Application of an appropriate discount rate when performing an impairment test of assets

Application of an appropriate discount rate when performing an impairment test of assets

When conducting an annual audit, significant issues may emerge that could substantially affect a company's financial results. One of the most common concerns among business owners is the impairment testing of assets. But why is it concerning? Asset impairment directly impacts the company's profit and loss statement by increasing expenses, which, in turn, reduces equity on the balance sheet. This reduction can limit the company’s ability to pay dividends, weaken its equity ratio, and, in severe cases, trigger a breach of bank loan covenants.

In practice, business owners frequently express confusion when auditors recommend reducing the value of assets recorded on the balance sheet. This reaction is understandable. It can be difficult for an entrepreneur to grasp the necessity of such adjustments when the business appears healthy — revenues are covering expenses, bills are paid on time, and future prospects seem stable. Also, it's important to recognize that asset impairment is an accounting adjustment that doesn’t directly affect the company’s cash position.

By preparing in advance for an asset impairment assessment and understanding the factors that influence this process, business owners can reduce uncertainty and maintain greater control. In most cases, discussions with auditors focus on two key areas: the discount rate applied and cash flow projections. This article will focus on the application of the discount rate, a critical component in determining the fair value of assets and ensuring accurate financial reporting.

Discount Rate: Theory and Practice

Surprisingly often, even financial professionals lack an in-depth understanding of the nature of the discount rate. While general knowledge about its calculation is widespread, nuances that can significantly impact the results of an asset impairment test are often overlooked.

In essence, the discount rate is the rate used to discount the future cash flow of an asset to determine its present value. Mathematically, a simplified example looks as follows:

Present value of cash flow = next year's cash flow / (1 + rate).

The concept of the discount rate is based on two assumptions:

1. Money loses value over time (e.g., due to inflation), so 1 euro today is worth more than 1 euro tomorrow.
2. Investments are risky – higher risk requires higher returns. For example, airline bonds are riskier than bank deposits, and this risk is reflected in higher interest rates.

Calculation of the Discount Rate

In practice, the discount rate is often selected intuitively or based on prior experience, with assumptions like 7%, 10%, or even 25%. While this approach might suffice for quick, informal evaluations, professional asset valuation requires discount rates that are carefully calculated, reflecting a thorough understanding of market conditions and the specific risk profile associated with the asset.

A classic form of the discount rate is the weighted average cost of capital (WACC), calculated using the formula:

WACC = Re x E + Rd x D, where Re – cost of equity; E – proportion of equity in the balance sheet; Rd – cost of debt; D – proportion of debt in the balance sheet.

Cost of Equity

The cost of equity is calculated using the formula:

Re = risk-free rate + β x market risk premium + asset-specific risk premium.

The risk-free rate is usually based on long-term government bond yields, such as those of Germany or Latvia; if using Western European rates, an adjustment for investment risk in Latvia must be applied. Beta is a coefficient that describes the asset’s risk level compared to the market. The market risk premium reflects overall stock market volatility. The asset-specific risk premium accounts for additional risk applied if the asset is riskier than the industry average. For Latvian companies, this could range between 2–5%, depending on the evaluator.

Cost of Debt

The cost of debt is calculated using the formula:

Rd = loan interest rate x (1 - corporate income tax (CIT) rate).

The cost of debt should be based on the company's actual loan terms if available. Otherwise, market average rates can be used. In Latvia, these are compiled by the Bank of Latvia (LB). The recommended CIT rate to apply is the current Latvian rate of 20%.

Uncertainties Regarding Debt and Equity Ratio

Ideally, the calculation should use the actual debt-to-equity ratio of the assessed company. However, quick fix valuers (especially for real estate) often are observed to assume a 1:1 ratio instead.

Deviations are permissible if convincingly justified. For example, a company may currently finance investments with equity, while industry peers use a mix of equity and debt. Thus, the company aims for an appropriate capital structure, and an increased debt proportion can be used in the WACC calculation compared to the actual capital structure.

Industry-specific capital structure parameters can be extracted from other companies’ annual reports (available from the Company Register) or the "Damodaran" database.

Asset Impairment is an Accounting Entry That Does Not Directly Reflect in the Company’s Bank Account

Risk-Free Rate

Classically, long-term government bond yields from highly secure countries, such as Germany (AAA rating, euro currency), or Latvia’s long-term bond rate, are used. If non-Latvian rates are used, an adjustment for investment risk in Latvia must be applied – such data are available in "Damodaran" databases.

Beta

At a high level, statistical methods are used to calculate the risk level of a comparable company. The calculation is based on the volatility of comparable companies' stocks relative to market volatility. If the beta coefficient is below 1, the risk level is lower than the overall stock market; if above 1, it is higher. In practice, beta is taken from publicly available "Damodaran" databases or sources such as Finance.yahoo.com, selecting the industry relevant to the evaluated company.

If using a specific company’s debt-to-equity ratio in the valuation, an unleveraged beta should be used and adjusted to reflect the company's actual debt and equity ratio.

Borrowing Rate

Often, WACC calculations use an arbitrarily chosen debt cost, which is incorrect. As mentioned earlier, a company’s financial statements, loan, and lease rates should be examined. If unavailable (the company has not yet borrowed but plans to), the Bank of Latvia's compiled debt rate statistics should be consulted.

Taxation Considerations

A common question is whether to apply pre-tax or post-tax cash flows in WACC calculations. Traditionally, WACC is calculated as an after-tax capital cost, thus discounting cash flows after CIT payments.

For asset sufficiency valuation, pre-tax cash flows should be discounted, requiring the adjustment of the discount rate from post-tax to pre-tax:

WACC (pre-tax) = WACC (post-tax) / (1 - CIT rate).

Additionally, applying CIT raises concerns – some prefer calculating cash flows without CIT expenses (yielding more positive cash flows) but discounting with a post-tax (lower) WACC. This is incorrect – calculations must apply Latvia’s CIT rate because:

1. At some point, the owner will pay dividends.
2. The CIT rate may change.

Timing of the Discount Rate Calculation

When assessing asset sufficiency for 2024, entrepreneurs argue that WACC is currently high due to expensive borrowing, but a lower rate should be used since it may decline in the long term. This is not allowed, as the discount rate is calculated at the asset valuation date – the last date of the financial year.

In conclusion, asset sufficiency tests are not complex, but differing interpretations of the same term – discount rate – can cause unnecessary disputes and concerns. It is crucial to remember:

1. The discount rate is calculable and justifiable, not arbitrarily determined.
2. Sufficient parameters exist to allow an entrepreneur, CFO, or accountant to justify their chosen formula.

An auditor will find it much easier to assess a company's arguments if they are reasonable and fact-based.