Impact of Discounting Future Cash Flows for Impairment Calculating the true impa

Question

Impact of Discounting Future Cash Flows for Impairment

Calculating the true impairment value of an asset involves estimating the fair value of it. As you discussed last week, estimating an accurate fair value of an asset can be particularly challenging. In many cases, companies use different techniques to determine the level of impairment of their assets, such as discounting future cash flows. While the use of these methods can be subjective and require a heightened ethical sensitivity, it provides essential information for company managers and investors.

Write a 2- to 4-page paper explaining in detail the issues of discounting and not discounting future cash flows for impairment and how that impacts the calculation of impairment as well as how this calculation impacts the balance sheet. In your response, also analyze the ethical considerations related to discounting of future cash flows for impairment. Provide your position on whether it is ethical to 'not discount' future cash flows for impairment. Be sure to support your position.

Explanation / Answer

As per IAS 36, first of all the impairment test is required on asset (fixed assets) if the indicators of impairment exists. The Carrying amount and reoverable amount is compared. If the carrying amount is more than than the recoverable amount then the difference is recognised as impairment loss.

Further carrying amount means amount at which any asset or liability is placed in the blance sheet. Carrying amount is calculated using the formula:

Carrying amount = Historical cost - Accumulated depreciation - Accumulated Impairment

Recoverable amount is the higher of a) "Net Selling price" and b) "Value in use"

Net Sellinng price is calculate by reducing the expected disposal cost from Expected sales value (FV).

Concept of value in Use: Value in use means Present value of future cah flow. For the calculation of present value of future cash flows discounting menthod is used. Here cash flow includes cash flow from use of asset, cash outflow due to use of work of asset and terminal cash flow.

Assets are shown in the balance sheet on carrying amount and calculation of carrying amount requires the fiqure of accumulated impairment. Therefore the calculation of value in use and subsequently the value of recovarable amount has a direct impact on the value of assets shown in the balance sheet.

From the above details it is clear that discounting has a direct impact on impairement (as it helps is calculation of Recovarable amount) and also has impact on balance sheet (as it requires the carrying amount).

Ethical Considerations:

The discount rate must be pre-tax rate and not the post tax rate. The current market risk free discount rate shall be used for discounting the cash flows. Further there is an option of selection of rate from the followings: a) Entity WACC, b) Entity incremental borrowing rate, c) Other market borrowing rate. Entity can use different rate for different periods.

Future cash flows does not include: a) Cash flow which is independent from assets (receivables), b) Cash outflows that are recognised as liability (Payables), c) Taxation cash flow, d) Future restructuring cost not yet commited, e) Cash flows from financing activities, f) Cost incurred for future savings/reduction in cost.

As per my opinion and as per IAS 36, it is not ethical to "not discount" the future cash flows for impairment.

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