Impairment testing cash generating unit with leases (or impairment of leased assets) is about a right-of-use asset (leased asset) and such an asset will frequently be included in a cash generating unit to be tested for impairment. At initial recognition, the right-of-use-asset equals the recognised lease liability, plus any lease payments made at or before the commencement date, less any lease incentives received, plus any initial direct costs incurred by the lessee and an estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset and restoring the site on which the leased asset is located.

The most significant part of the right-of-use asset will often be the lease liability, which is the present value of the lease payments discounted at the interest rate implicit in the lease if this rate is readily determinable, or otherwise at the lessee’s incremental borrowing rate.

Therefore, the discount rate applied to determine the lease liability can have a significant effect on the carrying amount of the right-of-use asset at initial recognition. If the value in use is determined in an impairment test mechanically, ignoring the lease liability and related lease payments from both the carrying amount and the value in use of the cash generating unit, the following effects will occur when compared with the value in use with operating leases under IAS 17:

- The carrying amount of the cash generating unit will increase by the net present value of the future lease payments discounted at the IFRS 16 rate.
- The value in use of the cash generating unit will increase by the net present value of the future lease payments discounted at the discount rate used under IAS 36.

These two effects will usually have an offsetting effect. As a result, generally, there will be a limited effect on the impairment test, i.e., the amount of headroom or impairment calculated will not be substantially different.

However, if the IAS 36 discount rate (for example, a discount rate based on the weighted average cost of capital (WACC)) exceeds the IFRS 16 discount rate (for example, the lessees’ incremental borrowing rate), this will have a net negative impact on the results of the impairment test as the carrying amount of the cash generating unit will increase more than the value in use of the cash generating unit.

In practice, this may be seen as less of an issue as long it results only in a decrease in an existing headroom. However, this effect might as well result in an increase in the impairment charge calculated. From an economic perspective, the underlying business and cash flows have not changed, thus, it is difficult to justify why there would be an effect on the impairment test as a result of the discounting effect.

**The discount rate in determining the lease liability will frequently be lower than the discount rate used in the impairment test. If applied mechanically, this may result in what appears to be an immediate impairment or reduction in headroom.**

**Such a ‘mechanical’ immediate impairment or reduction in headroom should generally not be used in impairment testing.**

*What to do instead?*

The discount rate for a value in use model must be the pre-tax rate that reflects current market assessments of:

- The time value of money;
- The risks specific to the asset for which the future cash flow estimates have not been adjusted.

Because right-of-use assets will be included in the carrying amount of cash generating units, it may be appropriate to adjust the discount rate for the impairment assessment to consider the changed nature of the assets under IFRS 16 compared to IAS 17. Some of the arguments for this are set out below, which address the analysis from different angles, but all based on the same underlying principle.

**Argument 1 – Return on equity remains stable**

Generally, it makes sense to consider that the return on equity, as demanded by equity investors, remains unchanged. Assuming that investors were already aware of the operating leases and based their risk assessment thereon, such effects are already included in the required equity return.

However, since the lease liability is now regarded as debt, the debt/equity ratio increases and – given that debt returns are generally lower than equity returns – the discount rate based on WACC would decrease if market participants are all impacted to the same extent.

**Argument 2 – Composition of assets has changed**

Effectively, the composition of the asset base has changed. In addition to the assets included in the impairment test under IAS 17, now right-of-use assets are also included. One of the concepts is that the WACC (return requirement assessed from a financing perspective) is equal to the weighted average return on assets (WARA) (return requirement assessed from an asset perspective).

The asset base increases with the right-of-use assets under IFRS 16. Since it is generally expected that, due to the lower risk inherent in the right-of-use assets, the return on right-of-use assets is lower than the WARA of the cash generating unit before use of IFRS 16, the WARA is lower with the inclusion of a right-of-use asset under IFRS 16.

**Argument 3 – ****Cash flows variability has decreased**

The discount rate for value in use should reflect the risks of the cash flows. Since the lease payments relating to operating leases under IAS 17 are no longer part of the free cash flow used in the value in use calculation, the gross free cash flows will increase. Subsequently, this implies that the relative volatility of the cash flows has decreased. For example, assume a free cash flow before IFRS 16 of 100.

If revenue increased by 10, this has an impact on the free cash flow of 10%. When the operating lease payment amounted to 40, the free cash flow under IFRS 16 is 140, which means that an increase of revenue of 10 would now only have an impact of 7.1% on free cash flow. If the (relative) volatility of the cash flows decreases, this implies a lower risk and, hence, the corresponding discount rate should decrease.

**Conclusions Impairment testing cash generating unit with leases**

The composition of the asset base being tested for impairment, and the associated cash flows included in the value in use calculation, have changed and the discount rate used in determining value in use should be recalculated to ensure consistency. As a result, the discount rate will generally be somewhat lower than the IAS 36 discount rate used when operating leases were off- balance sheet under IAS 17.

Such decrease does not result from any future anticipated change in behaviour or risk perception of market participants, but, instead, remains based on market conditions at the measurement date and results from the change in composition of the assets (recognition of right-of- use assets) and change in cash flows (lease payments as financing cash flows instead of operating cash flows).

Below is a simplified example of an impairment test that shows the situation pre-IFRS 16 and post-IFRS 16 and the effects of adjusting the (pre-tax) discount rate. The CGU has a finite life of five years, with no residual value. The lease term and useful life of the right-of-use asset are also five years.

*Impairment test after IFRS 16 Leases*

*Impairment test after IFRS 16 Leases*

Below is a simplified example of an impairment test that shows the situation of a impairment test after IFRS 16 Leases and the effects of adjusting the (pre-tax) discount rate. The CGU has a finite life of five years, with no residual value. The lease term and useful life of the right-of-use asset are also five years.

*Pre-IFRS 16*

Assumptions underlying the example:

- Five-year operating lease of 30 per year commencing at the start of year 1; cost of operating lease is relatively significant compared to the overall free cash flow (FCF).
- The carrying amount of the CGU includes goodwill; for a finite life time period, which is rare, although it may occur in practice that a CGU has goodwill while at the testing date the CGU has a limited life. The principles of the example would be the same if this were not goodwill, but a finite life intangible or PP&E, for example.
- Calculations are made on a pre-tax basis.
- This base case assumes, for the purposes of illustration, a business which is fully equity financed. The principle of the example would be the same if this were not the case. Under IAS 36, the discount rate must not be determined based on the capital structure of the entity, but on the capital structure typical in the industry. In this scenario, it is assumed that both the entity’s and industry’s capital structures do not differ and the extent to which the entity makes use of operating leases is in line with the industry.
- For illustrative purposes, working capital movements and capital expenditures are assumed to be nil.

*Post-IFRS 16, same discount rate as pre-IFRS 16*

The example below is based on the same information and the same date as the above example, but now applying the accounting principles of IFRS 16:

*Analysis: *

- The headroom post-IFRS 16 with an unadjusted discount rate has decreased by 19 (21 vs 2):
- The carrying amount increased by 133 (net present value of lease payments discounted at incremental borrowing rate of 5%) from 370 to 503.
- The VIU before deducting the carrying value of the lease liability increased by 114 (net present value of lease payments discounted at 12%) from 391 to 505.
- Whether or not the lease liability is deducted from both the carrying amount of the CGU and the VIU will have no impact on the headroom as both would reduce by 133.

- In this scenario, the discount rate has remained at 12.0%. Implicitly, this means that the cost of equity inherent in the discount rate derived from WACC has been adjusted to 14.5%. The discount rate in this situation has been calculated based on the debt/equity-ratio using the market values of debt and equity, under the assumption that the market value of the lease liability is equal to its book value and the market value of equity is equal to the VIU less the value of the lease liability.

*Post-IFRS 16, adjusted discount rate*

*Analysis:
*

- The adjusted discount rate, derived from WACC, has been calculated based on the debt/equity-ratio using the market values of debt and equity, under the assumption that the market value of the lease liability is equal to its book value and the market value of equity is equal to the VIU ignoring lease payments, less the value of the lease liability.
- This calculation arrives at an adjusted discount rate of approximately 10.2%, which results in headroom in the impairment test equal to the headroom under IAS 17.
- The decrease in the discount rate is relatively high due to the significance of the operating lease payments compared to the free cash flow.
- All of the calculations above are on a pre-tax basis in line with the requirements of IAS 36 for VIU. In practice, many impairment tests are done on a post-tax basis, as market data for the equity returns and discount rate is generally available only on a post-tax basis. Using appropriate assumptions and modelling, the outcome on a post-tax basis should be similar.
- As mentioned earlier, under IAS 36, the discount rate must not be determined based on the capital structure of the entity, but on the capital structure typical in the industry. In this scenario, it is assumed that the entity’s and industry’s capital structures do not differ and are impacted by IFRS 16 in the same way.
- Whether or not the lease liability is deducted from both the carrying amount of the CGU and the VIU will have no impact on the headroom as both would reduce by 133.

As can be seen from the above illustrative example, there is justification for a change in the discount rate to be applied for impairment calculation purposes.

Also read: Impairment and Leases

### Impairment test before and after IFRS 16

### Impairment testing cash generating unit

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