Careful consideration of the cashflow projections is essential in terms of the supportability and reasonableness of the calculations given the current market conditions. In particular, the projected cashflows need to be defensible based on what was known or could have reasonably been known at the reporting date of the conditions that existed as at that date.
Appendix A of IAS36 sets out two approaches that can be used to help determine present value:
1 The traditional approach, which uses a single cashflow projection, or most likely cashflow
2 The expected cashflow approach, which uses multiple, probability-weighted cashflow projections
Both above approaches can also be used by entities that report under FRS 102.
The expected cashflow approach to non-financial assets
Given the high degree of uncertainty due to the current conditions, it may be beneficial to
consider applying the expected cashflow approach as opposed to the traditional approach. Under the traditional approach, risk in relation to the cashflows is reflected in the estimation of the discount rate. Under the expected cashflow approach, the uncertainty about future cashflows can be reflected in the probability-weighted cashflow projections used, rather than in the discount rate.
The expected cashflow approach can, therefore, provide a better reflection of the range of possible future outcomes and can allow for both short- and long-term impacts. However, the probabilities that are applied to the cashflow projections equally need careful consideration and thought.
By using an expected cashflow approach, the financial impacts of COVID-19 can be modelled, however, it is not without complications.
Key items to consider in cashflow forecasting:
- How long and to what extent will revenues be impacted by COVID-19?
- What are the challenges to cash collection?
- Can cost savings be put into place?
- What government assistance will be available and for how long?
- When is it realistic to assume economic activity and the business financial performance may return to previous levels, if ever?
Determining discount rate
The discount rate used in a single predicted outcome approach may need to be adjusted to incorporate the uncertainty of the forecast cashflows associated with COVID-19. Management should ensure that appropriate risk is reflected in either the cashflows or the discount rate. Care should be taken not to double-count risk. If cashflows have been adjusted for the impact of the crisis then the discount rate should reflect those forecasts.
Many entities use the capital asset pricing model to determine the discount rate. One of the key elements is the risk-free rate that is generally based on the yield on government bonds. In many countries, the yield on long-term government bonds has decreased in the first quarter of 2020. For example, 10-year UK government bonds are at 0.23% on 30 April 2020 compared to 0.74% on 31 December 2019.
The decline in the risk-free rate does not, however, necessarily lead to a lower discount rate as there are potential increases in other inputs, such as the equity market-risk premium, that need to be considered together with, for example, possible increases in credit risk.
Supported valuation conclusions
Whichever approach management chooses to use to address possible variations in the expected future cashflows, ultimately the conclusion needs to be supported and to be reasonable, reflecting the expected present value of the future cashflows of the asset or group of assets being tested.
If you would like to discuss this further, get in touch with Michael Thornton.