specify the recoverable amount? According to IAS 36.18, the recoverable amount is the higher of either fair value less costs to sell or value in use. It represents the amount that a rational investor would obtain from an asset/cgu from its continued use. The company would compare the value from the further use (value in use) with a price recoverable from a sale to a third party. How is the fair value less costs to sell determined? Fair value less costs to sell is the amount obtainable from the sale of an asset or CGU in an arm s length transaction between knowledgeable, willing parties, less costs of disposal (IAS 36.6). This is considered from the perspective of a typical market participant. The costs to be deducted are legal fees or similar transaction costs, transport costs as well as expenses incurred to make the asset of CGU ready for sale (IAS 36.28). In practice, costs to sell are often determined at one to two percent of fair value as a simplified method According to IAS 36.25, market based methods are preferred when determining recoverable amounts for the fair value less costs to sell approach. Accordingly, there must be an active market for the asset and/or the CGU or at least for a comparable asset and/or CGU, whose market price could be applied to the asset or the CGU. If there are no such market prices, then the income approach is to be used In utilising the income approach, it must be ensured that all main planning parameters (e.g. price and volume trends, profit margin trends etc.) are not determined by the internal perspective of management but are to be substantiated by observable market data (industry reports, analysis reports, peer group analyses)

17 Cost of Capital and Impairment Testing Study It would appear that the question in our survey relating to which valuation method is most commonly used under value in use or fair value less costs to sell was not well understood based on the responses received. Respondents indicated that most preferred the equity method of valuation under these approaches. Equity method refers to cash flows discounted to an equity holder level at a cost of equity discount rate whilst entity/wacc method refers to cash flows discounted to equity and debt holder level discounted at a WACC discount rate. The equity approach is used predominately by banks and insurers, since financial liabilities are considered part of their operational activities. We therefore believe that no conclusions should be drawn from the responses to this question. The results from the European survey revealed that 71% of their respondents chose the entity/wacc method for value in use and fair value less costs to sell versus the 27% (value in use) and 15% (fair value less cost to sell) respectively for the South African respondents. We feel that the results from the European survey are more reflective of what occurs in practice, even in the South African environment. The large number of Other responses for the fair value less cost to sell (42%) is due to respondents not using these methodologies and answering Not applicable therefore supporting our view that perhaps the question was not properly understood. Fig 7: Valuation method used The multiple based approach was the least utilised method with no respondents using this approach for the fair value less cost to sell approach and with a minority (4%) of respondents using this approach for the value in use calculation. This would not be in line with IAS 36 which requires the use of the income approach. Overall, the lack of use of market based methods such as the multiple approach is attributed to depressed market prices brought about by the financial crisis as well as the lack of data on which to base the method. Overall the discounted cash flow approaches were the most significant valuation methodologies used % % 27% 42% Equity method 15% Entity WACC method 4% 0% Multiples based approach Other 2011 KPMG Services (Proprietary) Limited, a South African company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. Printed in South Africa. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. mc6734

18 15 Cost of Capital and Impairment Testing Study Balance sheet items included when determining the carrying amount After determining the recoverable amount of an asset or CGU it is then compared to the equivalent carrying amount on the balance sheet in order to determine if an impairment loss should be recognised. The carrying amount of a CGU should be determined in a way that is consistent with how the recoverable amount of the CGU is determined, referred to here as an equivalence principle. For example, if the cash flow projections include cash outflows in respect of recognised liabilities, or inflows in respect of assets that generate cash flows independently, then the carrying amount of the CGU that is used to determine the impairment loss should include the related assets and liabilities. 69% of respondents made an adjustment to the net asset value in determining the carrying amount. 31% of respondents made no adjustments. In this regard, it is important to consider whether the equivalence principle has been thoroughly considered. Of those respondents who made an adjustment 5 incorporated the working capital in the calculation of the carrying amount. Only if cash flow projections are adjusted to exclude the realisation of working capital balances, should the carrying amount of the CGU exclude working capital. However, even if working capital balances are not included in the carrying amount of a CGU, working capital cash flows related to amounts arising after the valuation date need to be reflected in the valuation analysis. 17% of respondents, who made an adjustment to the carrying amount, included their pension provisions in the calculation of the carrying amount. If this is the case, the equivalent cash flows must be reduced by the payments to the pension funds in determining the recoverable amount. Another aspect of the equivalence principle relates to deferred taxes from prior purchase price allocations. The higher the value of assets for tax purposes the higher the impact on the cash flows through the allowances for tax and the resultant tax savings. Most companies who made an adjustment (92%) do not include the deferred taxes from the purchase price allocation in the carrying amount. In this instance it is important to consider whether tax allowances and tax effects have been appropriately dealt with. In order to ensure that tax losses carried forward at the date of the impairment test do not distort the determination of the value in use, they should be excluded both from the carrying amount of the CGU and the cash flow forecasts. This was supported by the inclusion thereof by only 17% of respondents who made an adjustment. However, if the CGU forecasts losses, these can be included when determining cash flows. These findings are broadly in line with the results of the 2009/10 European survey, except for the inclusion of working capital in the carrying amount, which was more widely used with 92% of European respondents including it.

19 Cost of Capital and Impairment Testing Study Fig 8: Adjustments made to the carrying amount % 17% 10 0 Working capital Pension provisions Deferred taxes of prior purchase price allocations Tax losses carry-foward Background IFRS What is the composition of the carrying amount? When measuring the carrying amount of a CGU it is necessary to ensure that those assets which are included are also included in the cash flows from the basis for which determining the recoverable amount (equivalence principle, see IAS and 79) According to IAS assets and liabilities pertaining to income taxes, such as deferred tax assets and liabilities, tax refund claims or tax liabilities and provisions are not to be considered in the carrying amount of a CGU or in the cash flows of its recoverable amount. Only future set off possibilities that arise from forecast losses of the CGU in particular years, and which are balanced in the planning horizon by carry forward and thus are not subject to IAS 12, are to be considered However, deferred tax liabilities computed as a result of a purchase price allocation may be considered in the carrying amount in order to ensure consistency, in which case, when determining the cash flows to be discounted, expected actual tax payments according to regulations should be taken into account Financial liabilities are not allocated to a CGU in accordance with IAS 36.76(b). Pension provisions are therefore not considered in the carrying amount of the CGU since they represent an external financing component. Pursuant to IAS for example, trade receivables and payables as well as other obligations (working capital) may be included in the carrying amount for practical reasons.

20 17 Cost of Capital and Impairment Testing Study Measurement of cash flows Recoverable amount calculated using the discounted cash flow ( DCF ) method represents the present value of the future cash flows expected from the CGU. The cash flows are usually derived from the company budget prepared for the entire group. This may, however, possibly be modified depending on whether value in use or fair value less costs to sell is being applied. The equivalence principle which was discussed under section 3 is of key importance in determining the cash flows and the cost of capital as well as in calculating the recoverable amount and carrying amount. In view of this, the following issues are discussed: When is the group budget prepared and what modifications are made to the budget for the impairment test? Which principles are applied to the currency translation? (IAS 36.54) What is the basis for computing the tax expense for measuring cash flows? 4.1 Group budget preparation and modifications made to the budget for the impairment testw IAS requires the measurement of the value in use to be based on a company s current budget or management budget. The standard refers to the current market prices or comparable market transactions for the fair value less cost to sell calculation. As a result, we asked respondents to provide information regarding the timing of the budget preparation for the purposes of an impairment test. Approximately 80% of respondents prepared their budget a maximum of 3 months before performing the impairment test. Only 12% of respondents prepared a budget more than 6 months before the impairment test. For the 2009/10 European results, 90% of their respondents prepared the budget a maximum of 3 months before the impairment test. Approximately 80% of respondents prepared their budget a maximum of 3 months before performing the impairment test. Fig 9: Time of preparing group budget 50 42% % 0 Up to one month before the impairment test 2 to 3 months before the impairment test 4 to 6 months before the impairment test 7 to 9 months before the impairment test More than 9 months before the impairment test

21 Cost of Capital and Impairment Testing Study Depending on the valuation concept, IAS 36 has specific requirements in determining the recoverable amount for an impairment test. As a result, we asked respondents if either the group budget, a modified group budget or if a separate budget was used to calculate the value in use or fair value less costs to sell. The majority (5) of respondents (European survey 65%) stated that they used their unmodified budget for the purposes of the impairment test, with only 19% of respondents preparing a separate budget (European survey: 5%) and 23% stated that they do make adjustments to the group budget. We asked how the financial crisis had affected the budgets prepared by the participants. The majority (42%) stated that no adjustment had been made to their original budget, with 23% of respondents revising their budgets completely as a result of the crisis. The European survey indicated that the most significant adjustments that their respondents made was to perform a scenario analysis (51%) in response to the financial crisis, while only 19% of South African respondents performed a scenario analysis. Fig 10: Use of group budget for the goodwill impirment test Total Fig 11: Impacts of the financial crisis on the group budget % 23% Budget is completely revised 5 19% 42% No revision of the budget Yes, unchanged group budget is allocated to the CGUs Yes, the group budget is first modified and the allocated No, separate budget for impairment testing purposes Bottomup adjustmen ts to material value drivers 19% Calculation of scenario analysis Detailed horizon is exten ded to include the macroeconomic recovery Background to IFRS Which adjustments are to be made to the budget for the value in use and fair value less costs to sell? The purpose of measuring value in use is to determine the value of an enterprise from the continued use of its relevant asset/respective CGU. Cash flow estimates must reflect the asset in its current condition. Therefore, it is necessary to ensure that when measuring value in use, the estimated cash flows exclude future capital expenditure to which the entity is not yet committed. (IAS (b), IAS ff) If changes in future cash flows are expected due to new investments that have already been started as of the valuation date for which material outflows of funds have already occurred, then these cash flows changes are to be considered when measuring an impairment (IAS 36.48) These corresponding budget elements are, however, not to be eliminated when measuring fair value less costs to sell. Rather, forecast assumptions are to be reviewed when measuring fair value less costs to sell to determine whether they conform to market expectations. Accordingly, a management budget may not (in contrast to value in use approach) be adopted without further examination. Instead key assumptions, such as sales growth, profit margin development and long-term growth, should be derived from market expectations (e.g. industry or analyst reports). The enterprise-specific synergies not available to a typical potential buyer, are also not considered in the fair value less costs to sell approach.

22 19 Cost of Capital and Impairment Testing Study Principles applied in the currency translation International companies are invariably affected by the effects of foreign currency translations if they generate cash flows in a currency different from their reporting currency. If this is the case a company has two options: Discount the foreign currency cash flows at a foreign currency discount rate and then convert the present value at a spot rate to the reporting currency Convert foreign currency cash flows into the reporting currency and then discount these cash flows at a local discount rate. Of the respondent companies that require foreign currency translations, 74% prefer to discount foreign currency cash flows using a foreign currency discount rate and convert the present value at the spot rate to the reporting currency (70% where the CGU generates a single foreign currency and 7 where the CGU generates several foreign currencies). The results of the European survey are in contrast to this, with 63% of their respondents preferring to convert their cash flows into the reporting currency and then discounting them at a local discount rate. Fig 12: Exchange rates Fig 13: Currency translation Fair value less cost to sell 92% Cash flows discounted in foreign currency and present value translated Cash flows converted into reporting currency and discounted at a local rate. If a company chooses to first convert its cash flows into its reporting currency, a question arises as to which exchange rates would be used for this translation. In terms of the actual exchange rate used, 5 of respondents utilised the spot rate while 42% used the exchange rate for the group. The European survey reveals that 64% used the exchange rate for the group, 14% used the forecasted planning exchange rate and used the spot rate to convert their cash flows from the foreign currency to the reporting currency. Fig 14: Exchange rates used for conversation Value in use 5 54% 46% 42% % Spot rate Given exchange rate for the group 74% Cash flows discounted in foreign currency and present value translated Cash flows converted into reporting currency and discounted at a local rate.

23 Cost of Capital and Impairment Testing Study Background IFRS What is the rule for handling currency differences within the CGU? If there is a difference between the reporting currency i.e. the currency in which the carrying amount is presented, and the currency in which the corresponding cash flows occur, then a corresponding translation is required for the impairment test. The general rule is first to discount the expected cash flows in the currency in which they occur (IAS 36.54). Here attention must be paid to the fact that individual inflation expectations in each currency region, as well as other factors, lead to different costs of capital. Therefore, discounting the cash flows in the corresponding currency region should be based on a reasonable cost of capital. The resulting recoverable amount is then translated into the reporting currency at the spot rate on the day of the impairment test and compared with the carrying amount More extensive consideration is necessary if a CGU generates cash flows in several currencies. In this case, it is advisable to first translate the different expected cash flows into the reporting currency. Forward rates are recommended, corresponding to the forward forecast year. For example, the cash flows of the third planning year should be translated at the corresponding three year forward rate. If the forward rate of the reporting currency is used then the influences mentioned which lead to individual costs of capital for each currency region is considered. The cash flows expressed in the reporting currency can be discounted with the cost of capital for the reporting currency region without further adjustments. Finally, the resulting recoverable amount must then be compared to the carrying amount Only under special circumstances should constant translation rates for future foreign currency cash flows be used. Particularly when deriving the cost of capital, the consistency of the inflation expectations included in the cash flows, should be ensured.

24 21 Cost of Capital and Impairment Testing Study Basis for computing the tax expense for measuring cash flow We posed a question to respondents regarding the tax rates applied by companies who apply after tax calculations for determining recoverable amounts. Overall, 39% of respondents utilised the corporate tax rate which is adjusted for STC/ withholding tax, with 23% using the group tax rate. The remaining 3 of respondents equally used the country specific marginal tax rate (19%) or an individual CGU tax rate (19%). Of the European respondents, 40% used the group tax rate while 3 chose the individual tax rate applicable to each CGU. Fig 15: Applied tax rate 19% 19% 23% 39% Country specific marginal tax rate Individual tax rate of the CGU Group tax rate Corporate tax rate adjusted for STC/ withholding tax Background IFRS What is important in determining the corporate tax rate when computing value in use and fair value less costs to sell? If the enterprise bases its calculation on an after tax view, then the tax effects should also be considered in the cash flows. If there are tax effects, individual company circumstances, e.g. from loss carry forwards, should not be considered. A corporate tax rate should be determined, both for measuring fair value less cost to sell and for measuring value in use, which corresponds to the tax rate for a typical enterprise operating at the same location. It makes sense therefore to define a tax rate for each CGU If foreign sales are generated by a CGU, then a corresponding typical tax rate has to be determined for these countries. Ideally the foreign tax rate must be weighted with the EBIT (Earnings before Interest and Tax) generated in the respective country, and from that a tax rate can be determined that can be used both for determining of the free cash flows and for determining the cost of capital.

25 Cost of Capital and Impairment Testing Study

26 23 Cost of Capital and Impairment Testing Study Determination of the cost of capital The cost of capital plays a significant role if the DCF method is used. Academic literature provides numerous methods for determining the best approach to calculate a cost of capital in practice, each with a different theoretical foundation. In light of this, we investigated how companies determine their cost of capital. In addition, we focussed on the practical implementation of IAS 36 in performing an after-tax calculation. We posed the question of how a company derives its cost of capital as follows: In what detail has the cost of capital been derived for the impairment test and which methods were used? How is the requirement of the IASB dealt with to perform the impairment test on a pre-tax basis? 5.1 Detail applied in the cost of capital determination Academic theory suggests a variety of approaches in determining the cost of capital of a company. These include (amongst others): The capital asset pricing model ( CAPM ), the arbitrage pricing theory ( APT ), real option pricing and the market-derived capital asset pricing model ( MCAPM ). Overall, 72% respondents chose the CAPM approach. The European survey had 97% of respondents utilising this approach. 12% of respondents relied on their historic cost of capital while the European results revealed only 2% of respondents relied on this approach. A further pertinent question raised was regarding what level each company derives their cost of capital at i.e. CGU specific or group wide. In only specific cases it may be appropriate to use the same cost of capital of capital for all CGUs. However, as soon as these CGUs have different risk profiles, which may be a result of a separate regional focus or different operating activities, only a CGU-specific or asset specific derivation is appropriate. Our finding indicates that 54% of South African firms calculate a separate WACC per CGU while 46% do not. The European results reveal that 64% of their respondents calculate a separate cost of capital per CGU. Fig 16: Concepts used to determine the cost of capital 73% 12% 15% CAPM Cost of capital as usually incurred in the past Other Fig 17: Determination of CGU-specific cost of capital Yes No 46% 54% 72% of respondents utilise the CAPM to determine the cost of capital.

27 Cost of Capital and Impairment Testing Study Performing a pre-tax calculation Not surprisingly, for fair value less costs to sell, 92% of respondents use an after tax approach as the standard does not require any pre-tax computation for this method. In addition, market prices result from post-tax calculations. However, for value in use it appears that 54% of respondents use an after tax methodology, while a further 46% use an after tax approach in a first step but then determine a pre-tax figure in a second step. For the European survey, the respondents favoured the after tax approach (fair value less costs to sell, 93%, and value in use 85%). In performing the calculation to arrive at a pre-tax cost of capital for value in use, a small number of respondents make use of goal seek and grossing up techniques ( and 12%). The greatest proportion of respondents (46%) indicated that they calculate only a pre-tax cost of capital but it is unclear how they would go about determining this due to the lack of observable pre-tax cost of capital data. It is noteworthy that 35% of respondents indicate that they only calculate a posttax cost of capital. IAS 36 requirements require the computation and disclosure of a pre-tax rate. For respondents who make use of a fair value less costs to sell method of valuation, 3 use only an after tax cost of capital which is correct since IAS 36 only requires the pre-tax view for value in use calculations. make use of grossing up techniques. In this instance it should be ensured that the strict conditions for the derivation of cash flows should be adhered to in order to obtain the correct result. A small percentage () of respondents use goal seek techniques. Fig 18: Use of after tax approach Fair value less cost to sell 92% Cash flows after tax Cash flows before tax Fig 19: Iteration calculation to pre-tax cost of capital VIU FVLCS Value in use Goal seeking 54% 46% % Grossing up 46% 46% Without recalculation (before tax) 35% 3 Without recalculation (after tax)